Solution to Case 01
Financial Analysis and Forecasting
Growing Pains
Questions
1. Since this is the first time Jim and Mason will be conducting a financial forecast for
Oats’ R’ Us, how do you think they should proceed? Which approaches or models can
they use? What are the assumptions necessary for utilizing each model?
Jim and Mason should begin their planning with a reasonable sales forecast. The sales forecast
ought to be based on clearly stated assumptions about future economic conditions. Next, they
should prepare pro forma financial statements by either assuming that the key items vary
proportionately with sales or remain constant (as the case may be). Based on their asset
utilization rate, they would be able to determine the asset requirements for growth. Some of
the funds required to finance growth would be raised from spontaneous sources such as
accounts payables and accruals and from future retained earnings. The remaining funds
necessary for growth could then be raised from external sources such as new debt and stock
offering.
Jim and Mason can use one of the following approaches:
1.
Pro Forma Approach – where most of the income statement and balance sheet
items are assumed to maintain a constant proportion to sales, but individual
items can be forecasted using statistical techniques and feedback effects
involving changes in interest costs etc. can be included.
2.
EFN Formula Method – which is simple to use but does not allow the
inclusion of feedback effects.
2. If Oats’ R’ Us is operating its fixed assets at full capacity, what growth rate can it
support without the need for any additional external financing?
Here are the steps:
1.
Calculate the percent of sales figure for each balance sheet item, as well as the net
profit margin, and the retention rate.
2.
Using the External Funds Needed (EFN) formula (shown below), set EFN to 0,
plug in the required data, and solve for the change in sales that could be achieved
without any external financing.
EFN = (Ao/So)*(Change in sales) – (Lo/So)*(Change in Sales) - Net Margin*(S o + Change
in sales)*Retention Rate
where,
So = Current sales;
1
New Sales = S1 = (So + Change in sales)
Retention Rate = 1 – Payout Ratio
Income Statement –Percent of Sales
For the Year Ended Dec. 31st, 2004
Sales
Cost of Goods Sold
Gross Profit
Selling and G&A Expenses
Fixed Expenses
Depreciation Expense
Earnings Before Interest and Taxes
Interest Expense
Earnings Before Taxes
Taxes @ 40%
Net Income
Retained Earnings
% of
Sales
2004 2003
100% $ 3,760,000
82.5% 3,045,600
17.5% 714,400
5.9% 250,000
1.9% 90,000
0.5% 25,000
9.2% 349,400
1.4% 66,000
7.8% 283,400
3.1% 113360
4.7% 170,040
60.0%
102,024
2004
$
4,700,000
3,877,500
822,500
275,000
90,000
25,000
432,500
66,000
366,500
146600
219,900
131,940
% of
Sales
2003 2002
100% $ 3,000,000
81.0% 2,400,000
19.0% 600,000
6.6% 215,000
2.4% 90,000
0.7% 25,000
9.3% 270,000
1.8% 66,000
7.5% 204,000
3.0% 81600
4.5% 122,400
60.0%
73,440
% of
Sales
2002
100%
80.0%
20.0%
7.2%
3.0%
0.8%
9.0%
2.2%
6.8%
2.7%
4.1%
60.0%
Balance Sheet
For the Year Ended Dec. 31st, 2004
Assets
Cash and Cash Equivalents
Accounts Receivable
Inventory
Total Current Assets
Plant & Equipment
Accumulated Depreciation
Net Plant & Equipment
Total Assets
Liabilities and Owner's Equity
Accounts Payable
Notes Payable
Other Current Liabilities
Total Current Liabilities
Long-term Debt
Total Liabilities
Owner's Capital
Retained Earnings
Total Liabilities and Owner's Equity
Ao/So
2004
60,000
250,416
511,500
821,916
560,000
175,000
385,000
1,206,916
%
of
Sales
2004
2003
1.3%
97,376
5.3%
175,000
10.9% 390,000
17.5% 662,376
11.9% 560,000
3.7%
150,000
8.2%
410,000
25.7% 1,072,376
%
of
Sales
2003
2002
2.6%
48,000
4.7%
150,000
10.4% 335,000
17.6% 533,000
14.9% 560,000
4.0%
125,000
10.9% 435,000
28.5% 968,000
%
of
Sales
2002
1.6%
5.0%
11.2%
17.8%
18.7%
4.2%
14.5%
32.3%
135,000
275,000
43,952
453,952
275,000
728,952
155,560
322,404
1,206,916
2.9%
5.9%
0.9%
9.7%
5.9%
15.5%
3.3%
6.9%
25.7%
4.0%
7.3%
1.3%
12.7%
6.6%
19.3%
4.1%
5.1%
28.5%
4.3%
8.3%
1.5%
14.1%
10.0%
24.1%
5.2%
2.9%
32.3%
25.679%
2
151,352
275,000
50,000
476,352
250,000
726,352
155,560
190,464
1,072,376
128,000
250,000
46,000
424,000
300,000
724,000
155,560
88,440
968,000
Net Profit Margin
Retention Rate
Current Sales
Lo/So
Change in Sales
4.678%
60%
$4,700,000
2.872%
$659,591.40
Note: Used Excel’s Solver function to calculate Change in Sales (see spreadsheet).
Spreadsheet solution
EFN = Increase in Assets -
EFN=
0=
Increase in internal equity
25.679%*(Change in So) – 2.87*(Change in So) - [4.678%*0.6*($4.7 + Change in So)]
22.807%*(Change in So) – 0.0280*(Change in So) - $131,919.60
Change in So = $131,919.6/0.2000 = $659,591.40
Growth rate that can be supported with no external funds = 659,591.40/4,700,000 = 14.033%
EFN=
Increase in
Assets
0.00 =
169,376.48
-
Increase in
Spontaneous
Finances
18,943.47
-
Increase
in
Internal equity
$150,433.01
Alternative method
Compute the Internal growth rate.
Internal growth rate = (ROA x Retention Rate)/[1 - (ROA x Retention Rate]
= (18.2% x 0.6)/[1-(18.2% x 0.6)] = 12.26%
3. Oats’ R’ Us has a flexible credit line with the Midway Bank. If Mason decides to keep
the debt-equity ratio constant, up to what rate of growth in revenues can the firm
support? What assumptions are necessary when calculating this rate of growth? Are
these assumptions realistic in the case of Oats’ R’ Us? Please explain.
If a constant debt-equity ratio is maintained the firm would be able to achieve a higher rate of
growth. This growth rate is called the sustainable growth rate and is calculated as follows:
Sustainable Growth Rate =
ROE x Retention Rate =
1 - ROE x Retention Rate
3
38.1%
Where ROE = 46% and Retention rate = 60%.
The assumptions necessary when calculating the sustainable growth rate include:
1. The firm will maintain a constant debt-equity ratio.
2. The Net Profit margin will be constant.
3. Total asset turnover will be constant
4. The retention rate will be constant.
5.
The last three assumptions are unrealistic because they depend on the future performance of
the firm i.e. sales and cost control. A constant debt-equity ratio is a matter of management
policy and could be met quite easily.
4. Initially Jim assumes that the firm is operating at full capacity. How much additional
financing will it need to support revenue growth rates ranging from 25% to 40% per
year?
See Spreadsheet (Spreadsheet solution) Note: There is a slight difference in the spreadsheet
solutions because it carries out the calculations to a greater degree of mathematical accuracy.
Growth Rate
EFN (with excel)
25%
$103,054.00
30%
$150,052.80
35%
$197,051.60
40%
$244,050.40
For example: when the growth rate = 40%; So = 4,700,000; Change in Sales = 1,880,000; Net
Margin = 4.679%
EFN = (A/So)*(Change in sales) – (L/S0)*( Change in sales) – Net Margin*(So + Change in
sales)*Retention Rate
= 0.25679*1,880,000 – 0.02872*1,880,000 - 0.04679*6,580,000*0.6
= 482,765.2 – 53,993.60 - 184,726.92
= 244,044.68 (within rounding)
5. After conducting an interview with the production manager, Jim realizes that Oats’ R’
Us is operating its plant at 90% capacity, how much additional financing will it need to
support growth rates ranging from 25% to 40%?
4
Capacity Utilization =
90%
Current Sales =
Fixed Assets=
Fixed Assets/Sales Ratio=
Full Capacity Sales=
$ 4,700,000
385,000
8.19%
$ 5,222,222 =
4,700,000/90%
7.37%
17.49%
Sales Level Growth rate
Sales
Full Capacity Fixed Assets/Sales ratio
Current Asset/Sales ratio =
Current Sales 0%
Capacity
11%
Sales growth
25%
30%
35%
40%
Ao/So (full)
Net Margin
Retention Rate
25.679%
4.679%
60%
Full
capacity
sales
$ 4,700,000 $
$ 5,222,222 $ 522,222
Sales
exceeding
Full capacity
$ 5,875,000
$ 6,110,000
$ 6,345,000
$ 6,580,000
$
652,778
$
887,778
$ 1,122,778
$ 1,357,778
$
$
$
$
522,222
522,222
522,222
522,222
$
-
EFN
-$70,276.00
$54,929.00
$100,002.80
$145,076.60
$190,150.40
No New Fixed
Fixed and Current Assets
Assets Needed vary proportionately with sales
Only Current Assets
Increase with sales
6. What are some actions that Mason can take in order to alleviate some of the need for
external financing? Analyze the feasibility and implications of each suggested action.
Some actions that Mason can take to alleviate some of the need for external financing include:
1.
2.
3.
4.
5.
Increase accounts payables by using more trade credit – this would be possible up
to a point but can be risky and expensive especially if the firm could avail itself of
discounts for paying cash.
Increase accruals – limited scope, could hurt relations with employees.
Increase profit margins – easier said than done because of competition.
Increase retention rate – this is a policy decision and is feasible. The scope is
limited, though, because profits are typically only a small portion of sales.
Increase sales – once again, easier said than done.
7. How critical is the financial condition of Oats’ R’ Us? Is Vicky justified in being
concerned about the need for financial planning? Explain why.
5
Based on the calculations above, Oats’ R’ Us can grow another 11% or so without new
external financing, provided it maintains its net profit margin and retention rate. Since the
owners are expecting sales to grow by about 25% - 40% next year, there is a need for planning
their finances, although it does not seem to be critical. The owners could retain all the profits
if necessary, and at a 25% growth rate they would need to raise another $54,292. If financing
became a problem they could choose to cut back on their growth. The firm has a healthy ROA
and ROE. Their liquidity ratios are not too bad and although their Debt ratio (60.4%) seems a
bit high, their interest coverage ratio is pretty good at 6.6X. Thus they should not have too
much of a problem raising the additional funds. Planning is essential for success, however.
It’s therefore a good move on part of Vicky and Mason to analyze their financial condition.
8. (Optional) Mason prefers not to deviate from the firm’s 2004 debt-equity ratio, what
will the firm’s pro-forma income statement and balance sheet look like under the
scenario of 40% growth in revenue for 2005 (ignore feedback effects)
See Spreadsheet for detailed solution Case4Sheet. Please, check the numbers in red!!
Oats’ R’ Us
Pro Forma Income Statement
2005E
2004
Sales
6,580,000.00
4,700,000
Costs (92.2% of sales)
6,066,900.00
4,333,500
Taxable Income
513,100.00
366,500.00
Taxes (40%)
205,240.00
146,600.00
Net Income
307,860.00
219,900.00
Retained Earnings (60%)
184,716.00
131,940.00
Oats’ R’ Us
Pro Forma Balance Sheet
Assets
Cash and Cash Equivalents
Accounts Receivable
Inventory
Total Current Assets
Plant & Equipment
Accumulated Depreciation
Net Plant & Equipment
Total Assets
Liabilities and Owner's Equity
Accounts Payable
Notes Payable
Other Current Liabilities
Total Current Liabilities
Long-term Debt
2005E
2004
$
84,000
60,000
$
350,582
250,416
$
716,100
511,500
$ 1,150,682 821,916
$
784,000
560,000
$
245,000
175,000
$
539,000
385,000
$ 1,689,682 1,206,916
$
$
$
$
$
189,000
385,000
61,533
635,533
385,000
6
135,000
275,000
43,952
453,952
275,000
% of sales
1.28%
5.33%
10.88%
17.49%
11.91%
3.72%
8.19%
25.68%
2.87%
5.85%
0.94%
9.66%
5.85%
Total Liabilities
Owner's Capital
Retained Earnings
Total Liabilities and Owner's Equity
$ 1,020,533 728,952
$
155,560
155,560
$
507,120
219,900
$ 1,689,682 1,206,916
7
15.51%
3.31%
4.68%
25.68%