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Chapter 4 (Post-Midterm) Example Solutions
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Financial Forecasting
The Percentage of Sales Method
As a company grows, it requires new funding to support its greater asset base. The percentage of
sales method is a way of roughly estimating the additional funding a company will need
given a certain increase in sales. In the balance sheet below, what we are estimating is the
increase in long-term debt required as a result of a growth in sales.
Cash
Accounts receivable
Inventory
Total current assets
Capital assets (net)
Total assets
Growco Ltd.
Balance Sheet
As of May 31, 20X8
$1,000
Accounts payable
2,000
Short term loan
13,000
Total current liabilities
16,000
Long term debt
20,000
Common shares
Retained earnings
$36,000
Total liabilities and equity
$1,500
500
2,000
9,000
12,000
13,000
$36,000
Suppose that sales went from $50,000 to $55,000 – an increase of 10%.
Suppose that this meant that current assets went up by 10% as well – this would mean an
increase of 16,000 * 10% or $1,600. The idea is that greater sales would mean more cash, as
collections from sales increased, more receivables as sales went up, and more inventory, which
would be necessary to support higher sales.
Then if everything else stayed the same, the balance sheet wouldn’t balance unless long-term
debt went up by $1,600 as well.
The assets that increased as a result of the sales increase are represented by A. So now we can
say that the increase in long-term debt, also known as the required new funds, as a result of the
increase in assets, would be:
A * % increase in sales
Again suppose that sales went from $50,000 to $55,000 – an increase of 10%.
Suppose that this meant that current liabilities went up by 10% as well – this would mean an
increase in current liabilities of 2,000 * 10% or $200.
Then if everything else stayed the same, the balance sheet wouldn’t balance unless long-term
debt went down by $200 as well.
If the liabilities that increased as a result of the sales increase are represented by L, the decrease
in long-term debt, as a result of the increase in other liabilities, would be:
L * % increase in sales
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Chapter 4 (Post-Midterm) Example Solutions
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So far we have determined that we can estimate the increase in funding required as a result of an
increase in sales by the expression:
A * % increase in sales – L* % increase in sales
Note that the second term is subtracted, as an increase in other liabilities would decrease the need
for new funding.
Increase in Retained Earnings
There is one more thing to consider. If retained earnings went up, long-term debt would have to
go down, in order for the balance sheet to balance. In other words, the required new funds
would decrease as a result in an increase in retained earnings.
Profits available for use by the company would increase retained earnings. Dividends paid out
would decrease retained earnings. The net amount of the increase in retained earnings is next
years’ net income less next years’ dividends.
The Complete Formula for Required New Funds
When we put together all the above components, the formula for Required New Funds (RNF)
becomes:
A * % increase in sales – L * % increase in sales – increase in retained
earnings
Alternately,
(A – L) * % increase in sales – increase in retained earnings
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Chapter 4 (Post-Midterm) Example Solutions
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Example 1
Rapco
% increase in sales is (120,000-100,000)/100,000 = 20%
A is 20,000, L is 2,000
Increase in retained earnings is:
Next year’s earnings 120,000*.05
6,000
Next year’s dividends 6,000*50%
(3,000)
Increase in retained earnings
3,000
RNF= A* % increase in sales – L* % increase in sales – increase in retained
earnings
= 20,000*20% – 2,000*20% – 3,000
= $600
Example 2
Rapco again
A becomes 20,000 + 90,000 = 110,000
RNF = 110,000*20% – 2,000*20% – 3,000
= $18,600
Example 3
Rapco yet again
A is 20,000, but an additional $10,000 of financing is required to upgrade the
plant.
RNF = 20,000*20% + 10,000 – 2,000*20% – 3,000
= $10,600
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Chapter 4 (Post-Midterm) Example Solutions
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Example 4
Problem 4-26
Clyde’s Well Servicing
A is 500,000
L is 275,000
To calculate increase in retained earnings we need to know next years’ net income.
Since the profit margin stays constant, we can find next years’ net income by
increasing this year’s profit by 30%: 174,000*1.3 = $226,200
Since dividend payout rate stays the same, next years’ dividend will be
104,400*1.3 = $135,720
The increase in retained earnings will be 226,200 – 135,720 = 90,480
RNF = (A – L)* % increase in sales – increase in retained earnings
= (500,000 – 275,000)*.3 – 90,480
= (22,980)
A negative need for new funds indicates a surplus – no new funds required.
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Chapter 4 (Post-Midterm) Example Solutions
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Example 5 Barb Dwyer
(a)
A is 75,000
L is 60,000
To calculate increase in retained earnings we need to know next years’ net income.
This year’s net income is 100,000*.12 = 12,000. Since the profit margin stays
constant, we can find next years’ net income by increasing this year’s profit by
15%: 12,000 * 1.15 = 13,800
Since dividend payout rate stays the same, next years’ dividend will be 13,800*.4
= 5,520
The increase in retained earnings will be 13,800 – 5,520 = 8,280
RNF = (A – L)* % increase in sales – increase in retained earnings
= (75,000 – 60,000)*.15 – 8,280 = $(6,030), so no new funding is required
(b) All the same, except A is 160,000
RNF = (A – L)* % increase in sales – increase in retained earnings
= (160,000 – 60,000)*.15 – 8,280 = $6,720
(c) Same as (a), with an additional $8,000 of funding
RNF = (6,030) + 8,000 = $1,970