Chapter Six
Financial Planning: Short Term and
Long Term
Estimation of Sustainable Growth Rate
First way:
Second way: g = (NI/Ebeg) × RR
Third way:
Fourth way: g = Operating Performance × Financial Policy
g = ROA × FP (Equity multiplier × RR)
Incremental sales
It is a concept where in a company manages to sell more products as compared to its
estimates.
It usually happen when a business used advertising and promotion methods to attract &
lure the customer into buying the products or services.
It must lead to incremental overall profits and free cash flows.
Potential impediments to a lockstep relationship between incremental sales and
incremental cash flows (incremental sale – incremental operating expenses + noncash
operating expenses) are:
First, the incremental sales must be sold at prices that cover all incremental costs
(capacity and variable costs). This may not be so easy if the venture, like most firms,
faces downward-sloping demand (with lower prices required to sell more units).
Second, the revenues from additional unit sales must cover increases in working capital
investments (inventory and accounts receivable) required to support those incremental
sales. Only when sales revenues cover all of these costs are there free cash flows that can
give rise to an increase in venture value.
Internally Generated Funds
A firm’s net income or profit after taxes, also referred to as its internally generated
funds, can be distributed to owners or reinvested to support growth.
The portion retained in the business becomes an increase in retained earnings.
Estimation of Sustainable Sales Growth Rate
It is the rate supported without external equity capital (through the retention
of profits). If a firm can scale itself up without changing its strategy and
margins, the firm can increase its sales at the growth rate of its book value
of equity:
where g is the annual percentage growth rate in equity, ΔE is the change in
equity during the year, and Ebeg is the equity at the beginning of the
year.
Assuming that the venture does not raise new external equity (or retire
existing equity), we see that its equity only changes by earnings retention.
The change in equity can be expressed as:
ΔE = Net Income × Retention Rate =NI × RR
where RR is the proportion of net income retained in the firm. For early-stage
ventures, the retention rate will be 100 percent. More mature firms may
use some of their income to fund a dividend; the retention rate is one
minus the dividend payout percentage (1 − DPO%).
Dividing both sides of equation by the beginning equity gives:
Δ E/Ebeg = (NI/Ebeg) × RR
By substituting g in the left side of equation we get
g = (NI/Ebeg) × RR
(Note that NI/Ebeg is the return on beginning equity ROE)
Assume that the venture started the year with $10 million in book value of
equity. It plans no intermediate equity injections or withdrawals and
projects net income of $2 million for the year. It will pay a $500,000 (25
percent) dividend at the beginning of the next period and retain $1,500,000
(75 percent). Assuming it will scale up with the same margins, we see that
the venture will grow by:
g = ($2,000,000/$10,000,000) × 0.75 = 0.20 × 0.75
= 0.15, or 15%
The venture’s maximum sustainable growth rate is at 100 percent retention,
where
gmax = ($2,000,000/$10,000,000) × 1.00 = 0.20 or 20%
Comment: If the firm projects growth in excess of 20 percent, it must raise
external equity capital, have some scaling advantage leading to improved
asset efficiency, and have lower incremental variable costs or some other
organic change (including increased use of nonequity financing).
A venture’s maximum sustainable growth rate, gmax, is its return on
beginning equity, which decomposes into the product of net profit margin,
asset turnover ratio, and the firm’s equity multiplier ratio. When the
venture retains less than 100 percent of the net income, this maximum
sustainable growth rate must be adjusted downward to the venture’s
projected sustainable growth rate (g) by multiplying gmax by the
retention ratio (RR).
ROE = Net Profit Margin × Asset Turnover × Equity Multiplier
GameToy has a projected sales growth rate of 30 percent per year. Sales in the
first full year of operation were $1.6 million. These sales were supported by an
investment in assets of $1 million and produced a net income of $160,000.
Equity at the beginning of last year was $800,000. Management intends to
retain all profits in the venture. Assuming the components of the ROE model
scale remain constant with growth, the sustainable sales growth rate is:
GameToy can grow its sales at 20 percent each year as long as profit margins,
asset turnovers, and financial leverage ratios remain constant during the
increases, and all net income (profit) is retained.
Another way to look at sustainable growth is to separate the firm’s operating performance
and financial policy. A firm’s return on assets (ROA) is the product of its net profit margin
(NI/NS) and its asset turnover (NS/TA); it measures the firm’s operating performance over
a specified time period.
The product of the first two components [(NI/NS) × (NS/TA)] provides the ROA measure of
operating performance.
The product of the financial leverage or equity multiplier component (TA/CEbeg) and the
retention rate (RR, or 1 − DPO%) reflects the firm’s financial policy (FP).
Sustainable growth is: g = Operating Performance × Financial Policy
g = ROA × FP (Equity multiplier × RR)
To illustrate, we return to the GameToy venture. Recall that the equity multiplier was 1.25
($1,000,000/$800,000), using beginning-of-period equity, and retention is 100 percent.
Accordingly, the financial policy factor is 1.25 (i.e., 1.25 × 1.00), and its sustainable
growth rate is:
g = ROA × (1:25 × 1.00) = ROA × 1:25 = .16 × 1.25 = 20%
Sustainable growth varies linearly with the venture’s return on assets as long as the
financial policy (financial leverage and retention of profits decisions) remains
stable.
The solid line depicts sustainable growth at various ROAs. Growth rates above the line,
such as the 30 percent target sales growth rate, are not feasible without operating
improvements, changes in financial policy, or external equity capital. Owing to
market capture considerations, many early-stage ventures will not want to limit
growth to the sustainable level.
Improvements in profit margins and/or asset turnovers, leading to improved ROA, can
pave the way for some growth beyond the current sustainable level. For example,
we can solve for the ROA operating performance that GameToy would need in
order to achieve 30 percent sustainable growth:
0.30 = ROA × 1:25, or
ROA = 0.30/1:25 = 0.24, or 24%
To achieve a sustainable growth of 30 percent, GameToy would have to improve its
return on assets from 16 percent to 24 percent—a 50 percent improvement, an
unlikely prospect.
Debt is notoriously scarce and most likely already would have been used to the extent
possible. If GameToy had been funding part of its assets with debt, the sustainable
growth rate of 20 percent already incorporates the benefit of continuing the debt
strategy (as a percent of assets).
To enable additional growth, GameToy must borrow even more per dollar of assets
than it currently borrows. As GameToy probably has exhausted all avenues for
improving operating efficiency and expanding debt, external equity capital markets
become the only viable path to realizing its growth ambitions.
Financial capital needed (FCN)
It is the additional funding required to support a firm’s projected growth.
Some of this funding gap will be covered by trade credit and other current
liabilities that increase spontaneously with sales.
Spontaneously generated funds
These are increases in accounts payables and accruals (wages and taxes) that
accompany sales increases. For example, when sales increase, credit
purchases from suppliers should also increase, leading to lockstep
increases in accounts payable.
If the venture is profitable and scaling up without margin changes, its increase
in profits, when retained, helps meet a firm’s FCN.
Additional funds needed (AFN)
It is the gap remaining between the FCN and the capital funded by
spontaneously generated funds and retained earnings:
AFN = Required Increase in Assets − Spontaneously Generated Funds −
Increase in Retained Earnings
AFN = Required Increase in Assets − Spontaneously Generated Funds − Increase in
Retained Earnings
where TA is the total assets, NS is the net sales, ΔNS is the change in net sales
expected between the current year and next year, AP is the accounts payable, AL is
the accrued liabilities, NI is the net income, RR is the retention rate as previously
defined, and the subscripts “0” and “1” represent the current year and the
forecast for next year, respectively.
Difference between Sustainable Growth Rate and the AFN equations
The AFN recognizes spontaneously generated funds (the second term in the
equation) and does not assume that financial policy (leverage) is proportional as is
the case with the sustainable growth calculation.
The AFN focuses on determining the total funding gap, allowing management to
decide whether debt or equity will bridge the gap.
The AFN equation, like the sustainable sales growth equation, does not include
amortization- and depreciation generated sources of funds. This is because these
equations assume that depreciation and amortization funds are used to replace
existing assets and thus are not available to finance new sales growth.
Recall that GameToy’s last year’s sales were $1.6 million and were supported by a $1
million investment in assets. The sales produced a net income of $160,000. We will
calculate the AFN assuming GameToy contemporaneously had current assets of
$520,000, fixed assets of $480,000, accounts payable of $48,000, and accrued liabilities
of $32,000. At a 30 percent growth rate, next year’s sales will reach $2.08 million ($1.6
million × 1.3), a change of $480,000 ($2.08 million − $1.6 million).
AFN = Required Increase in Assets − Spontaneously Generated Funds − Increase in
Retained Earnings
GameToy will need $300,000 in additional financial capital to acquire the assets needed to
achieve the projected 30 percent growth in sales. The company projects $24,000 to
come from spontaneously generated funds (liabilities to suppliers, employees, and the
government) and $208,000 from retained earnings. The remaining AFN of $68,000 must
be raised from new external financiers (debt and/or equity).
Projected balance sheet changes for Gametoy company
Panel A in Figure illustrates the $300,000 increase in GameToy’s assets
necessary to support next year’s 30 percent growth. Notice that the
percentage change in assets is the same as the percentage change in
sales, because the AFN model assumes that the past relationship between
assets and sales remains stable (scaling with no margin change).
Projected balance sheet changes for Gametoy company
Panel B depicts how the $300,000 in additional assets will be financed.
Management has only three choices to consider when the achievable sales growth rate is constrained
by inadequate financing:
(1) improvements in operating performance,
(2) changes in financial policy (debt and payout), or
(3) Sale of part ownership through equity fund raising.
Impact of Different Growth Rates on AFN
While $68,000 may not be a substantial gap for some ventures, the AFN usually grows linearly with sales
growth rates. For example, consider how GameToy’s AFN rises when sales are projected to grow at
50 percent. Sales would reach $2,400,000 ($1,600,000 × 1.50), an increase of $800,000. If we
assume that the other financial relationships remain the same, the new AFN is:
AFN = Required Increase in Assets − Spontaneously Generated Funds − Increase in Retained
Earnings
If sales are projected to grow at 50 percent (rather than 30 percent), the AFN rises to $220,000 from
$68,000, a greater than threefold increase.
Estimating the AFN for Multiple Years
For example, if GameToy expects sales to grow at 30 percent per year for each of the next
two years, we can calculate the total two-year AFN. All we need to do is plug two-year
changes in sales into equation. After two years of 30 percent sales growth, sales will
reach $2,704,000 ($1,600,000 × 1.30 × 1.30). Total two-year sales will be $4,784,000
($2,080,000 + $2,704,000), reflecting a two-year change in sales of $1,104,000
($2,704,000 − $1,600,000). Inserting our numbers into equation gives a two-year AFN of:
GameToy needs to raise $156,400 over the next two years. Because we have already
calculated that the one-year forward AFN is $68,000, the additional amount to be raised
to support the second year of growth is $88,400 ($156,400 − $68,000).
Why SG and AFN is necessary?
Sustainable growth and AFN calculations are useful
For understanding how financial measures interact and relate
to future financing needs.
The goal is to create a set of projected financial statements
that quantify the venture’s view of the future.
Percent-of-sales forecasting method
It projects account balances by assuming that most expenses and balance
sheet items can be expressed as a percent of sales. For example, if a
venture’s cost of goods sold varies proportionately with sales (i.e., they are
variable costs as defined earlier), they represent a constant percent of
sales. If the cost of goods sold last year was 60 percent of sales, it will be
forecasted to remain 60 percent of sales next year.
Similarly, if assets were 66.7 percent of sales last year, they will be forecasted
to be 66.7 percent of sales next year. If sales are expected to grow by 30
percent next year, assets also are forecasted to grow at a rate of 30
percent to sustain 66.7 percent of sales next year.
constant-ratio forecasting method
In general, if a cost or balance sheet item is expected to remain at the same
percentage of sales from year to year, then it will grow at the same rate as
sales. Using a constant percent of sales in projections results in constant
ratios and is one way to implement a constant-ratio forecasting method.
if one keeps the ratios constant for all years, or
one keeps the percents of sales constant for all years,
the two approaches coincide.
The financial forecasting process used to project financial
statements is:
1. Forecasted sales
2. Project the income statement
3. Project the balance sheet
4. Project the statement of cash flows
NB: Please go through page no (217-222)
