Introduction & Learning Objectives
This guide is your interactive companion to understanding **Long-Term Financial Planning and Growth**, based on **Chapter 4 of Ross's textbook**. This chapter introduces the financial planning process, models used for forecasting, and the critical relationship between a firm's growth and its financing needs.
Learning Objectives (Ross, page 96)
- Apply the percentage of sales method.
- Compute the external financing needed to fund a firm's growth.
- Name the determinants of a firm's growth.
- Anticipate some of the problems in planning for growth.
1. Financial Planning Models
The Percentage of Sales Approach (Ross, page 104)
This is a popular method for creating pro forma statements. It assumes that certain income statement and balance sheet items are a constant percentage of sales. Items that don't vary directly with sales are treated as a "plug" variable to balance the pro forma balance sheet.
Key Ratios:
- **Dividend Payout Ratio:** Cash dividends / Net income
- **Retention Ratio (Plowback Ratio):** Addition to retained earnings / Net income
- **Capital Intensity Ratio:** Total assets / Sales
Exam Hint: You'll need to be able to apply this method to create pro forma statements and identify the external financing needed (EFN). This was tested in **Question 4.1** of the self-test problems.
2. EFN and Sustainable Growth
External Financing Needed (EFN) (Ross, page 111)
**EFN** is the projected shortfall or surplus in financing that a firm needs to support its planned growth in assets. The higher the growth rate, the greater the need for external financing, all else being equal.
Exam Hint:
The EFN calculation is a common and important exam problem. You'll need to compute EFN given a sales growth rate and a set of financial statements. It was tested in **Question 4.1** of the self-test problems.
Sustainable Growth Rates (Ross, page 114)
**Internal Growth Rate:** The maximum growth rate a firm can achieve with no external financing of any kind. This rate is limited by internally generated funds (retained earnings).
**Sustainable Growth Rate:** The maximum growth rate a firm can achieve without external equity financing while maintaining a constant debt-equity ratio.
Exam Hint: You should be able to calculate and interpret both of these rates. The sustainable growth rate is especially important as it links a firm's profitability, asset turnover, dividend policy, and financial leverage. This was tested in **Question 4.3** of the self-test problems.
3. Problems & Solutions
Problem Statement: Based on the following information for the Skandia Mining Company, what is EFN if sales are predicted to grow by 10 percent? Use the percentage of sales approach and assume the company is operating at full capacity. The payout ratio is constant.
Skandia Mining Company Financial Statements
| Income Statement | Amount ($M) | Balance Sheet | Amount ($M) |
|---|---|---|---|
| Sales | $4,250.0 | Current Assets | $900.0 |
| Costs | $3,936.7 | Net Fixed Assets | $2,200.0 |
| Taxable Income | $313.3 | Total Assets | $3,100.0 |
| Taxes (21%) | $65.8 | Current Liabilities | $500.0 |
| Net Income | $247.5 | Long-Term Debt | $1,800.0 |
| Dividends | $82.6 | Owners' Equity | $800.0 |
| Add. to Retained Earnings | $164.9 | Total Liabilities & Equity | $3,100.0 |
Solution:
1. Calculate Pro Forma Income Statement:
New Sales = $4,250 * 1.10 = $4,675. Costs = $3,936.7 / 4,250 * 4,675 = $4,330.4$. Net Income = $(4,675 - 4,330.4) \times (1-0.21) = \$272.3$. Dividends = $247.5 \times (82.6/247.5) = \$90.9$. Addition to RE = $272.3 - 90.9 = \$181.4$.
2. Calculate Pro Forma Balance Sheet:
Total Assets = $3,100 \times 1.10 = \$3,410$. Current Liabilities = $500 \times 1.10 = \$550$. Total Liabilities & Equity = $550 + 1,800 + 800 + 181.4 = \$3,331.4$.
3. Calculate EFN:
EFN = Total Assets - Total Liabilities & Equity = $3,410 - 3,331.4 = \$78.6 \text{ million}$.
Problem Statement: S&S Air needs to prepare a financial plan for next year. Using their financial statements, you must calculate the internal and sustainable growth rates, and the EFN for a planned 12% growth rate assuming full capacity. You also have to calculate a new EFN assuming a lumpy fixed cost structure.
Solution:
1. Internal and Sustainable Growth Rates:
Payout Ratio = $565,000 / 1,854,232 = 0.3047$. Retention Ratio ($b$) = $1 - 0.3047 = 0.6953$.
ROA = $1,854,232 / 18,388,130 = 0.1008$.
ROE = $1,854,232 / 10,481,803 = 0.1769$.
Internal Growth = $\frac{ROA \times b}{1 - ROA \times b} = \frac{0.1008 \times 0.6953}{1 - 0.1008 \times 0.6953} = 7.55\%$.
Sustainable Growth = $\frac{ROE \times b}{1 - ROE \times b} = \frac{0.1769 \times 0.6953}{1 - 0.1769 \times 0.6953} = 14.04\%$.
These numbers mean S&S Air can grow at 7.55% without any external financing and at 14.04% without selling new equity.
2. EFN at 12% Growth (Full Capacity):
New Sales = $37,038,492 \times 1.12 = \$41,483,111$. Assets = $18,388,130 \times 1.12 = \$20,600,706$. Additions to RE = $1,289,232 \times 1.12 = \$1,443,940$.
EFN = $20,600,706 - (2,806,327 \times 1.12) - (5,100,000 \times 1.12) - (10,481,803 + 1,443,940) = -\$104,260$ (Surplus, not EFN).
3. EFN with Lumpy Fixed Assets:
New Fixed Assets = $16,305,556 + 5,000,000 = \$21,305,556$. New Total Assets = $2,082,574 \times 1.12 + 21,305,556 = \$23,636,808$.
EFN = $23,636,808 - (2,806,327 \times 1.12) - (5,100,000 \times 1.12) - (10,481,803 + 1,443,940) = $2,931,842
This means the company will need nearly $3M in external financing. This implies a significant jump in capacity utilization from 100% to over 112%, and that the previous asset-to-sales ratio is no longer valid.