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;

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 New Sales = S1 = (So + Change in sales)
Retention Rate = 1 – Payout Ratio

Income Statement –Percent of Sales

For the Year Ended Dec. 31st, 2004
% of % of % of
Sales Sales Sales
  2004 2004 2003 2003 2002 2002
Sales $ 4,700,000 100% $ 3,760,000 100% $ 3,000,000 100%
Cost of Goods Sold 3,877,500 82.5% 3,045,600 81.0% 2,400,000 80.0%
Gross Profit 822,500 17.5% 714,400 19.0% 600,000 20.0%
Selling and G&A Expenses 275,000 5.9% 250,000 6.6% 215,000 7.2%
Fixed Expenses 90,000 1.9% 90,000 2.4% 90,000 3.0%
Depreciation Expense 25,000 0.5% 25,000 0.7% 25,000 0.8%
Earnings Before Interest and Taxes 432,500 9.2% 349,400 9.3% 270,000 9.0%
Interest Expense 66,000 1.4% 66,000 1.8% 66,000 2.2%
Earnings Before Taxes 366,500 7.8% 283,400 7.5% 204,000 6.8%
Taxes @ 40% 146600 3.1% 113360 3.0% 81600 2.7%
Net Income 219,900 4.7% 170,040 4.5% 122,400 4.1%
Retained Earnings 131,940 60.0% 102,024 60.0% 73,440 60.0%
              

Balance Sheet
For the Year Ended Dec. 31st, 2004
% of % of % of
Sales Sales Sales
Assets 2004 2004 2003 2003 2002 2002
Cash and Cash Equivalents 60,000 1.3% 97,376 2.6% 48,000 1.6%
Accounts Receivable 250,416 5.3% 175,000 4.7% 150,000 5.0%
Inventory 511,500 10.9% 390,000 10.4% 335,000 11.2%
Total Current Assets 821,916 17.5% 662,376 17.6% 533,000 17.8%
Plant & Equipment 560,000 11.9% 560,000 14.9% 560,000 18.7%
Accumulated Depreciation 175,000 3.7% 150,000 4.0% 125,000 4.2%
Net Plant & Equipment 385,000 8.2% 410,000 10.9% 435,000 14.5%
Total Assets 1,206,916 25.7% 1,072,376 28.5% 968,000 32.3%
Liabilities and Owner's Equity
Accounts Payable 135,000 2.9% 151,352 4.0% 128,000 4.3%
Notes Payable 275,000 5.9% 275,000 7.3% 250,000 8.3%
Other Current Liabilities 43,952 0.9% 50,000 1.3% 46,000 1.5%
Total Current Liabilities 453,952 9.7% 476,352 12.7% 424,000 14.1%
Long-term Debt 275,000 5.9% 250,000 6.6% 300,000 10.0%
Total Liabilities 728,952 15.5% 726,352 19.3% 724,000 24.1%
Owner's Capital 155,560 3.3% 155,560 4.1% 155,560 5.2%
Retained Earnings 322,404 6.9% 190,464 5.1% 88,440 2.9%
Total Liabilities and Owner's Equity 1,206,916 25.7% 1,072,376 28.5% 968,000 32.3%
         

Ao/So 25.679%

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Net Profit Margin 4.678%
Retention Rate 60%
Current Sales $4,700,000
Lo/So 2.872%
Change in Sales $659,591.40

Note: Used Excel’s Solver function to calculate Change in Sales (see spreadsheet).

Spreadsheet solution

EFN = Increase in Assets - Increase in internal equity

EFN= 25.679%*(Change in So) – 2.87*(Change in So) - [4.678%*0.6*($4.7 + Change in So)]

0= 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%

Increase in
Increase in Spontaneous Increase in
EFN= Assets - Finances - Internal equity
0.00 = 169,376.48 18,943.47 $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 = 38.1%

1 - ROE x Retention Rate

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 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%?

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Capacity Utilization = 90%

Current Sales = $ 4,700,000

Fixed Assets= 385,000
Fixed Assets/Sales Ratio= 8.19%
Full Capacity Sales= $ 5,222,222 =
4,700,000/90%
Full Capacity Fixed Assets/Sales ratio 7.37%
Current Asset/Sales ratio = 17.49%
Sales Level Growth rate Sales Full Sales EFN
capacity exceeding
sales Full capacity
Current Sales 0% $ 4,700,000 $ -
Capacity 11% $ 5,222,222 $ 522,222 $ -
-$70,276.00
Sales growth
25% $ 5,875,000 $ 522,222 $ 652,778 $54,929.00
30% $ 6,110,000 $ 522,222 $ 887,778 $100,002.80
35% $ 6,345,000 $ 522,222 $ 1,122,778 $145,076.60
40% $ 6,580,000 $ 522,222 $ 1,357,778 $190,150.40

Ao/So (full) 25.679%

Net Margin 4.679%
Retention Rate 60% 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. 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.
2. Increase accruals – limited scope, could hurt relations with employees.
3. Increase profit margins – easier said than done because of competition.
4. 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.
5. 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.

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 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 2005E 2004 % of sales
Cash and Cash Equivalents $ 84,000 60,000 1.28%
Accounts Receivable $ 350,582 250,416 5.33%
Inventory $ 716,100 511,500 10.88%
Total Current Assets $ 1,150,682 821,916 17.49%
Plant & Equipment $ 784,000 560,000 11.91%
Accumulated Depreciation $ 245,000 175,000 3.72%
Net Plant & Equipment $ 539,000 385,000 8.19%
Total Assets $ 1,689,682 1,206,916 25.68%
Liabilities and Owner's Equity
Accounts Payable $ 189,000 135,000 2.87%
Notes Payable $ 385,000 275,000 5.85%
Other Current Liabilities $ 61,533 43,952 0.94%
Total Current Liabilities $ 635,533 453,952 9.66%
Long-term Debt $ 385,000 275,000 5.85%

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Total Liabilities $ 1,020,533 728,952 15.51%
Owner's Capital $ 155,560 155,560 3.31%
Retained Earnings $ 507,120 219,900 4.68%
Total Liabilities and Owner's Equity $ 1,689,682 1,206,916 25.68%