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 !ou thin" the! should #roceed$ %hich a##roaches or models can
the! use$ %hat are the assum#tions necessar! for utili&ing 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. !ased on their asset
utili"ation rate, they would be able to determine the asset re#uirements for growth. $ome of
the funds re#uired to finance growth would be raised from spontaneous sources such as
accounts payables and accruals and from future retained earnings. The remaining funds
necessary for growth could then be raised from external sources such as new debt and stock
offering.
Jim and Mason can use one of the following approaches%
&. 'ro (orma )pproach * where most of the income statement and balance sheet
items are assumed to maintain a constant proportion to sales, but individual
items can be forecasted using statistical techni#ues and feedback effects
involving changes in interest costs etc. can be included.
+. ,(N (ormula Method * which is simple to use but does not allow the
inclusion of feedback effects.
'. (f Oats R Us is o#erating its fi)ed assets at full ca#acit! what growth rate can it
su##ort without the need for an! additional e)ternal financing$
-ere are the steps%
&. .alculate the percent of sales figure for each balance sheet item, as well as the net
profit margin, and the retention rate.
+. /sing the ,xternal (unds Needed (,(N formula (shown below, set ,(N to 0,
plug in the re#uired data, and solve for the change in sales that could be achieved
without any external financing.
*+, - ./
o
0S
o
12.3hange in sales1 4 .5
o
0S
o
12.3hange in Sales1 6 ,et Margin2.S
o
7 3hange
in sales12Retention Rate
where, $
o
1 .urrent sales2
&
New $ales 1 $
&
1 ($
o
3 .hange in sales
4etention 4ate 1 & * 'ayout 4atio
(ncome Statement 4Percent of Sales
+or the 8ear *nded 9ec. :1
st
';;<
2004
% of
Sales
2004 2003
% of
Sales
2003 2002
% of
Sales
2002
$ales 5 6,700,000 &008 5 9,7:0,000 &008 5 9,000,000 &008
.ost of ;oods $old 9,<77,=00 <+.=8 9,06=,:00 <&.08 +,600,000 <0.08
Gross Profit 822,500 &7.=8 714,400 &>.08 600,000 +0.08
$elling and ;?) ,xpenses +7=,000 =.>8 +=0,000 :.:8 +&=,000 7.+8
(ixed ,xpenses >0,000 &.>8 >0,000 +.68 >0,000 9.08
@epreciation ,xpense +=,000 0.=8 +=,000 0.78 +=,000 0.<8
Earnings Before Interest and Taes 432,500 >.+8 34!,400 >.98 270,000 >.08
Anterest ,xpense ::,000 &.68 ::,000 &.<8 ::,000 +.+8
Earnings Before Taes 366,500 7.<8 283,400 7.=8 204,000 :.<8
Taxes B 608 &6::00 9.&8 &&99:0 9.08 <&:00 +.78
"et In#o$e 21!,!00 6.78 170,040 6.=8 122,400 6.&8
4etained ,arnings &9&,>60 :0.08 &0+,0+6 :0.08 79,660 :0.08

=alance Sheet
+or the 8ear *nded 9ec. :1
st
';;<
%ssets 2004
% of
Sales
2004 2003
% of
Sales
2003 2002
% of
Sales
2002
.ash and .ash ,#uivalents :0,000 &.98 >7,97: +.:8 6<,000 &.:8
)ccounts 4eceivable +=0,6&: =.98 &7=,000 6.78 &=0,000 =.08
Anventory =&&,=00 &0.>8 9>0,000 &0.68 99=,000 &&.+8
Total Current Assets 821,916 &7.=8 662,376 &7.:8 533,000 &7.<8
'lant ? ,#uipment =:0,000 &&.>8 =:0,000 &6.>8 =:0,000 &<.78
)ccumulated @epreciation &7=,000 9.78 &=0,000 6.08 &+=,000 6.+8
Net Plant & Equipment 9<=,000 <.+8 6&0,000 &0.>8 69=,000 &6.=8
Total %ssets 1,206,!16 +=.78 1,072,376 +<.=8 !68,000 9+.98
&ia'ilities and ()ner*s E+,it-
)ccounts 'ayable &9=,000 +.>8 &=&,9=+ 6.08 &+<,000 6.98
Notes 'ayable +7=,000 =.>8 +7=,000 7.98 +=0,000 <.98
Cther .urrent Diabilities 69,>=+ 0.>8 =0,000 &.98 6:,000 &.=8
Total Current ia!ilities "53,952 >.78 "76,352 &+.78 "2",000 &6.&8
DongEterm @ebt +7=,000 =.>8 +=0,000 :.:8 900,000 &0.08
Total ia!ilities 728,952 &=.=8 726,352 &>.98 72",000 +6.&8
CwnerFs .apital &==,=:0 9.98 &==,=:0 6.&8 &==,=:0 =.+8
4etained ,arnings 9++,606 :.>8 &>0,6:6 =.&8 <<,660 +.>8
Total &ia'ilities and ()ner*s E+,it- 1,206,!16 +=.78 1,072,376 +<.=8 !68,000 9+.98

)oG$o +=.:7>8
+
Net 'rofit Margin 6.:7<8
4etention 4ate :08
.urrent $ales 56,700,000
DoG$o +.<7+8
.hange in $ales 5:=>,=>&.60
,ote> Used *)cels Sol?er function to calculate 3hange in Sales .see s#readsheet1.
S#readsheet solution
,(N 1 Ancrease in )ssets E Ancrease in internal e#uity
,(N1 +=.:7>8H(.hange in $o * +.<7H(.hange in $o E I6.:7<8H0.:H(56.7 3 .hange in $oJ
0 1 ++.<078H(.hange in $o * 0.0+<0H(.hange in $o E 5&9&,>&>.:0
.hange in $o 1 5&9&,>&>.:G0.+000 1 5:=>,=>&.60
;rowth rate that can be supported with no external funds 1 :=>,=>&.60G6,700,000 1 &6.0998
,(N1
Ancrease in
)ssets
E
Ancrease in
$pontaneous
(inances
E
Ancrease in
Anternal e#uity
0.00 = 169,376.48 18,943.47 $150,433.01
/lternati?e method
.ompute the Anternal growth rate.
Anternal growth rate 1 (4C) x 4etention 4ateGI& E (4C) x 4etention 4ateJ
1 (&<.+8 x 0.:GI&E(&<.+8 x 0.:J 1 &+.+:8
:. Oats R Us has a fle)ible credit line with the Midwa! =an". (f Mason decides to "ee#
the debt6e@uit! ratio constant u# to what rate of growth in re?enues can the firm
su##ort$ %hat assum#tions are necessar! when calculating this rate of growth$ /re
these assum#tions realistic in the case of Oats R Us$ Please e)#lain.
Af a constant debtEe#uity 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 = R! " Retention Rate = 38.1#
1 $ R! " Retention Rate
9
Khere 4C, 1 6:8 and 4etention rate 1 :08.
The assumptions necessary when calculating the sustainable growth rate include%
&. The firm will maintain a constant debtEe#uity ratio.
+. The Net 'rofit margin will be constant.
9. Total asset turnover will be constant
6. The retention rate will be constant.
=.
The last three assumptions are unrealistic because they depend on the future performance of
the firm i.e. sales and cost control. ) constant debtEe#uity ratio is a matter of management
policy and could be met #uite easily.
<. (nitiall! Jim assumes that the firm is o#erating at full ca#acit!. Aow much additional
financing will it need to su##ort re?enue growth rates ranging from 'BC to <;C #er
!ear$
$ee $preadsheet ($preadsheet solution Note% There is a slight difference in the spreadsheet
solutions because it carries out the calculations to a greater degree of mathematical accuracy.
;rowth 4ate ,(N (with excel
+=8 5&09,0=6.00
908 5&=0,0=+.<0
9=8 5&>7,0=&.:0
608 5+66,0=0.60
(or example% when the growth rate 1 6082 $
o
1 6,700,0002 .hange in $ales 1 &,<<0,0002 Net
Margin 1 6.:7>8
*+, - ./0S
o
12.3hange in sales1 4 .50S
;
12. 3hange in sales1 4 ,et Margin2.S
o
7 3hange in
sales12Retention Rate
1 0.+=:7>H&,<<0,000 * 0.0+<7+H&,<<0,000 E 0.06:7>H:,=<0,000H0.:
1 6<+,7:=.+ * =9,>>9.:0 E &<6,7+:.>+
1 +66,066.:< (within rounding
B. /fter conducting an inter?iew with the #roduction manager Jim reali&es that Oats R
Us is o#erating its #lant at D;C ca#acit! how much additional financing will it need to
su##ort growth rates ranging from 'BC to <;C$
6
.apacity /tili"ation 1 >08
.urrent $ales 1 5 6,700,000
(ixed )ssets1 9<=,000
(ixed )ssetsG$ales 4atio1 <.&>8
(ull .apacity $ales1 5 =,+++,+++ 1
6,700,000G>08
(ull .apacity (ixed )ssetsG$ales ratio 7.978
.urrent )ssetG$ales ratio 1 &7.6>8
$ales Devel ;rowth rate $ales (ull
capacity
sales
$ales
exceeding
(ull capacity
,(N
.urrent $ales 08 5 6,700,000 5 E
.apacity
$ales growth
&&8 5 =,+++,+++ 5 =++,+++ 5 E
E570,+7:.00
+=8 5 =,<7=,000 5 =++,+++ 5 :=+,77< 5=6,>+>.00
908 5 :,&&0,000 5 =++,+++ 5 <<7,77< 5&00,00+.<0
9=8 5 :,96=,000 5 =++,+++ 5 &,&++,77< 5&6=,07:.:0
608 5 :,=<0,000 5 =++,+++ 5 &,9=7,77< 5&>0,&=0.60
)oG$o (full +=.:7>8
Net Margin 6.:7>8
No New (ixed
)ssets Needed
(ixed and .urrent )ssets
vary proportionately with sales
4etention 4ate :08
Cnly .urrent )ssets
Ancrease with sales
E. %hat are some actions that Mason can ta"e in order to alle?iate some of the need for
e)ternal financing$ /nal!&e the feasibilit! and im#lications of each suggested action.
$ome actions that Mason can take to alleviate some of the need for external financing include%
&. Ancrease accounts payables by using more trade credit * this would be possible up
to a point but can be risky and expensive especially if the firm could avail itself of
discounts for paying cash.
+. Ancrease accruals * limited scope, could hurt relations with employees.
9. Ancrease profit margins * easier said than done because of competition.
6. Ancrease retention rate * this is a policy decision and is feasible. The scope is
limited, though, because profits are typically only a small portion of sales.
=. Ancrease sales * once again, easier said than done.
F. Aow critical is the financial condition of Oats R Us$ (s Gic"! Hustified in being
concerned about the need for financial #lanning$ *)#lain wh!.
=
!ased on the calculations above, CatsL 4L /s can grow another &&8 or so without new
external financing, provided it maintains its net profit margin and retention rate. $ince the
owners are expecting sales to grow by about +=8 E 608 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 +=8 growth rate they would need to raise another 5=6,+>+. Af financing
became a problem they could choose to cut back on their growth. The firm has a healthy 4C)
and 4C,. Their li#uidity ratios are not too bad and although their @ebt ratio (:0.68 seems a
bit high, their interest coverage ratio is pretty good at :.:M. Thus they should not have too
much of a problem raising the additional funds. 'lanning is essential for success, however.
AtLs therefore a good move on part of Nicky and Mason to analy"e their financial condition.

I. .O#tional1 Mason #refers not to de?iate from the firms ';;< debt6e@uit! ratio what
will the firms #ro6forma income statement and balance sheet loo" li"e under the
scenario of <;C growth in re?enue for ';;B .ignore feedbac" effects1

$ee $preadsheet for detailed solution .ase6$heet. 'lease, check the numbers in redOO
Oats R Us
'ro (orma Ancome $tatement
+00=, +006
$ales :,=<0,000.00 6,700,000
.osts (>+.+8 of sales :,0::,>00.00 6,999,=00
Taxable Ancome =&9,&00.00 9::,=00.00
Taxes (608 +0=,+60.00 &6:,:00.00
Net Ancome 907,<:0.00 +&>,>00.00
4etained ,arnings (:08 &<6,7&:.00 &9&,>60.00
Oats R Us
'ro (orma !alance $heet

%ssets 2005E 2004 % of sales
.ash and .ash ,#uivalents 5 <6,000 :0,000 &.+<8
)ccounts 4eceivable 5 9=0,=<+ +=0,6&: =.998
Anventory 5 7&:,&00 =&&,=00 &0.<<8
Total Current Assets 5 &,&=0,:<+ 821,916 &7.6>8
'lant ? ,#uipment 5 7<6,000 =:0,000 &&.>&8
)ccumulated @epreciation 5 +6=,000 &7=,000 9.7+8
Net Plant & Equipment 5 =9>,000 9<=,000 <.&>8
Total %ssets . 1,68!,682 1,206,!16 +=.:<8
&ia'ilities and ()ner*s E+,it-
)ccounts 'ayable 5 &<>,000 &9=,000 +.<78
Notes 'ayable 5 9<=,000 +7=,000 =.<=8
Cther .urrent Diabilities 5 :&,=99 69,>=+ 0.>68
Total Current ia!ilities 5 :9=,=99 "53,952 >.::8
DongEterm @ebt 5 9<=,000 +7=,000 =.<=8
:
Total ia!ilities 5 &,0+0,=99 728,952 &=.=&8
CwnerFs .apital 5 &==,=:0 &==,=:0 9.9&8
4etained ,arnings 5 =07,&+0 +&>,>00 6.:<8
Total &ia'ilities and ()ner*s E+,it- 5 &,:<>,:<+ 1,206,!16 +=.:<8

7