Summary Ross Chapter 4
1. A Financial Planning Model: The Ingredients
a) Sales Forecast
The sales forecast will be the “driver”, meaning that the user of the planning model will supply
this value, and most other values will be calculated based on it. Frequently, the sales forecast will
be given as the growth rate in sales rather than as an explicit sales figure. Our goal is to examine
the interplay between investment and financing needs at different possible sales levels.
b) Pro Forma Statements
A financial plan will have a forecast balance sheet, income statement, and statement of cash flows.
financial planning model will generate these statements based on projections of key items such as
sales.
c) Asset Requirements
The projected balance sheet will contain changes in total fixed assets and net working capital.
These changes are effectively the fi rm’s total capital budget.
d) Financial Requirements
The plan will include a section about the necessary financing arrangements. This part of the plan
should discuss dividend policy and debt policy.
e) The Plug
After the firm has a sales forecast and an estimate of the required spending on assets, some amount
of new financing will often be necessary because projected total assets will exceed projected total
liabilities and equity. In other words, the balance sheet will no longer balance. So we need to
adjust (add or subtract) the Liabilities and Equity Section from the Pro Forma Balance Sheet.
2. The Percentage of Sales Approach
The basic idea is to separate the income statement and balance sheet accounts into two groups—those
that vary directly with sales and those that do not. Given a sales forecast, we will then be able to
calculate how much financing the fi rm will need to support the predicted sales level.
3. Dividend Payout Ratio
The amount of cash paid out to shareholders divided by net income.
4. Retention Ratio
The addition to retained earnings divided by net income. Also called the plowback ratio.
5. Capital Intensity Ratio
Ratio of total assets to sales is sometimes called the capital intensity ratio . It tells us the amount of
assets needed to generate $1 in sales; so the higher the ratio is, the more capital-intensive is the firm.
Notice also that this ratio is just the reciprocal of the total asset turnover ratio we defined in the last
chapter.
6. Calculating EFN and Adjust them to the Balance Sheet as The Plug
Rosengarten has projected a 25 percent increase in sales for the coming year. Find the EFN and make
the Proforma Income Statement and Balance Sheet!
For more in-depth explanation go to the excel file section!
7. Capacity Utilization
The assumption that assets are a fixed percentage of sales is convenient, but it may not be suitable in
many cases. In particular, note that we effectively assumed that Rosengarten was using its fixed assets at
100 percent of capacity because any increase in sales led to an increase in fixed assets. For most
businesses, there would be some slack or excess capacity, and production could be increased by perhaps
running an extra shift. According to the Federal Reserve, the overall capacity utilization for U.S.
manufacturing companies in May 2011 was 74.5 percent, up from a low of 64.4 percent in June 2009.
8. EFN And Growth
To explain this we need to see some example
Suppose the Hoffman Company is forecasting next year’s sales level at $600, a $100 increase. Notice
that the percentage increase in sales is $100/500 = 20%.
9. Financial Policies and Growth Rate
We see that there is a direct link between growth and external financing. In this section, we discuss two
growth rates that are particularly useful in long-range planning.
A. The Internal Growth Rate
The Internal Growth Rate is the maximum growth rate that can be achieved with no external
financing of any kind. At this point, the required increase in assets is exactly equal to the
addition to retained earnings, and EFN is therefore zero. We have seen that this happens when
the growth rate is slightly less than 10 percent in the previous example. Here are the formula
*ROA= Return on Asset = Net Income/Asset
b = Retention Ratio = Retained Earning/Net Income
Example:
For the Hoffman Company, net income was $66 and total assets were $500. ROA is thus
$66/500 5 13.2%. Of the $66 net income, $44 was retained, so the plowback ratio, b , is
$44/66 5 2/3. With these numbers, we can calculate the internal growth rate
Thus, the Hoffman Company can expand at a maximum rate of 9.65 percent per year without
any external financing. Or in other words, they can used their own equity account from last
year(retained earning) to acquire new asset to fullfill the firm’s sales projected growth which in
this case is maxed at 9,65%. Above from that the firm need to acquire new asset with an External
Financing.
B. The Sustainable Growth Rate
The Sustainable Growth Rate is the maximum growth rate a firm can achieve with no external
equity financing while it maintains a constant debt–equity ratio. This rate is commonly called the
sustainable growth rate because it is the maximum rate of growth a firm can maintain without
increasing its financial leverage. There are various reasons why a firm might wish to avoid
equity sales. First, new equity sales can be expensive. Alternatively, the current owners may not
wish to bring in new owners or contribute additional equity.
*ROE= Return on Equity = Net Income/Equity
b = Retention Ratio = Retained Earning/Net Income
Example :
For the Hoffman Company, net income was $66 and total equity was $250; ROE is thus
$66/250 5 26.4 percent. The plowback ratio, b, is still 2/3, so we can calculate the sustainable
growth rate as follows:
Thus, the Hoffman Company can expand at a maximum rate of 21,36% per year without external
equity financing. This mean that the Company can have a sales growth of 21,36 percent that
going to top the DER=1 . From the previous Chapter we know that The DER is considerably
healthy if it’s less than 1. This mean that at its highest the company can only increase its sales for
21,36%, otherwise the company need to have another financing, the company can’t issue more
debt cause it can make the DER even higher. The only option for a company to go through the
sales growth benchmark (21,36%) is to raise new equity, this action can lower the DER too since
the nominator to the formula is Equity.
10. Determinants of Growth
A. Profit margin
An increase in profit margin will increase the firm’s ability to generate funds internally and thereby
increase its sustainable growth.
B. Financial policy
An increase in the debt–equity ratio increases the firm’s financial leverage. Because this makes
additional debt financing available, it increases the sustainable growth rate.
C. Total asset turnover
An increase in the fi rm’s total asset turnover increases the sales generated for each dollar in assets. This
decreases the fi rm’s need for new assets as sales grow and thereby increases the sustainable growth rate.
Notice that increasing total asset turnover is the same thing as decreasing capital intensity.
D. Dividend policy
A decrease in the percentage of net income paid out as dividend will increase the retention ratio. This
increases internally generated equity and thus increases sustainable growth.
*Notice that this determinants of Growth is almost the same with the Dupont Identity we analyze earlier on Ch 3.
The new addition here is Dividend Policy or How much the firm choose to generate Dividend or Retained their
Net Income.
11. A Note About Sustainable Growth Rate Calculations
Very commonly, the sustainable growth rate is calculated using just the numerator in our expression,
ROE × b . This causes some confusion, which we can clear up here. The issue has to do with how ROE
is computed. Recall that ROE is calculated as net income divided by total equity. If total equity is taken
from an ending balance sheet (as we have done consistently, and is commonly done in practice), then
our formula is the right one. However, if total equity is from the beginning of the period, then the
simpler formula is the correct one.
Example :
Suppose a firm has a net income of $20 and a retention ratio of .60. Beginning assets are $100. The
debt–equity ratio is .25, so beginning equity is $80.
If we use beginning numbers, we get the following:
For the same firm, ending equity is $80 1 .60 3 $20 5 $92. So, we can calculate this:
12. Profit Margin and Sustainable Growth
The Sandar Co. has a debt–equity ratio of .5, a profit margin of 3 percent, a dividend payout ratio of 40
percent, and a capital intensity ratio of 1. What is its sustainable growth rate? If Sandar desired a 10
percent sustainable growth rate and planned to achieve this goal by improving profit margins, what
would you think?
