A. Recall that the Total Coverage Inc. 2006 projections assume that sales grow at 5.94%, that cost of goods sold grows at the sales growth rate, and inventory days increase from 75 days to 90 days, a 15 day increase.

We start with the formula for the calculation of inventory days:

• (inventory balance) / (COGS ex depreciation) x 365 = inventory days

We know, given the formula, that:

• (inventory balance) / (COGS ex depreciation) x 365 = 90

Therefore:

• inventory balance =  ((COGS ex depreciation)) x (90/365)

Projected COGS is the 2005 COGS times 1.054.  Therefore:

• Projected Inventory Balance = (($1,405,512) x (1.0594)) x (90/365) = $367,151

The 2005 inventory balance was $287,342, and so the projected increase in inventory is:

• $367,151 –  $287,342 = $79,809.

To determine how much of that increase is attributable to the 15 day increase, we compute what the inventory balance would have been if days had not increased, i.e., if days had remained at 75 days, and compare that number to the projected  inventory balance at 90 days.  If days had stayed the same, then inventory would have grown at the sales growth rate of 5.95%:

• 2005 inventory of ($287,342) x (1.0594) = $304,410
• The 15 Day Increase drains away $62,741 of cash flow in 2006
• 2006 inventory balance @ 75 days = $304,410
• 2006 inventory balance @ 90 days = $367,151
  
• difference between 75 days and 90 days = $62,741 cash drain

Q. What does it mean to hold income statement accounts constant?

A.  If we are holding the gross margins constant at 56.75%, that means that the Cost of Goods sold will grow by whatever the sales growth rate is.  If we had a particular amount from a miscellaneous account such as $10,000 of other income, and we let it grow by the sales growth rate, then that amount itself would grow by the projected sales growth rate. 

In this case, if sales growth were 5.94%, $10,000 would increase to $10,594.  Once again, it is important to understand your software system and how it accounts for the miscellaneous accounts without your intervention. 

Most of the software systems focus the user on the Business Drivers.  And when we view the results, it is common to overlook the miscellaneous accounts.  So find out how the system handles balances for miscellaneous accounts, because the influence of those accounts may be surprising.

Q.  How do you extrapolate fixed asset spending going forward?

A.  Fixed asset spending is difficult to project. It happens in discontinuous bites for most companies.  It does not move in lock-step with sales growth.  Fixed asset spending decisions are made on a discrete basis. I.e., there might be a large expenditure for fixed assets one year, and virtually nothing the next. 

Our advice is to ask management for their budget for fixed asset spending and then use it.  We don't have that luxury with Total Coverage, Inc, and so we used a nice easy number, $100,000, which is greater than the $73,000 for 2005 and makes sense for two reasons.  First, as sales grow, it is logical to believe that fixed asset spending will increase.  Second, it seems best to error on the high side, and $100,000 likely does that.