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Solution to Case 01 Financial Analysis and Forecasting

Growing Pains Questions 1. Since this is the first time Jim and Mason will be conducting a financial forecast 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. The sales forecast ought to be based on clearly stated assumptions about future 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 rate, they would be able to determine the asset requirements for growth. Some of the funds required to finance growth would be raised from spontaneous sources such as accounts payables and accruals and from future retained earnings. The remaining 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 Forma Approach – where most of the income statement and balance sheet items are assumed to maintain a constant proportion to sales, but individual items can be forecasted using statistical techniques and feedback effects involving changes in interest costs etc. can be included. 2. EFN Formula Method – which is simple to use but does not allow the inclusion of feedback effects. 2. If Oats’ R’ Us is operating its fixed assets at full capacity, what growth 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. 2. Using the External Funds Needed (EFN) formula (shown below), set EFN to 0, plug in the required data, and solve for the change in sales that could be achieved without any external financing. EFN = (Ao/So)*(Change in sales) – (Lo/So)*(Change in Sales) - Net Margin*(S o + 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

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

% of Sales 2004 2003 100% $ 3,760,000 82.5% 3,045,600 17.5% 714,400 5.9% 250,000 1.9% 90,000 0.5% 25,000 9.2% 349,400 1.4% 66,000 7.8% 283,400 3.1% 113360 4.7% 170,040 60.0% 102,024

2004 $ 4,700,000 3,877,500 822,500 275,000 90,000 25,000 432,500 66,000 366,500 146600 219,900 131,940

% of Sales 2003 2002 100% $ 3,000,000 81.0% 2,400,000 19.0% 600,000 6.6% 215,000 2.4% 90,000 0.7% 25,000 9.3% 270,000 1.8% 66,000 7.5% 204,000 3.0% 81600 4.5% 122,400 60.0% 73,440

% of Sales 2002 100% 80.0% 20.0% 7.2% 3.0% 0.8% 9.0% 2.2% 6.8% 2.7% 4.1% 60.0%

Balance Sheet For the Year Ended Dec. 31st, 2004

Assets Cash and Cash Equivalents Accounts Receivable Inventory Total Current Assets Plant & Equipment Accumulated Depreciation Net Plant & Equipment Total Assets Liabilities and Owner's Equity Accounts Payable Notes Payable Other Current Liabilities Total Current Liabilities Long-term Debt Total Liabilities Owner's Capital Retained Earnings Total Liabilities and Owner's Equity

Ao/So

2004 60,000 250,416 511,500 821,916 560,000 175,000 385,000 1,206,916

% 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 8.2% 410,000 25.7% 1,072,376

% 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 10.9% 435,000 28.5% 968,000

% of Sales 2002 1.6% 5.0% 11.2% 17.8% 18.7% 4.2% 14.5% 32.3%

135,000 275,000 43,952 453,952 275,000 728,952 155,560 322,404 1,206,916

2.9% 5.9% 0.9% 9.7% 5.9% 15.5% 3.3% 6.9% 25.7%

4.0% 7.3% 1.3% 12.7% 6.6% 19.3% 4.1% 5.1% 28.5%

4.3% 8.3% 1.5% 14.1% 10.0% 24.1% 5.2% 2.9% 32.3%

25.679%

2

151,352 275,000 50,000 476,352 250,000 726,352 155,560 190,464 1,072,376

128,000 250,000 46,000 424,000 300,000 724,000 155,560 88,440 968,000

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 -

EFN= 0=

Increase in internal equity

25.679%*(Change in So) – 2.87*(Change in So) - [4.678%*0.6*($4.7 + Change in So)] 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 in Assets

0.00 =

169,376.48

-

Increase in Spontaneous Finances 18,943.47

-

Increase in Internal equity $150,433.01

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’ R’ Us has a flexible credit line with the Midway Bank. If Mason decides to keep the debt-equity ratio constant, up to what rate of growth in revenues can the firm support? What assumptions are necessary when calculating this rate of 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 follows: 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 will maintain a constant debt-equity ratio. 2. The Net Profit margin will be constant. 3. Total asset turnover will be constant 4. The retention rate will be constant. 5. The last three assumptions are unrealistic because they depend on the future performance of the firm i.e. sales and cost control. A constant debt-equity ratio is a matter of management policy and could be met quite easily. 4. Initially Jim assumes that the firm is operating at full capacity. How much additional financing will it need to support revenue growth rates ranging from 25% to 40% per year? See Spreadsheet (Spreadsheet solution) Note: There is a slight difference in the spreadsheet solutions because it carries out the calculations to a greater degree of mathematical accuracy. Growth Rate

EFN (with excel)

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)*(Change 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 an interview with the production manager, Jim realizes that Oats’ R’ Us is operating its plant at 90% capacity, how much additional 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 some actions that Mason can take in order to alleviate some of the need 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 relations with employees. Increase profit margins – easier said than done because of competition. Increase retention rate – this is a policy decision and is 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 critical is the financial condition of Oats’ R’ Us? Is Vicky justified in 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 financing, provided it maintains its net profit margin and 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. 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 are not too bad and 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 raising the additional funds. Planning is essential for success, however. It’s therefore a good move on part of Vicky and Mason to analyze their financial condition. 8. (Optional) Mason prefers not to deviate from the firm’s 2004 debt-equity ratio, what will the firm’s pro-forma income statement and balance sheet look like under the scenario of 40% growth in revenue for 2005 (ignore feedback effects) See Spreadsheet for detailed solution Case4Sheet. Please, check the numbers in red!! Oats’ R’ Us Pro Forma Income Statement 2005E 2004 Sales 6,580,000.00 4,700,000 Costs (92.2% of sales) 6,066,900.00 4,333,500 Taxable Income 513,100.00 366,500.00 Taxes (40%) 205,240.00 146,600.00 Net Income 307,860.00 219,900.00 Retained Earnings (60%) 184,716.00 131,940.00

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

2005E 2004 $ 84,000 60,000 $ 350,582 250,416 $ 716,100 511,500 $ 1,150,682 821,916 $ 784,000 560,000 $ 245,000 175,000 $ 539,000 385,000 $ 1,689,682 1,206,916 $ $ $ $ $

189,000 385,000 61,533 635,533 385,000

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135,000 275,000 43,952 453,952 275,000

% of sales 1.28% 5.33% 10.88% 17.49% 11.91% 3.72% 8.19% 25.68% 2.87% 5.85% 0.94% 9.66% 5.85%

Total Liabilities Owner's Capital Retained Earnings Total Liabilities and Owner's Equity

$ 1,020,533 728,952 $ 155,560 155,560 $ 507,120 219,900 $ 1,689,682 1,206,916

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15.51% 3.31% 4.68% 25.68%