External Funds

Requirement
Sales Forecast -Preparation of Pro-Forma
Income Statement and Balance Sheet - Growth
and External Funds Requirement - EFR

 Explain the role of financial planning in the

strategic planning process.

Describe the working capital flows within a
company,
and
how
shortening
the
cash
conversion cycle can minimize external financial
needs.
Prepare proforma financial statements and use
them to identify a firms external financing
requirements.
Explain the relationship between a companys
financing needs and its working capital policy.
Understand the concept of sustainable growth
and how it is related to a firms profitability,
asset utilization, leverage, and dividend policy.

 Prepare a cash budget and use it to

identify the amounts and timing of a
firms short-term needs.
Discuss the risk-return tradeoffs of the
strategies that can be used to finance a
firms working capital requirements.

ASSETS

LIABILITIES

EQUITY
Current Assets

Current Liabilities

Noncurrent Assets
Liabilities

Noncurrent
Equity

ASSETS

LIABILITIES

EQUITY
Permanent Assets
Liabilities
Temporary Assets

Permanent Current
Short-Term Liabilities
Long-Term Capital

Purchase

Cash

Made

Received

Sales on Credit

Inventory Conversion Period

Collection Period

Operating Cycle

Payables Period

Cash Conversion Cycle

Cash Outlay

 Inventory Conversion Period

Collection Period
Operating Cycle
Payables Period

 Sales Force Estimates

Customer Surveys
Time Series Analysis
Economic Models

Assumes that each expense, asset

and liability item can be estimated
using a percentage of sales. The
percent of sales method assumes a
linear relationship between projected
sales and a specific expense, asset,
and liability category.

USES OF FUNDS
Net Investment in Assets to
Support Sales Change

= SOURCES OF FUNDS
=

Internal Sources +
External Sources

Increase in =
Net Assets
=
Where:

S =
A/S =

CL/S =

Increase in Total Assets

(S)(A/S)

Increase in
Current Liabilities
(S)(CL/S)

Change in sales
Assets needed to support a dollar
of sales
Ratio of spontaneous current
liabilities to sales

Internal Financing Provided = (1-a)(NPM)(S)

Where:
a

NPM
S

=
=

Proportion of earnings paid out in

dividends
After-tax profit margin on sales
Forecasted level of sales.

EFN = (S)(A/S) - (S)(CL/S) - (1-a)

(NPM)(S)

Special Sandalwood Products (SSP)

wants to assess its financing needs
for the coming year. The firms sales
are $200 million and are expected to
rise 10% to $220 million in 2014.
Because making steel is capital
intensive, $0.90 in assets are
needed to generate a dollar of sales.
Current liabilities are 20% of sales.
After-tax profit margins are 5.1%,
and SSP typically pays out 40% of its
earnings in dividends.

These characteristics of SSP yield the

following values for the parameters for the
EFN formula: S = $20 million, (A/S) = 0.90,
(C/L) = 0.20, NPM = 0.05, a = 0.40, and S
=$220 million. Using these values, we find
that SSPs financing needs (EFN) are:
EFN =

$20,000,000 (0.90) - $20,000,000

(0.20)
- (1 - 0.40)(0.051)($220,000,000)
=

$7,268,000

SSP
RELATIONSHIP BETWEEN SALES GROWTH
AND FINANCING REQUIREMENTS
Sales Growth
Financing
Rate (%)
Needs

Change

Forecasted

in Sales

Sales

30
$60,000,000
$34,044,000
20
40,000,000
20,656,000
10
20,000,000
7,268,000
0
-0 6,120,000
10
20,000,000
19,508,000
20
40,000,000
32,896,000
30
60,000,000
46,284,000

External

$260,000,000
240,000,000
220,000,000
200,000,000
180,000,000
160,000,000
140,000,000

Income Statement
2014 Forecast

2013 Actual

Percent
of Sales

Sales
$200,000
Cost of Goods Sold
140,000
$220,000 = 154,000
Gross Profits
$ 60,000
$ 66,000
Operating Expenses
40,000
20%
= 44,000
Operating Profits (EBIT)
$ 20,000
$ 22,000
Interest
3,000
3,000*
Profit Before Taxes
17,000
$ 19,000
Taxes @ 40%
6,800
7,600
Net Income
$ 10,200
$ 11,400
Dividends@40% of Net Income 4,080
4,560
Additions to Ret. Earnings
$ 6,120
$ 6,840
* Assumes that no new debt is issued.

$220,000
70%
0.7 x
0.2 x $220,000

Percent
Balance Sheet
2013 Actual
2014 Forecast

of Sales

Assets
Current Assets
$ 80,000
40%
0.4 x $220,000
$ 88,000
Net Fixed Assets
100,000
112,000
Total Assets
$180,000
$200,000
Liabilities
Current Liabilities
$ 40,000
20%
0.2 x $220,000
$ 44,000
Long-Term Debt
30,000
30,000
Common Stock
20,000
20,000
Retained Earnings
90,000
$90,000+
$6,840 =
96,840
Total Liabilities+ Equity $180,000
Total Internal Sources
$ 190,840
Additional External Financing
9,260
Total Liabilities+Equity
$ 200,000

The firm is growing as fast as possible without resorting to new security

issues. This is called the internal growth rate. The growth rate is internal
because it can be maintained without resorting to additional external
sources of capital.

Notice that if we set required external financing to zero, we can solve for
the internal growth rate as:
Internal Growth Rate= Retained Earnings/Net Assets

This means that a firm with a high volume of reinvested earnings relative to
its assets can generate a higher growth rate without needing to raise more
capital.

We can gain more insight into what determines the internal growth rate by
multiplying the top and bottom of the expression for internal growth by net
income and equity as follows:
Internal Growth Rate =
Retained Earnings/Net Income * Net Income/Equity * Equity/Assets

Plowback Ratio * ROE * Equity/Assets

A firm can achieve a higher growth rate without raising external capital if
(1) it plows back a high proportion of its earnings, (2) it has a high return on
equity (ROE), and (3) it has a low debt-to-asset ratio.

It is the highest growth rate the firm can maintain without

resorting to issue of external equity. It turns out that the
sustainable growth rate depends only on the plowback
ratio and return on equity. The firm issues only enough
debt to keep its debt-equity ratio constant.

g* =

Where:
RE =
NI =
ROE =

[RE/NI][ROE]

Retained earnings
Net Income after-taxes
Return on equity

The models used to calculate sustainable

growth assume that the business wants to:
1) maintain a target capital structure
without issuing new equity
2) maintain a target dividend payment
ratio
3) The assets of the firm will increase
proportionally to sales
4)Net profit margin is constant
5) Will maintain a constant asset-to-sales
ratio

Since the asset to beginning of period

equity ratio is constant and the firm's
only source of new equity is retained
earnings, sales and assets cannot
grow any faster than the retained
earnings plus the additional debt that
the retained earnings can su pport

To illustrate the derivation of the sustainable growth

rate, Higgins used the following notation:
p = Net profit margin on new and existing sales
d = the target dividend payout ratio ((1d) is the
target retention ratio)
L = the target debt-to-equity ratio
t = the ratio of total assets to net sales on new and
existing sales
s = sales at the beginning of the year
s = increase in sales during the year
ROE = the firms return on equity
NI = Net Income

Starting with the fundamental

accounting equation (Assets =
Liabilities + Equity), it is known that
over any given time period any
change in assets must be
subsequently matched by a
corresponding change in liabilities
and/or equity.
Assets = Liabilities + Equity (1)

The objective is to determine how each of

these components can be expected to
change. Starting with assets, it is known
that if a firm experiences an increase in
sales of s over the period,
it will need to grow its asset base by s
(t) to support the higher level of sales,
therefore:
Assets = s(t)

Also, since a firm's profit margin is

expected to stay constant, a firm
experiencing an increase in sales of s
will generate (s + s)(p) in profits.
With a constant dividend payout ratio,
this will translate into additional
retained earnings of (s + s)(p)(1 d).
The Equity, therefore, will equal
(s + s)(p)(1 d).

Lastly, because it is known that a

firm maintains a constant debt-toequity ratio, L, for every additional
dollar in earnings a firm retains, a
firm can safely raise L in new debt. In
total, therefore,
Liabilities = (s + s)(p)(1 d)(L).

Substituting each of these expressions

into equation (1) yields:
s(t) = (s + s)(p)(1 d)(L) + (s + s)(p)
(1 d)
Solving for the growth rate, s /s,
produces Equation (2) represents
Higgins' original sustainable growth
formula (sustainable growth = g):
g= (p)(1d)(1+L)
(t)(p)(1d)(1+L)

(2)

Imposing the assumption that the ratio of assets-to-net sales

(t) equals 1 allows for further simplification. This assumption
implies that a firm's asset growth parallels its sales growth.
If a firm wishes to grow its sales by 15 percent, it needs to
grow its asset base, whether it be through inventories or
property plant and equipment, by approximately 15 percent
as well to support the higher level of sales.
Then, since (1 + Debt/Equity) = (Equity + Debt)/Equity, Assets
= Debt + Equity, and t = 1, equation (2) can be simplified to
(where ROE is equal to net income divided by beginning of
period equity):
g = (ROE (1 d))/(1 (ROE (1 d)))
(3)

g*

RE
NI

[Net Income]

[Sales]

[Sales]

[Assets]
x
x
[Assets]
[Equity]

ROE = Profit Margin (Profit/Sales) * Total Asset

Turnover (Sales/Assets) * Equity Multiplier
(Assets/Equity)

DuPont analysis tells us that ROE is

affected by three things:
- Operating efficiency, which is
measured by profit margin
- Asset use efficiency, which is
measured by total asset turnover
- Financial leverage, which is
measured by the equity multiplier

SUSTAINABLE GROWTH RATE

FACTOR INCREASES
Dividend Payouts
Net Profit Margins
Asset Utilization
Leverage

CHANGE IN SUSTAINABLE
GROWTH
Decreases
Increases
Increases
Increases

CONDENSED BALANCE SHEET AND INCOME STATEMENTS -2013

(in million $ except ratios)
Sales
Profit After Tax @ 5.1% Sales
Current Assets @ 40% Sales
Fixed Assets
Total Assets
Current Liabilities @ 20% Sales
Long-Term Debt
Common Stock
Total Liabilities+Equity

10.2

$ 200.0
80.0
100.0
$ 180.0
$ 40.0
30.0
110.0
$ 180.0

Dividends as Proportion of Earnings =

0.40
Retained Earnings as Proportion of Net Income =
0.60
Net Profit Margin
= $10.2/$200.0 =
0.051
Asset Turnover = Sales/Assets = $200.0/$180.0 =
1.11
Equity Multiplier = Assets/Common Stock = $180.0/$110 =
1.66

g*

RE
NI

[Net Income]

[Sales]

[Assets]
x
x
[Assets]
[Equity]

(0.6)(0.051)(1.11)(1.66)

0.056 or 5.6 percent

[Sales]

 Increase Net Profit Margin

Improve Asset Utilization
Increase leverage
Increase Earning Retention Rate

 Details cash inflows and outflows

over some time period.

Can be prepared on a daily,

weekly,
basis.

monthly,

or

quarterly

Indicates a firms cash balances

and defines its borrowing needs.

Sustainable Growth Rate (SGR) concept by Robert C. Higgins,

describes optimal growth from a financial perspective assuming a
given strategy with clear defined financial frame conditions/
limitations.

Sustainable growth is defined as the annual

percentage of increase in sales that is consistent
with a defined financial policy (target debt to equity
ratio, target dividend payout ratio, target profit
margin, target ratio of total assets to net sales). This
concept provides a comprehensive financial
framework and formula for case/ company specific
SGR calculations

http://www.youtube.com/watch?
v=BPd_8At6Kzo