Case 01a Growing Pains Solution

 

Solution to Case 01 Financial Analysis and Forecasting 

Growing Pains Questions 1. Since Since this is the first first time Jim and Mason Mason will be conduc conducting ting a financial financial foreca forecast st 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. forecast. The sales forecast ought to be based on clearly stated stated assumptions about future economic 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 utili zation rate, rate, they would be able to determine the asset requ requirem irements ents for growth. growth. Some of  the funds required to finance growth would be raised from spontaneous sources such as account acco untss payabl payables es and accrua accruals ls and from from future future retained retained earnings earnings.. The remainin remaining g funds 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 Pro For Forma ma Appro Approac ach h – wher wheree mos mostt o off the the inco income me stat statem ement ent and and bal balanc ancee she sheet et items are assumed to maintain a constant proportion to sales, but individual items items can be foreca forecaste sted d using using stati statisti stical cal techni technique quess and feedba feedback ck effect effectss involving changes in interest costs etc. can be included. 2. EFN Formula ula Method – which is sim simple to use use but but doe does not not all allow tth he inclusion of feedback effects. 2. If Oats’ Oats’ R’ Us is opera operatin ting g its fixed fixed ass assets ets at full capac capacity ity,, wh what at growth growth rate 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. Using the External Funds Needed (EFN) formula (shown below), set EFN to 0, 2.  plug in the required data, and solve for the change in sales that could be achieved without any external financing. EFN = (Ao/So)*(Chan )*(Change ge in sales) – (Lo/So)*(Change in Sales) - Net Margin*(So + Change in sales)*Retention Rate

where,

So = Current sales; 1

 

 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   Sales

% of   Sales

% of   Sales

  Sales Cost of Goods Sold Gross Profit Selling and G&A Expenses Fixed Expenses Depreciation Expense  Earnings Before Interest and Taxes Taxes Interest Expense  Earnings Before Taxes Taxes @ 40%

2004 $ 4,700,000 3,877,500 822,500 275,000 90,000 25,000 432,500 66,000 366,500 146600

2004 1 10 00% 82.5% 17.5% 5.9% 1.9% 0.5% 9.2% 1.4% 7.8% 3.1%

2003 $ 3,760,000 3,045,600 714,400 250,000 90,000 25,000 349,400 66,000 283,400 113360

2003 100% 81.0% 19.0% 6.6% 2.4% 0.7% 9.3% 1.8% 7.5% 3.0%

2002 $ 3,000,000 2,400,000 600,000 215,000 90,000 25,000 270,000 66,000 204,000 81600

2002 100% 80.0% 20.0% 7.2% 3.0% 0.8% 9.0% 2.2% 6.8% 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

 Assets Cash and Cash Equivalents Accounts Re Receivable Inventory Total Current Assets Plant & Equipment Accumulated Depreciation

2004 60,000 250,416 511,500 821,916   560,000 175,000

% of   Sales 2004 2003 1.3% 97,376 5.3% 175,000 10.9% 390,000 17.5% 662,376  11.9% 560,000 3.7% 150,000

% of   Sales 2003 2002 2. 6% 48,000 4. 7% 150,000 10.4% 335,000 17.6% 533,000 14.9% 560,000 4. 0% 125,000

% of   Sales 2002 1.6% 5.0% 11.2% 17.8% 18.7% 4.2%

 Net Plant & Equipment  Total Assets

385,000 1,206,916  

8.2% 25.7%

410,000 1,072,376 

10.9% 28.5%

435,000 968,000

14.5% 32.3%

128,000 250,000 46,000 424,000 300,000 724,000 155,560 88,440

4.3% 8.3% 1.5% 14.1% 10.0% 24.1% 5.2% 2.9%

968,000

32.3%

 Liabilities and Owner's Equity Equity Accounts Payable  Notes Payable Other Current Liabilities Total Current Liabilities Long-term Debt Total Liabilities Owner's Capital Retained Earnings

135,000 275,000 43,952 453,952 275,000 728,952 155,560 322,404

2.9% 5.9% 0.9% 9.7% 5.9% 15.5% 3.3% 6.9%

151,352 275,000 50,000 476,352 250,000 726,352 155,560 190,464

  4. 0% 7.3% 1. 3% 12.7% 6. 6% 19.3% 4. 1% 5. 1%

Tota Totall L Lia iabi bili liti ties es an and d Owne Owner' r'ss E Equ quit ityy

1,206 1,206,9 ,916  16 

25.7%

1,072,376 

28.5%

  Ao/So

25.679%

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 Net Profit Margin Retention Rate Current Sales Lo/So Change in Sales

4.678% 60% $4,700,000 2.872%  $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%

 

EFN=

Increase Increa se in Assets

 

0.00 0.00 =

16 169, 9,37 376. 6.48 48

-

In Incr crea ease se in Spontaneous Finances 18,9 18,943 43.4 .47 7

-

Increase in Internal equity $1 $150 50,4 ,433 33.0 .01 1

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’ Oats’ R’ Us has has a flexibl flexiblee cred credit it line line with the the Midway Midway Bank Bank.. If Mason Mason decide decidess to keep keep the debt-equity ratio constant, up to what rate of growth in revenues can the firm support? support ? What assumptions assumptions are are necessary necessary when calculating calculating this rate rate of growth? 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 foll follows: ows: Sustainable Growth Rate = ROE x Retention Rate =   1 - ROE x Retention Rate

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38.1%

 

Where ROE = 46% and Retention rate = 60%. The assumptions necessary when calculating the sustainable growth rate include: 1. The firm firm will maintain maintain a constant constant debt-equ debt-equity ity ratio. ratio. 2. The Net Net Profi Profitt margin margin will will be co const nstant ant.. 3. Total Total asset asset turn turnover over will will be cons constan tantt 4. The rete retenti ntion on rate rate wil willl be cons constan tant. t. 5. The last three assumptions are unrealistic because they depend on the future performance of  the firm i.e. sales sales and cost control. A constant debt-equit debt-equity y ratio is a matter of management management  policy and could be met quite easily. 4. Initiall Initially y Jim assume assumess that the the firm is opera operating ting at fu full ll cap capacit acity. y. How m much uch additi additional onal financing will it need to support revenue growth rates ranging from 25% to 40% per year?

See Spreadsheet (Spreadsheet solution) solution) Note:  Note: There is a slight slight difference difference in the the spreadsheet spreadsheet solutions because it carries out the calculations to a greater degree of mathematical accuracy.

  Growt Gr owth h Rate

EFN (with (wit h excel) exc el)

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)*(Chan )*(Change ge 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 conducting an interview interview with the production production manager, manager, Jim Jim realizes realizes that Oats’ Oats’ R’ Us is operating its plant at 90% capacity, how much additiona additionall financing will it need to support growth rates ranging from 25% to 40%?

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Capacity Utilization =

90%

Current Sales = Fixed Assets= Fixed Assets/Sales Ratio= Full Capacity Sales=

$ 4,700,000 385,000 8.19% $ 5,222,222 = 4,700,000/90% 7.37% 17.49% Sales Level Growth rate Sales

Full Capacity Fixed Assets/Sales ratio Current Asset/Sales ratio =

Current Sales 0% Capacity 11% Sales growth 25% 30% 35% 40% Ao/So (full)  Net Margin Retention Rate

25.679% 4.679% 60%

Full capacity sales $ 4,700,000 $ $ 5,222,222 $ 522,222

Sales exceeding Full capacity

$ 5,875,000 $ 6,110,000 $ 6,345,000 $ 6,580,000

$ 652,778 $ 887,778 $ 1,122,778 $ 1,357,778

 

$ $ $ $

522,222 522,222 522,222 522,222

$

-

EFN

-$70,276.00 $54,929.00 $100,002.80 $145,076.60 $190,150.40

No New Fixed Fixed and Current Assets Assets Needed vary proportionately with sales

Only Current Assets Increase with sales

6. What are are some action actionss that Mason Mason can take take in order order to alleviate alleviate some some of the ne need ed 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.

2. 3. 4. 5.

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. Increase accruals – limited scope, could hurt h urt relations with employees. Increase profit margins – easier said than done because of competition. Increase Incre ase retention retention rate – this is a policy policy decision decision and is feasible. feasible. The scope is limited, though, because profits are typically only a small portion of sales. Increase sales – once again, easier said than done.

7. How How critic critical al is the finan financia ciall cond conditi ition on of Oats’ Oats’ R’ Us? Is Vicky Vicky justi justifie fied d in being 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 extern al financing, financing, provided it maintains maintains its net profit margin margin and retention 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. $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 ratios are not too bad and although 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 problem raising the additional additional funds. Planning Planning is essential essential for success, success, however. It’s therefore a good move on part of Vicky and Mason to analyze their financial condition.

8. (Option (Optional) al) Mason prefer preferss not to deviate deviate from the firm’s firm’s 2004 debt-equ debt-equity ity ratio, ratio, what willl the firm’s pro-forma wil pro-forma incom incomee stateme statement nt and balanc balancee sheet sheet look like under under the scenario of 40% growth in revenue for 2005 (ignore feedback effects)  

See Spreadsheet for detailed solution Case4Sheet. Case4Sheet. Please, check the numbers in red!!     Sales Costs (92.2 (92.2% % of sales) sales) Taxable Income Taxes (40%)  Net Income Retain Ret ained ed Ear Earnin nings gs (60 (60%) %)

Oats’ R’ Us   Pro Forma Income Statement 2005E 20 2004 6,580,000.00 4,700,000

6,066,900.00 6,066,900.00 513,100.00 205,240.00 307,860.00 184,71 184,716.0 6.00 0

4,333,500 366,500.00 146,600.00 219,900.00 131 131,94 ,940.0 0.00 0

Oats’ R’ Us   Pro Forma Balance Sheet

   Assets Cash and Cash Equivalents Accounts Receivable Inventory Total Current Assets Plant & Equipment Accumulated Depreciation  Net Plant & Equipment 

$ $ $  $ $  $  $

Total Assets

$ 1,689,682 1,206,916  

 Liabilities and Owner's Equity Equity Accounts Payable  Notes Payable Other Current Liabilities

$ $ $

189,000 385,000 61,533

13 1 35,000 275,000 43,952

2.87% 5.85% 0.94%

Total Current Liabilities Long-term Debt

 $ $

635,533 385,000

453,952 2 27 75,000

9.66% 5.85%

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2005E 84,000 350,582 716,100 1,150,682 784,000 245,000 539,000

2004 60,000 250,416 511,500 821,916  560,000 175,000 385,000

% of sales 1.28% 5.33% 10.88% 17.49% 11.91% 3.72% 8.19%

25.68%

 

Total Liabilities Owner's Capital Retained Earnings

 $ 1,020,533  $ 155,560  $ 507,120

728,952 155,560 219,900

15.51% 3.31% 4.68%

Total Liabilities and Owner's Equity

 $ 1,689,682 1,206,916 

25.68%

 

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