Long-Term Financial Planning and Corporate Growth

Adapted from Fundamentals of Corporate Finance RWJR, Fourth Canadian Edition (Chapter 4)

Definition

Financial planning establishes guidelines for change and growth in a firm.

It focuses on the major elements of a firm's financial and investment policies without examining the individual components of those policies in detail.

How it works

Forecasted growth in assets has to be matched with a corresponding growth in financing:

Start with forecasting the growth in assets Determine how much additional financing is needed Determine whether internal funds are sufficient If necessary, plan for external financing

Exemplification: Rosengarten Corp. Balance sheet ($) & Income Statement

Cash 160

Accounts receivable 440

Inventory 600

Current assets 1200

Fixed assets 1,800

Total assets 3,000

Accounts payable 300

Notes payable 100

Current liabilities 400

Long-term debt 800

Common stock 800

Retained earnings 1,000

Equity 1,800

Total liabilities 3,000

Sales 1,000

Costs (800)

Taxable income 200

Tax (68)

Net income 132

Addition to RE 88

Dividends 44

Assumption

Sales are forecasted to increase by 25%

Pro-forma income statement ($)

This year Forecasted

Sales 1,000 1,250

Costs (800) (1,000)

Taxable income 200 250

Tax (68) 85

Net income 132 165

Addition to RE 88 110

Dividends 44 55

Pro-forma balance sheet ($)

This year Forecasted

Cash 160 200

Accounts receivable 440 550

Inventory 600 750

Current assets 1,200 1,500

Fixed assets 1,800 2,250

Total assets 3,000 3,750

Accounts payable

Notes payable

Current liabilities

Long-term debt

Common stock

Retained earnings

Equity

Total liabilities

Pro-forma balance sheet ($)

This year Forecasted

Cash 160 200

Accounts receivable 440 550

Inventory 600 750

Current assets 1,200 1,500

Fixed assets 1,800 2,250

Total assets 3,000 3,750

Accounts payable 300 375

Notes payable 100 100

Current liabilities 400 475

Long-term debt 800 800

Common stock 800 800

Retained earnings 1,000 1,110

Equity 1,800 1,910

Total liabilities 3,000

Pro-forma balance sheet ($)

This year Forecasted

Cash 160 200

Accounts receivable 440 550

Inventory 600 750

Current assets 1,200 1,500

Fixed assets 1,800 2,250

Total assets 3,000 3,750

Accounts payable 300 375

Notes payable 100 100

Current liabilities 400 475

Long-term debt 800 800

Common stock 800 800

Retained earnings 1,000 1,110

Equity 1,800 1,910

Total liabilities 3,000 3,185 (?!)

Implication:

We need $565 in external financing!

External financing and growth

EFN = Increase in TA - Addition to RE

EFN = (A)(sg) - (p)(S)(R)(1+sg)

EFN = $750 - $110 = $640

The difference between $565 and $640 = $75, the increase in accounts payable.

If you consider accounts payable internal financing, then

EFN = Increase in TA - Addition to RE - Increase in Acc. payable

where:

A = total assets

S = current sales

p = profit margin = net income/sales

R = retention ratio

sg = rate of growth in sales

Internal growth rate:

The growth rate a firm can maintain with internal financing only (ignore increase in accounts payable)

IGR = (p)(S)(R) / [A - (p)(S)(R)]

IGR = ROA(R) / [1-ROA(R)]

IGR = (0.132)(1,000)(2/3) / [3,000 - (0.132)(1,000)(2/3)] = 3.02%

Sustainable growth rate:

The growth rate a firm can maintain given its capital structure, ROE, and retention ratio.

EFN = Increase in TA - Addition to RE - New borrowing

SGR = (ROE)(R) / [1 - (ROE)(R)] = (0.0734)(2/3) / [1 - (0.073)(2/3)]

SGR = 5.14%

SGR = (p)(S/A)(1+D/E)(R)/[1- (p)(S/A)(1+D/E)(R)]

Growth and capacity usage

What happens if the firm is not operating at full capacity?

Case (i): Firm operates at 70% capacity

Case (ii): Firm operates at 90% capacity

Additional information: when reaching full capacity the firm will have to expand production by building additional operating plants. Each plant has the potential to increase output/sales by 30 percentage points.

Case (i): Pro-forma balance sheet at 25% growth

This year

Forecasted

Cash

160

200

Accounts receivable

440

550

Inventory

600

750

Current assets

1,200

1,500

Fixed assets

1,800

1800

Total assets

3,000

3,300

Accounts payable

300

375

Notes payable

100

100

Current liabilities

400

475

Long-term debt

800

800

Common stock

800

800

Retained earnings

1,000

1,110

Equity

1,800

1,910

Total liabilities

3,000

3,185 (?!)

Case (i): EFN

We need $3,300 - $3,185 = $115 in external financing.

We could borrow $115 in the short term by issuing commercial paper or short-term notes.

Case (ii): Pro-forma balance sheet at 25% growth

This year

Forecasted

Cash

160

200

Accounts receivable

440

550

Inventory

600

750

Current assets

1,200

1,500

Fixed assets

1,800

2340

Total assets

3,000

3,840

Accounts payable

300

375

Notes payable

100

100

Current liabilities

400

475

Long-term debt

800

800

Common stock

800

800

Retained earnings

1,000

1,110

Equity

1,800

1,910

Total liabilities

3,000

3,185 (?!)

Case (ii): EFN

We need $3,840 - $3,185 = $655 in external financing.

We need to borrow in the long-run and/or issue additional equity.

Comment

Calculating EFN, IGR, SGR with the help of formulas makes the implicit assumption that the firm is operating at full capacity. In reality this is seldom the case.

Forecasting financial growth with the help of pro-forma financial statements is always preferable.

Determinants of growth:

• Profit margin: An increase in the profit margin, increases the firm's ability to generate funds internally and thereby increases its sustainable growth.

• Dividend policy: A decrease in the payout ratio increases internally generated equity, and thus increases sustainable growth.

• Capital structure: An increase in the firm's leverage makes additional debt financing available, and hence increases the sustainable growth rate.

• Total asset turnover: An increase in S/A decreases the firm's need for new assets as sales grow. Hence it increases the sustainable growth rate.