Learn | Consult | Research Long Term Financial Planning & Growth.

Learn | Consult | Research

Long Term Financial Planning & Growth

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Financial Planning System: IntroductionFinancial Planning System: IntroductionFinancial Planning System: IntroductionFinancial Planning System: Introduction

• Long-Range Financial Planning: Long-Range Financial Planning:

means of systematically thinking about the future means of systematically thinking about the future and anticipating possible problems before they and anticipating possible problems before they arrive.arrive.

to avoid financial distress and failureto avoid financial distress and failure establishes guidelines for change and growth in a establishes guidelines for change and growth in a

firmfirm concerned with the major elements of a firm’s concerned with the major elements of a firm’s

financial and investment policiesfinancial and investment policies interrelatedness of the various investment and interrelatedness of the various investment and

financing decisions a firm makesfinancing decisions a firm makes

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Basic elements of firm’s financial policyBasic elements of firm’s financial policyBasic elements of firm’s financial policyBasic elements of firm’s financial policy

• The firm’s needed investment in new assets.The firm’s needed investment in new assets. Capital Budgeting PolicyCapital Budgeting Policy

• The degree of financial leverage the firm The degree of financial leverage the firm chooses to employ.chooses to employ. Capital Structure PolicyCapital Structure Policy

• The amount of cash the firm thinks is The amount of cash the firm thinks is necessary and appropriate to pay necessary and appropriate to pay shareholders.shareholders. Dividend PolicyDividend Policy

• The amount of liquidity and working capital the The amount of liquidity and working capital the firm needs on an ongoing basis.firm needs on an ongoing basis. Working Capital PolicyWorking Capital Policy

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These Policies and Decisions affectThese Policies and Decisions affectThese Policies and Decisions affectThese Policies and Decisions affect

• Future ProfitabilityFuture Profitability

• Need for external financingNeed for external financing

• Opportunities for growthOpportunities for growth

Firm’s investment and financing policies interact and thus Firm’s investment and financing policies interact and thus cannot truly be considered in isolation from one another.cannot truly be considered in isolation from one another.

Most company use explicit, company wide growth rate as a Most company use explicit, company wide growth rate as a major component of their long-run financial planningmajor component of their long-run financial planning

Financial Planning Models can be used to better understand Financial Planning Models can be used to better understand how growth shall be achieved.how growth shall be achieved.

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What are 4 Ps of Marketing ?What are 4 Ps of Marketing ?What are 4 Ps of Marketing ?What are 4 Ps of Marketing ?

Proper Proper

PriorPrior

Planning Planning

Prevents Prevents

Poor Poor

PerformancePerformance

What are 6 Ps of Financial Planning ?What are 6 Ps of Financial Planning ?What are 6 Ps of Financial Planning ?What are 6 Ps of Financial Planning ?

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What is Financial Planning ?What is Financial Planning ?What is Financial Planning ?What is Financial Planning ?

• Making a roadmap for what is to be done in Making a roadmap for what is to be done in future so as to formulate the way in which future so as to formulate the way in which financial goals are to be achieved.financial goals are to be achieved.

• Remember ? Remember ?

Financial Management operates in an Financial Management operates in an uncertain worlduncertain world

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Growth as a Financial Management GoalGrowth as a Financial Management GoalGrowth as a Financial Management GoalGrowth as a Financial Management Goal

• Growth, by itself, is not an appropriate goal for the Growth, by itself, is not an appropriate goal for the financial manager.financial manager.

• Growth may thus be a desirable consequence of good Growth may thus be a desirable consequence of good decision making, but it is not an end unto itself.decision making, but it is not an end unto itself.

• But, growth rates are very commonly used in planning But, growth rates are very commonly used in planning process.process.

• Growth is a convenient means of summarizing various Growth is a convenient means of summarizing various aspects of a firm’s financial and investment policies.aspects of a firm’s financial and investment policies.

• If we think of growth as growth in the market value of the If we think of growth as growth in the market value of the equity of the firm, then its equivalent to goal of equity of the firm, then its equivalent to goal of maximizing the shareholder’s wealth.maximizing the shareholder’s wealth.

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Dimensions of Financial PlanningDimensions of Financial PlanningDimensions of Financial PlanningDimensions of Financial Planning

1.1. Planning Horizon:Planning Horizon: Short Run: 12 monthsShort Run: 12 months Long Run: 2 to 5 yearsLong Run: 2 to 5 years

• Establish the Planning HorizonEstablish the Planning Horizon

2.2. Aggregation:Aggregation: Of all the individual projects and investments the Of all the individual projects and investments the

firm will undertakefirm will undertake

• Fix the Level of AggregationFix the Level of Aggregation

3.3. Assumptions regarding the important variablesAssumptions regarding the important variables Eg. Preparing alternative business plans for three Eg. Preparing alternative business plans for three

scenarios: Worst Case, Normal Case, and Best Casescenarios: Worst Case, Normal Case, and Best Case

• Make realistic Assumptions regarding the forthcoming Make realistic Assumptions regarding the forthcoming events and variablesevents and variables

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Why spend time on planning ?Why spend time on planning ?Why spend time on planning ?Why spend time on planning ?

1.1. Examining InteractionsExamining Interactions• Between investment proposals and financing choicesBetween investment proposals and financing choices

2.2. Exploring OptionsExploring Options• Various investment and financing options exploredVarious investment and financing options explored• Their impact on the firm’s shareholders can be evaluated.Their impact on the firm’s shareholders can be evaluated.

3.3. Avoiding SurprisesAvoiding Surprises• Contingency PlanningContingency Planning

4.4. Ensuring Feasibility and Internal ConsistencyEnsuring Feasibility and Internal Consistency• Making explicit linkages between various specific goalsMaking explicit linkages between various specific goals• Imposing unified structure for reconciling different goals Imposing unified structure for reconciling different goals

and objectives.and objectives.• Establishing prioritiesEstablishing priorities

What can Planning Accomplish ?What can Planning Accomplish ?What can Planning Accomplish ?What can Planning Accomplish ?

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Financial Planning ModelsFinancial Planning ModelsFinancial Planning ModelsFinancial Planning Models

1.1. Sales ForecastSales Forecast• It is generally the “driver”It is generally the “driver”• Given as the growth rate in salesGiven as the growth rate in sales• Perfect forecast is IMPOSSIBLE.Perfect forecast is IMPOSSIBLE.

2.2. Pro-forma StatementsPro-forma Statements• Forecasted Balance Sheet, Income Statement and Forecasted Balance Sheet, Income Statement and

Statement of Cash FlowStatement of Cash Flow• Pro formas are the output of financial planning modelsPro formas are the output of financial planning models

3.3. Assets RequirementsAssets Requirements• Projected Capital Spending = changes in total fixed Projected Capital Spending = changes in total fixed

assets and net working capital = Total Capital Budgetassets and net working capital = Total Capital Budget

A Financial Planning Model: ElementsA Financial Planning Model: ElementsA Financial Planning Model: ElementsA Financial Planning Model: Elements

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A Financial Planning Model: Elements A Financial Planning Model: Elements (contd…)(contd…)

A Financial Planning Model: Elements A Financial Planning Model: Elements (contd…)(contd…)

4.4. Financial RequirementsFinancial Requirements• What are the necessary financing What are the necessary financing

arrangements and how shall those be raised arrangements and how shall those be raised

5.5. The PlugThe Plug• The plug is the designated source or sources The plug is the designated source or sources

of external financing needed to deal with any of external financing needed to deal with any shortfall (or surplus) in financing and thereby shortfall (or surplus) in financing and thereby bring the balance sheet into balance.bring the balance sheet into balance.

6.6. Economic AssumptionsEconomic Assumptions• State explicitly the economic environment in State explicitly the economic environment in

which the firm expects to reside over the life which the firm expects to reside over the life of the planof the plan

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ExampleExampleExampleExample

ABC Co

Financial Statements of most recent year

Income Statement Balance Sheet

Sales $1,000 Assets $500 Debt $250

Costs 800 Equity $250

Net Income $200 Total $500 Total $500

• Assumption: All variables are tied directly to sales and Assumption: All variables are tied directly to sales and current relationships are optimal. This means that all items current relationships are optimal. This means that all items will grow at exactly the same rate as sales.will grow at exactly the same rate as sales.

• Suppose the sales increase by 20 %, rising from $ 1,000 to $ Suppose the sales increase by 20 %, rising from $ 1,000 to $ 1,200.1,200.

• Make Pro forma Income Statement and Balance SheetMake Pro forma Income Statement and Balance Sheet

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Example (contd…)Example (contd…)Example (contd…)Example (contd…)

Pro Forma

Income Statement

Sales $1,200

Costs 960

Net Income $240

Pro Forma Balance Sheet

Assets $600 Debt $300

Equity 300

Total $600 Total $600

• Reconcile these two pro formasReconcile these two pro formas

• Can net income be equal to $ 240 and equity increase by only Can net income be equal to $ 240 and equity increase by only $ 50 ?$ 50 ?

• ABC must have paid out the difference of $ 240 - $ 50 = $ ABC must have paid out the difference of $ 240 - $ 50 = $ 190 possibly as cash dividend.190 possibly as cash dividend.

• In this case, dividends are the plug variable.In this case, dividends are the plug variable.

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Example ( contd….)Example ( contd….)Example ( contd….)Example ( contd….)

• Suppose ABC doesn’t pay out the $ 190Suppose ABC doesn’t pay out the $ 190

• What happens to Equity ?What happens to Equity ?

• It grows to $ 240 + $ 250 = $ 490It grows to $ 240 + $ 250 = $ 490

• Now everything is fine ?Now everything is fine ?

• What happens to Debt ?What happens to Debt ?

• Debt must be retired to keep total assets $ 600Debt must be retired to keep total assets $ 600

• Debt will have to be $ 600 - $ 490 = $ 110Debt will have to be $ 600 - $ 490 = $ 110

• Debt to be retired = $ 250 - $ 110 = $ 140Debt to be retired = $ 250 - $ 110 = $ 140

• In this case Debt is the Plug VariableIn this case Debt is the Plug Variable

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Example (contd…)Example (contd…)Example (contd…)Example (contd…)


Assets $600 Debt $110

Equity 490

Total $600 Total $600 • Example shows the interaction between sales growth and

financial policy.

• As sales increase, so do total assets. WHY ?

• The firm must invest in net working capital and fixed assets to support higher sales levels.

• Since assets are growing, total liabilities and equity will grow as well

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The Percentage of Sales ApproachThe Percentage of Sales ApproachThe Percentage of Sales ApproachThe Percentage of Sales Approach

• Every item doesn’t increase at the same rate as Every item doesn’t increase at the same rate as sales.sales.

• Eg: Long-Term Borrowing – something that doesn’t Eg: Long-Term Borrowing – something that doesn’t necessarily relate directly to the level of salesnecessarily relate directly to the level of sales

• The basic idea is to separate the income statement The basic idea is to separate the income statement and balance sheet accounts into two groups:and balance sheet accounts into two groups:

Those that do vary directly with sales Those that do vary directly with sales Those that don’t vary directly with sales.Those that don’t vary directly with sales.

• Given the sales forecast, calculate how much Given the sales forecast, calculate how much financing the firm will need to support the predicted financing the firm will need to support the predicted sales level.sales level.

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PoS Approach for Income StatementPoS Approach for Income StatementPoS Approach for Income StatementPoS Approach for Income Statement

• Assumes that the future relationship between Assumes that the future relationship between various elements of costs to sales will be various elements of costs to sales will be similar to their historical relationship.similar to their historical relationship.

• When using this method, a decision has to be When using this method, a decision has to be taken about taken about which historical cost ratios to be which historical cost ratios to be used.used.

• Should these ratios pertain to the previous Should these ratios pertain to the previous yearyear

• OR the average of two or more years.OR the average of two or more years.

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PoS Approach for Income Statement PoS Approach for Income Statement (contd….)(contd….)


XYZ Corporation

Income Statement (Most Recent)

Sales $1,000

Costs (Cost + Depreciation + Interest) 800

Taxable Income $200

Taxes @ 34 % 68

Net Income $132

Dividends $44

Addition to Retained Earnings $88

XYZ has projected a 25 % increase in sales for the coming year

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• What will be the sales for coming year ?What will be the sales for coming year ?• $ 1250 $ 1250 • What will be the cost for coming year ?What will be the cost for coming year ?• Assuming that the ratio of cost to sales shall remain same.Assuming that the ratio of cost to sales shall remain same.• 80 % of $ 1250 = $ 100080 % of $ 1250 = $ 1000• What will be the Net Income ?What will be the Net Income ?• $ 165$ 165• What was the percentage of NI to sales and what is it now ?What was the percentage of NI to sales and what is it now ?• 13.2 %13.2 %• Now what about dividend ?Now what about dividend ?• Assume that the management of XYZ pays constant rate of dividend out Assume that the management of XYZ pays constant rate of dividend out

of NI (Dividend payout ratio is constant)of NI (Dividend payout ratio is constant)• What is dividend payout ratio of XYZ ?What is dividend payout ratio of XYZ ?• $ 44 / $ 132 = 33.33 %$ 44 / $ 132 = 33.33 %• What is the retention or plowback ratio of XYZ ?What is the retention or plowback ratio of XYZ ?• $ 88 / $ 132 = 66.67 % = 100 % - 33.33 %$ 88 / $ 132 = 66.67 % = 100 % - 33.33 %• Make pro forma income statement for coming year.Make pro forma income statement for coming year.

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XYZ Corporation

Pro Forma Income Statement

Sales $1,250

Costs (Cost + Depreciation + Interest) 1000

Taxable Income $250

Taxes @ 34 % 85

Net Income $165

Dividends $55

Addition to Retained Earnings $110

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PoS Approach for Balance SheetPoS Approach for Balance SheetPoS Approach for Balance SheetPoS Approach for Balance Sheet

• Some of the items vary directly with sales and Some of the items vary directly with sales and others do not.others do not.

• For those items that do vary with sales, we For those items that do vary with sales, we express each as a percentage of sales for the express each as a percentage of sales for the year just ended. For others we write “n/a”year just ended. For others we write “n/a”

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PoS Approach for Balance Sheet (contd…)PoS Approach for Balance Sheet (contd…)PoS Approach for Balance Sheet (contd…)PoS Approach for Balance Sheet (contd…)

XYZ Corporation

Most Recent Balance Sheet

$ % of sales $ % of sales

Assets Liabilities

Current Assets Current Liabilities

Cash 160 16 Accounts payable 300 30

Accounts Receivable 440 44 Notes payable 100 n/a

Inventory 600 60 Total 400 n/a

Total 1200 120 Long term Debt 800 n/a

Fixed Assets Owner's Equity

New plant and equipment 1800 180

Common stock and paid in surplus 800 n/a

Retained Earnings 1000 n/a

Total 1800 n/a

Total Assets 3000 300Total liabilities and owner's equity 3000 n/a

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• Ratio of total assets to sales = 3Ratio of total assets to sales = 3• It is called It is called Capital Intensity RatioCapital Intensity Ratio• What does this ratio tell us ?What does this ratio tell us ?• Tells us the amount of assets needed to generate $ 1 in Tells us the amount of assets needed to generate $ 1 in

sales.sales.• Its reciprocal of Total Assets Turnover RatioIts reciprocal of Total Assets Turnover Ratio• On the liability side, why only A/C payable is assumed to be On the liability side, why only A/C payable is assumed to be

varying with sales ?varying with sales ?• What is Notes Payable ?What is Notes Payable ?

Short term debts such as bank and corporate borrowings.Short term debts such as bank and corporate borrowings.• What about Retained Earning ? Does it vary with sales ?What about Retained Earning ? Does it vary with sales ?

But we shall calculate it based on our projected net income But we shall calculate it based on our projected net income and dividend (governed by dividend policy)and dividend (governed by dividend policy)

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• Construct a partial pro forma balance sheet Construct a partial pro forma balance sheet

• For each items, also find out the change from For each items, also find out the change from previous year in $.previous year in $.

• For those items that don’t vary directly with sales, For those items that don’t vary directly with sales, initially assume no change and simply write in the initially assume no change and simply write in the original amounts.original amounts.

• What about change in Retained Earnings ? Is it nil ?What about change in Retained Earnings ? Is it nil ?

• Assets increase by $ 750 while liabilities and equity Assets increase by $ 750 while liabilities and equity increase only by $ 185increase only by $ 185

• The difference $ 565 is The difference $ 565 is External Financing Need External Financing Need (EFN)(EFN)

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PoS Approach for Balance Sheet (contd…)PoS Approach for Balance Sheet (contd…)PoS Approach for Balance Sheet (contd…)PoS Approach for Balance Sheet (contd…)XYZ Corporation

Partial Pro Forma Balance Sheet

$

Change from previous year

$ Change from previous year

Assets Liabilities



Accounts Receivable 550 110 Notes payable 100 0

Inventory 750 150 Total 475 75

Total 1500 300 Long term Debt 800 0


New plant and equipment 2250 450

Common stock and paid in surplus 800 0

Retained Earnings 1110 110

Total 1910 110

Total Assets 3750 750Total liabilities and owner's equity 3185 185

External Financing Need 565 565

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Scenario 1Scenario 1Scenario 1Scenario 1

• Now there’s a good news and a bad news.Now there’s a good news and a bad news.

• Good News – We’re projecting 25 % increase in Good News – We’re projecting 25 % increase in sales.sales.

• Bad News – This isn’t going to happen unless Bad News – This isn’t going to happen unless XYZ can somehow raise $ 565 in new financing.XYZ can somehow raise $ 565 in new financing.

• If for eg, XYZ has goal of not borrowing any If for eg, XYZ has goal of not borrowing any additional funds and not selling any new equity, additional funds and not selling any new equity, then 25% increase in sales is probably not then 25% increase in sales is probably not feasible.feasible.

• This is how the planning process can point out This is how the planning process can point out problems and potential conflicts.problems and potential conflicts.

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Scenario 1 (contd…)Scenario 1 (contd…)Scenario 1 (contd…)Scenario 1 (contd…)

• Given the EFN $ 565, XYZ has three possible Given the EFN $ 565, XYZ has three possible sources:sources: Short-Term borrowingShort-Term borrowing Long-Term borrowingLong-Term borrowing Issuance of New EquityIssuance of New Equity

• Choice of any combination of above sources Choice of any combination of above sources is up to management. is up to management.

• Lets say that XYZ decides to borrow $ 565- Lets say that XYZ decides to borrow $ 565- some over the short-term and some over the some over the short-term and some over the long-termlong-term

Scenario 1 (contd…) Scenario 1 (contd…) – Construct Pro Forma BS– Construct Pro Forma BS

Scenario 1 (contd…) Scenario 1 (contd…) – Construct Pro Forma BS– Construct Pro Forma BS

Leave net working capital unchangedLeave net working capital unchanged

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XYZ Corporation


$

Change from previous

year$


year

Assets Liabilities



Accounts

Receivable 550 110 Notes payable

Inventory 750 150 Total 700 300 Total 1500 300 Long term Debt


New plant and

equipment 2250 450 Common stock and paid

in surplus

Retained Earnings

Total

Total Assets 3750 750Total liabilities and

owner's equity 3750 750

Accounts Payable rose by $ 75Accounts Payable rose by $ 75Accounts Payable rose by $ 75Accounts Payable rose by $ 75

How much could XYZ borrow in short-How much could XYZ borrow in short-term Notes Payable ?term Notes Payable ?

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XYZ Corporation


$


year$


year

Assets Liabilities



Accounts

Receivable 550 110 Notes payable 325 225 Inventory 750 150 Total 700 300

Total 1500 300 Long term Debt


New plant and


in surplus

Retained Earnings

Total

Total Assets 3750 750Total liabilities and owner's

equity 3750 750

How much more is needed now ?How much more is needed now ?How much more is needed now ?How much more is needed now ?

$ 565 - $ 225 = $ 340$ 565 - $ 225 = $ 340

How will XYZ raise $ 340 ?How will XYZ raise $ 340 ?How will XYZ raise $ 340 ?How will XYZ raise $ 340 ?

Long Term BorrowingsLong Term Borrowings

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XYZ Corporation


$


year$


year

Assets Liabilities



Accounts

Receivable 550 110 Notes payable 325 225


Total 1500 300 Long term Debt 1140 340Fixed Assets Owner's Equity

New plant and


in surplus

Retained Earnings

Total


equity 3750 750

Now fill up all the items of Pro Forma Now fill up all the items of Pro Forma BSBS

Now fill up all the items of Pro Forma Now fill up all the items of Pro Forma BSBS

How much is common stock and paid-How much is common stock and paid-in surplus ?in surplus ?

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XYZ Corporation


$


year$


year

Assets Liabilities



Accounts

Receivable 550 110 Notes payable 325 225


Total 1500 300 Long term Debt 1140 340


New plant and


in surplus 800 0

Retained Earnings 1110 110

Total 1910 110


equity 3750 750

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• Here, what have we used as plug ?Here, what have we used as plug ?

• Plug – Combo of short and long term debtPlug – Combo of short and long term debt

• This is just one possible strategyThis is just one possible strategy

• While planning, we should investigate many of While planning, we should investigate many of such scenariossuch scenarios

• Now what can be the use of Ratio analysis here ?Now what can be the use of Ratio analysis here ?

• We would surely like to examine the CURRENT We would surely like to examine the CURRENT RATIO and TOTAL DEBT RATIO RATIO and TOTAL DEBT RATIO

• Now we can form projected statement of cash Now we can form projected statement of cash flows too.flows too.

• TRY IT !TRY IT !

Alternative ScenarioAlternative ScenarioAlternative ScenarioAlternative Scenario

What if XYZ is using operating at only What if XYZ is using operating at only 70 % capacity ?70 % capacity ?

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Alternative Scenario (contd….)Alternative Scenario (contd….)Alternative Scenario (contd….)Alternative Scenario (contd….)

• Assumption that assets are a fixed percentage Assumption that assets are a fixed percentage of sales is convenient, but it may not be of sales is convenient, but it may not be suitable in many cases.suitable in many cases.

• In previous example, we assumed that XYZ In previous example, we assumed that XYZ was using its fixed assets at 100 % of was using its fixed assets at 100 % of capacity. capacity.

• Hence, for any increase in sales, increase in Hence, for any increase in sales, increase in investment in fixed assets seemed realistic.investment in fixed assets seemed realistic.

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XYZ operating at 70 % of capacityXYZ operating at 70 % of capacityXYZ operating at 70 % of capacityXYZ operating at 70 % of capacity

• It would mean that sales of $ 1000 is only 70 % of It would mean that sales of $ 1000 is only 70 % of the full capacity sales.the full capacity sales.

• Then, what is full capacity sales ?Then, what is full capacity sales ?

• $1000/ 0.70 = $ 1429$1000/ 0.70 = $ 1429

• That means sales could increase by almost 43 % That means sales could increase by almost 43 % before any new fixed assets would be needed.before any new fixed assets would be needed.

• For our previous example, we assumed that sales For our previous example, we assumed that sales would increase by only 25 % < 43 %.would increase by only 25 % < 43 %.

• Now what shall be EFN ? Will it still be $ 565 ?Now what shall be EFN ? Will it still be $ 565 ?

• Hint : Now XYZ wont need $ 450 in net new assets Hint : Now XYZ wont need $ 450 in net new assets investment.investment.

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What shall be EFN in this case ?What shall be EFN in this case ?What shall be EFN in this case ?What shall be EFN in this case ?

• EFN = $ 565 - $ 450 = $ 115EFN = $ 565 - $ 450 = $ 115

• Lessons Learnt :Lessons Learnt : It is inappropriate to blindly manipulate It is inappropriate to blindly manipulate

financial statement information in the financial statement information in the planning process.planning process.

Results depend critically on the assumptions Results depend critically on the assumptions made about the relationships between sales made about the relationships between sales and assets need.and assets need.

Projected growth rates play an important Projected growth rates play an important role in the planning process. role in the planning process.

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External Financing and GrowthExternal Financing and GrowthExternal Financing and GrowthExternal Financing and Growth

• What is the relationship between EFN and growth in What is the relationship between EFN and growth in sales and assets ?sales and assets ?

• Other things remaining constant, the relationship is Other things remaining constant, the relationship is directly proportional.directly proportional.

Lets examine the relationship between Lets examine the relationship between Financial Policy of the firm and its ability to Financial Policy of the firm and its ability to finance new investments and thereby grow.finance new investments and thereby grow.

Lets examine the relationship between Lets examine the relationship between Financial Policy of the firm and its ability to Financial Policy of the firm and its ability to finance new investments and thereby grow.finance new investments and thereby grow.

i.e. The Financial Policy of the firm is given

– Sounds more practical

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PQR Co

Income Statement

Sales $500

Costs 400

Taxable Income 100

Taxes @ 34 % 34

Net Income 66

Dividends 22

Addition to Retained Earnings 44

Balance Sheet


Assets Liabilities

Current Assets $200 40% Total Debt $250 n/a

Net Fixed Assets 300 60% Owner's Equity 250 n/a

Total Assets 500 100% Total Liabilities and Owner's equity 500 n/a

EFN and Growth (contd….) ExampleEFN and Growth (contd….) ExampleEFN and Growth (contd….) ExampleEFN and Growth (contd….) Example

Debt = Short Term + Long Term

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Example (contd….)Example (contd….)Example (contd….)Example (contd….)

Assumptions:Assumptions:• Sales grow by 20 %Sales grow by 20 %• PoS approach seems reasonable.PoS approach seems reasonable.• Retention Ratio is same.Retention Ratio is same.• PQR is operating in full capacityPQR is operating in full capacity• Financing Policy: NO NEW EQUITY SALE, BORROW ALL NEEDED Financing Policy: NO NEW EQUITY SALE, BORROW ALL NEEDED

FUNDS AND USE ALL SURPLUS FUNDS IF ANY, TO RETIRE DEBTFUNDS AND USE ALL SURPLUS FUNDS IF ANY, TO RETIRE DEBT

Questions:Questions:• Prepare prior Pro forma Income Statement and Balance SheetPrepare prior Pro forma Income Statement and Balance Sheet• How much goes as addition to Retained Earnings ?How much goes as addition to Retained Earnings ?

66.67 % of 79.2 % = $ 52.866.67 % of 79.2 % = $ 52.8• How much more PQR needs to invest in new assets ?How much more PQR needs to invest in new assets ?

$ 600 - $ 500 = $ 100$ 600 - $ 500 = $ 100• How much is EFN ?How much is EFN ?

$ 100 - $ 52.8 = $ 47.2$ 100 - $ 52.8 = $ 47.2

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PQR Co


Sales $600

Costs 480

Taxable Income 120

Taxes @ 34 % 40.8

Net Income 79.2

Dividends 26.4

Addition to Retained Earnings 52.8



Assets Liabilities

Current Assets $240 40% Total Debt $250 n/a

Net Fixed Assets 360 60% Owner's Equity 302.8 n/a

Total Assets 600 100% Total Liabilities and Owner's equity 552.8 n/a

External Financing Needed (EFN) 47.2

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• Due of financing policy of PQR, all EFN are borrowed.Due of financing policy of PQR, all EFN are borrowed.

• What was original Debt-Equity Ratio of PQR ?What was original Debt-Equity Ratio of PQR ? $ 250 / 250 = 1.00$ 250 / 250 = 1.00

• What shall be new Debt amount of PQR ?What shall be new Debt amount of PQR ? $ 250 + $ 47.2 = $ 297.2$ 250 + $ 47.2 = $ 297.2

• What shall be new Debt-Equity Ratio after borrowing ?What shall be new Debt-Equity Ratio after borrowing ? $ 297 / $ 302.8 = 0.98$ 297 / $ 302.8 = 0.98

• PQR borrowed some funds but their Debt-Equity ratio fell ? PQR borrowed some funds but their Debt-Equity ratio fell ? WHY ?WHY ? Because, for this particular example, PQR earned and Because, for this particular example, PQR earned and

retained more than EFN which was borrowed.retained more than EFN which was borrowed. i.e. Increase in Equity was more than Increase in Debt.i.e. Increase in Equity was more than Increase in Debt.

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Example (contd….)- Exploring RelationshipsExample (contd….)- Exploring RelationshipsExample (contd….)- Exploring RelationshipsExample (contd….)- Exploring Relationships

• What shall be Increase in Assets Required for What shall be Increase in Assets Required for PQR for various growth rates ?PQR for various growth rates ?

• What shall be Addition to Retained Earnings What shall be Addition to Retained Earnings for PQR for various growth rates ?for PQR for various growth rates ?

• What shall be EFN of PQR Co’ for various What shall be EFN of PQR Co’ for various growth rates ?growth rates ?

• What shall be Projected Debt-Equity ratio of What shall be Projected Debt-Equity ratio of PQR for various growth rates, given the PQR for various growth rates, given the Financing Policy of borrowing EFN and retiring Financing Policy of borrowing EFN and retiring debt with surplus if any ? debt with surplus if any ?

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Growth and Projected EFN for PQR Co’Growth and Projected EFN for PQR Co’Growth and Projected EFN for PQR Co’Growth and Projected EFN for PQR Co’

Projected Sales Growth

Increase in Assets Required ($)

Addition to Retained Earnings ($)

EFN ($)Projected Debt-

Equity Ratio

0%

5

10

15

20

Projected Sales Growth

Increase in Assets Required ($)

Addition to Retained Earnings ($)

EFN ($)Projected Debt-

Equity Ratio

0% 0 44 -44 0.70

5 25 46.2 -21.2 0.77

10 50 48.4 1.6 0.84

15 75 50.6 24.4 0.91

20 100 52.8 47.2 0.98

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EFN and Growth (contd….)EFN and Growth (contd….)EFN and Growth (contd….)EFN and Growth (contd….)

• Note:Note: Increase in assets required = % of growth Increase in assets required = % of growth

rate of original assets.rate of original assets. Addition to retained earnings = Original Addition to retained earnings = Original

Retained earnings + % of growth rate of Retained earnings + % of growth rate of original retained earnings.original retained earnings.

For relatively low growth rates, PQR runs a For relatively low growth rates, PQR runs a surplus and Debt-Equity ratio will decline.surplus and Debt-Equity ratio will decline.

Once growth rate increases to about 10 %, Once growth rate increases to about 10 %, surplus becomes deficit.surplus becomes deficit.

As growth rate exceeds approx 20 % the As growth rate exceeds approx 20 % the Debt Equity ratio passes its original value of Debt Equity ratio passes its original value of 1.01.0

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EFN and Growth (contd…)EFN and Growth (contd…)EFN and Growth (contd…)EFN and Growth (contd…)

Growth and Related Financing Needed for PQR Co

0

25

50

75

100

125

150

0% 5 10 15 20 25

Projected Growth in Sales

Ass

ets

ne

ed

s an

d r

eta

ine

d

ear

nin

gs

Increase in assets required Projected Addition to RE

EFN < 0 (surplus)

EFN > 0 (deficit)

What can you infer from this diagram ?

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EFN and Growth (contd…)EFN and Growth (contd…)EFN and Growth (contd…)EFN and Growth (contd…)

• The need for new assets grows at much faster The need for new assets grows at much faster rate than the addition to retained earnings.rate than the addition to retained earnings.

• Internal financing provided by the addition to Internal financing provided by the addition to retained earnings rapidly disappears.retained earnings rapidly disappears.

• Whether a firm runs cash surplus or deficit Whether a firm runs cash surplus or deficit depends upon growth.depends upon growth.

• It is possible for a firm to experience greater It is possible for a firm to experience greater cash balance even when its growth has cash balance even when its growth has slowed down.slowed down.

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Financial Policy and GrowthFinancial Policy and GrowthFinancial Policy and GrowthFinancial Policy and Growth

• Two kinds of growth rates are particularly useful Two kinds of growth rates are particularly useful in long-range planning.in long-range planning.

1.1. Internal Growth RateInternal Growth Rate

2.2. Sustainable Growth RateSustainable Growth Rate

1.1. The Internal Growth RateThe Internal Growth Rate Is the maximum growth rate that can be achieved with no Is the maximum growth rate that can be achieved with no

external financing of any kindexternal financing of any kind At this point, the required increase in assets is exactly At this point, the required increase in assets is exactly

equal to the addition to the retained earning, and EFN is equal to the addition to the retained earning, and EFN is therefore, zero. therefore, zero.

Represented by the point, where two lines crossed.Represented by the point, where two lines crossed. For PQR Co, its slightly less than 10 %For PQR Co, its slightly less than 10 %

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1. Internal Growth Rate1. Internal Growth Rate1. Internal Growth Rate1. Internal Growth Rate

9.65% )3/2(132.01

)3/2(132.0IGR

3

2

66

44 b %,2.13

500

66 ROA

Co' PQRFor

ratioretention b where,bROA1

bROAIGR

Thus, PQR Co’ can expand at a maximum rate of 9.65 % per year without external financing

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2. The Sustainable Growth Rate2. The Sustainable Growth Rate2. The Sustainable Growth Rate2. The Sustainable Growth Rate

2.2. The Sustainable Growth RateThe Sustainable Growth Rate Is the maximum growth rate that can be Is the maximum growth rate that can be

achieved with no external equity financing achieved with no external equity financing while maintaining a constant debt-equity ratiowhile maintaining a constant debt-equity ratio

i.e. this is the maximum growth a firm can i.e. this is the maximum growth a firm can sustain without increasing its financial sustain without increasing its financial leverage.leverage.

Why a firm might wish to avoid equity Why a firm might wish to avoid equity financing ?financing ? Equity sales can be very expensiveEquity sales can be very expensive

Current owners may not wish to bring in new owners Current owners may not wish to bring in new owners to contribute additional equity.to contribute additional equity.

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2. The Sustainable Growth Rate (contd….)2. The Sustainable Growth Rate (contd….)2. The Sustainable Growth Rate (contd….)2. The Sustainable Growth Rate (contd….)

21.36% )3/2(264.01

)3/2(264.0SGR

3

2

66

44 b %,4.26

250

66 ROE

Co' PQRFor

ratioretention b where,bROE1

bROESGR

PQR can expand @ 21.36 % without equity financing and without disturbing its leverage.

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EA

bPMSA

EA

bPMg

E

Db)g1(SPMb)g1(SPMgA

Debtin Change Equity in Change Assetsin Change Now,

gA Assets toAdditionE

Db)g1(SPM borrowings toAddition

b)g1(SPM earnings retained toAddition

)g1(SPMSPM periodnext for the Income

)g1(S year next for SalesS

yearcurrent for SalesS

Assets A Debt, D Equity, E

RatioRetention b

salesin rategrowth g Margin,Profit PM If,

0

00

0

0

01

01

0

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2. The Sustainable Growth Rate (contd….)2. The Sustainable Growth Rate (contd….)2. The Sustainable Growth Rate (contd….)2. The Sustainable Growth Rate (contd….)• How would pro forma statement for PQR look like if it exactly grows @ 21.36 % ?How would pro forma statement for PQR look like if it exactly grows @ 21.36 % ?

PQR Co


Sales $606.8

Costs 485.4

Taxable Income 121.4

Taxes @ 34 % 41.3

Net Income 80.1

Dividends 26.7

Addition to Retained Earnings 53.4



Assets Liabilities

Current Assets $242.7 40% Total Debt $250 n/a

Net Fixed Assets 364.1 60% Owner's Equity 303.4 n/a

Total Assets 606.8 100% Total Liabilities and Owner's equity 553.4 n/a

External Financing Needed (EFN) 53.4

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Ratio (Plowback)Retention b

MarginProfit PM

salesin growth projected g

Equity Total E

Debt Total D

Assets Total A

sales syear' Previous S

,If

% 20 g when Co' PQRfor iprelationsh Apply this

bSPMgbSPM -A EFN

ip,relationsh following theProve

47.2 $

3/2500132.020.02/35000.132 - 500 EFN

%, 20 g with PQR,For

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Financial Policy and Growth (contd…..)Financial Policy and Growth (contd…..)Financial Policy and Growth (contd…..)Financial Policy and Growth (contd…..)

bROA-1

bROA IGR

:Prove

bSPMgbSPM -A EFN

ip,relationsh following of help With the

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Determinants of GrowthDeterminants of GrowthDeterminants of GrowthDeterminants of Growth

? ipsrelationsh thesefromout makeyou can What

bROE-1

bROE SGR

know, weAnd

MultiplierEquity Turnover Assets Total Margin Profit ROE

know, weIdentity,Pont Du From

Anything that increases ROE and ‘b’ increases SGR.

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Determinants of Growth (contd….)Determinants of Growth (contd….)Determinants of Growth (contd….)Determinants of Growth (contd….)

• Firm’s ability to sustain growth depends explicitly Firm’s ability to sustain growth depends explicitly on the following four factors:on the following four factors:

1.1. Profit MarginProfit Margin

2.2. Dividend PolicyDividend Policy

3.3. Financial PolicyFinancial Policy

4.4. Total Assets TurnoverTotal Assets Turnover

EXPLAINEXPLAIN

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1.1. Increase in profit margin will increase the firm’s ability to Increase in profit margin will increase the firm’s ability to generate funds internally and thereby increase its generate funds internally and thereby increase its sustainable growth rate.sustainable growth rate.

2.2. Decrease in Dividend Ratio = Increase in Retention Ratio, Decrease in Dividend Ratio = Increase in Retention Ratio, this increases internally generated equity and thus this increases internally generated equity and thus increases sustainable growth.increases sustainable growth.

3.3. Increase in debt-equity ratio increases the firm’s leverage. Increase in debt-equity ratio increases the firm’s leverage. This makes additional debt financing available, it This makes additional debt financing available, it increases the sustainable growth rate.increases the sustainable growth rate.

4.4. Increase in Total Assets Turnover increases the sales Increase in Total Assets Turnover increases the sales generated for each $ of assets. This decreases the firm’s generated for each $ of assets. This decreases the firm’s need for new assets as sales grow and thereby increases need for new assets as sales grow and thereby increases sustainable growth rate. That is equivalent to decreasing sustainable growth rate. That is equivalent to decreasing capital intensity of the firm.capital intensity of the firm.

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• Hence, SGR is useful planning number, as it Hence, SGR is useful planning number, as it illustrates the explicit relationship between firm’s illustrates the explicit relationship between firm’s four major areas of concern:four major areas of concern:

1.1. Operating Efficiency (as measured by Profit Operating Efficiency (as measured by Profit Margin)Margin)

2.2. Assets Use Efficiency (as measured by Total Assets Use Efficiency (as measured by Total Assets Turnover)Assets Turnover)

3.3. Dividend Policy (as measured by Retention Ratio)Dividend Policy (as measured by Retention Ratio)

4.4. Financial Policy (as measured by Debt-Equity Financial Policy (as measured by Debt-Equity Ratio)Ratio)

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IF A FIRM DOESNOT WISH TO SELL IF A FIRM DOESNOT WISH TO SELL NEW EQUITYNEW EQUITY

AND ITS AND ITS PROFIT MARGINPROFIT MARGIN, , DIVIDEND POLICYDIVIDEND POLICY, ,

FINANCIAL POLICYFINANCIAL POLICY, AND , AND TOTAL ASSETS TOTAL ASSETS

TURNOVERTURNOVER (OR CAPITAL INTENSITY) ARE ALL (OR CAPITAL INTENSITY) ARE ALL

FIXED, THEN, THERE IS ONLY ONE POSSIBLE FIXED, THEN, THERE IS ONLY ONE POSSIBLE

GROWTH RATE.GROWTH RATE.

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IF A FIRM WISHES TO GROW ITS SALES IF A FIRM WISHES TO GROW ITS SALES AT GREATER RATE THAN SUSTAINABLE AT GREATER RATE THAN SUSTAINABLE GROWTH RATE, THE FIRM MUST :GROWTH RATE, THE FIRM MUST :

• EITHER INCREASE PROFIT MARGINSEITHER INCREASE PROFIT MARGINS

• OR INCREASE TOTAL ASSETS TURNOVEROR INCREASE TOTAL ASSETS TURNOVER

• OR INCREASE FINANCIAL LEVERAGEOR INCREASE FINANCIAL LEVERAGE

• OR INCREASE EARNINGS RETENTIONOR INCREASE EARNINGS RETENTION

• OR SELL NEW SHARESOR SELL NEW SHARES

• OR ANY COMBINATION OF ABOVEOR ANY COMBINATION OF ABOVE

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WARNINGS REGARDING FINANCIAL WARNINGS REGARDING FINANCIAL PLANNING MODELSPLANNING MODELS

WARNINGS REGARDING FINANCIAL WARNINGS REGARDING FINANCIAL PLANNING MODELSPLANNING MODELS

• Financial Planning Models don’t always ask the right Financial Planning Models don’t always ask the right question:question: They tend to rely on accounting relationships not financial They tend to rely on accounting relationships not financial

relationshipsrelationshipsCash Flow, Risk and Timing: three basic elements of firm’s Cash Flow, Risk and Timing: three basic elements of firm’s

value tend to get left out value tend to get left out

• Divert attention from strategies needed to increase firm’s Divert attention from strategies needed to increase firm’s value to association of leverage and growthvalue to association of leverage and growth

• Useful for pointing out inconsistencies and reminding us of Useful for pointing out inconsistencies and reminding us of financial needs, but they offer very little guidance financial needs, but they offer very little guidance concerning what to do about these problems.concerning what to do about these problems.

• Financial Planning should be iterative processFinancial Planning should be iterative processCreate, examine, modify over and overCreate, examine, modify over and overProcrustes ApproachProcrustes Approach

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May the future of all of you be a rewarding one.

Learn | Consult | Research Long Term Financial Planning & Growth.

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