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Workbook 7 – Financial Planning and Growth
PoS Approach for Income Statement
XYZ has projected a 25 % increase in sales for the coming
year
Income Statement (Most Recent)
• What will be the sales for coming year ?
• What will be the cost for coming year ? (Assuming
Sales
$1,000
that the ratio of cost to sales shall remain same.)
Costs (Cost + Depreciation + Interest)
800
• What will be the Net Income ?
• What was the percentage of NI to sales and what is
Taxable Income
$200
it now ?
Taxes @ 34 %
68
• Now what about dividend ?
• Assume that the management of XYZ pays
Net Income
$132
constant rate of dividend out of NI (Dividend
Dividends
$44
payout ratio is constant)
• What is dividend payout ratio of XYZ ?
Addition to Retained Earnings $88
• What is the retention or plowback ratio of XYZ ?
• Make pro forma income statement for coming year.
XYZ Corporation
XYZ Corporation
Pro Forma Income Statement
•
•
Sales
?
Costs (Cost + Depreciation + Interest)
?
Taxable Income
?
Taxes @ 34 %
?
Net Income
$165
Dividends
?
Addition to Retained Earnings
?
PoS Approach for Balance Sheet
Some of the items vary directly with sales and others do not.
For those items that do vary with sales, we express each as a percentage of sales for the year just ended.
For others we write “n/a”
XYZ Corporation
Most Recent Balance Sheet
$
Assets
S.B.Khatri- FM
%
sales
of
$
%
sales
of
Liabilities
Page 1
Current Assets
Current Liabilities
Cash
160
16
Accounts payable
300
30
Accounts Receivable
440
44
Notes payable
100
n/a
Inventory
600
60
400
n/a
1200
120
800
n/a
Common stock and paid in
surplus
800
n/a
Retained Earnings
1000
n/a
Total
1800
n/a
Total liabilities and owner's equity
3000
n/a
Total
Total
Long term Debt
Fixed Assets
New
plant
equipment
Owner's Equity
and
1800
Total Assets
•
•
•
•
•
•
3000
180
300
Ratio of total assets to sales = ?
 It is called Capital Intensity Ratio
What does this ratio tell us ?
 Tells us the amount of assets needed to generate $ 1 in sales.
 Its reciprocal of Total Assets Turnover Ratio
On the liability side, why only A/C payable is assumed to be varying with sales ?
What is Notes Payable ?
 Short term debts such as bank and corporate borrowings.
What about Retained Earning ? Does it vary with sales ?
 But we shall calculate it based on our projected net income and dividend (governed by dividend
policy)
Construct a partial pro forma balance sheet
 For each items, also find out the change from previous year in $.
 For those items that don’t vary directly with sales, initially assume no change and simply write in
the original amounts.
• What about change in Retained Earnings ? Is it nil ?
XYZ Corporation
Partial Pro Forma Balance Sheet
$
Change
from
previous year
Assets
Liabilities
Current Assets
Current Liabilities
Cash
S.B.Khatri- FM
?
?
Accounts payable
$
Change
from
previous year
375
?
Page 2
Accounts
Receivable
?
110
Inventory
?
150
Total
1500
300
Long term Debt
Total
Notes payable
Fixed Assets
New plant
equipment
?
0
475
75
?
0
Common stock and
paid in surplus
800
0
Retained Earnings
1110
110
Total
1910
110
3185
185
?
?
Owner's Equity
and
Total Assets
?
3750
450
Total
liabilities
owner's equity
750
and
External Financing Need
•
•
•
•
•
•
Assets increase by $ 750 while liabilities and equity increase only by $ 185
The difference $ 565 is External Financing Need (EFN)
Now there’s a good news and a bad news.
Good News – We’re projecting 25 % increase in sales.
Bad News – This isn’t going to happen unless XYZ can somehow raise $ 565 in new financing.
If for eg, XYZ has goal of not borrowing any additional funds and not selling any new equity, then 25%
increase in sales is probably not feasible.
• This is how the planning process can point out problems and potential conflicts.
• Given the EFN $ 565, XYZ has three possible sources:
 Short-Term borrowing
 Long-Term borrowing
 Issuance of New Equity
• Choice of any combination of above sources is up to management.
• Lets say that XYZ decides to borrow $ 565- some over the short-term and some over the long-term
Scenario 1- Leave net working capital unchanged (NWC = CA – CL)
XYZ Corporation
Partial Pro Forma Balance Sheet
$
Change
from
previous year
Assets
Liabilities
Current Assets
Current Liabilities
$
Change
from
previous year
75
Cash
200
40
Accounts payable
375
Accounts Receivable
550
110
Notes payable
?
S.B.Khatri- FM
?
Page 3
Inventory
Total
750
150
1500
300
Total
?
3750
750
$
Change
from
previous year
Long term Debt
Fixed Assets
New plant
equipment
?
Owner's Equity
and
2250
Common stock and paid
in surplus
450
Retained Earnings
Total
Total Assets
3750
Total liabilities and owner's
equity
750
Accounts Payable rose by $ 75
How much could XYZ borrow in short-term Notes Payable ?
How much could XYZ borrow in short-term Notes Payable ?
How much more is needed now ? $ 565 - $ 225 = $ 340
How will XYZ raise $ 340 ?
Long Term Borrowings
Now fill up all the items of Pro Forma BS
How much is common stock and paid-in surplus ?
XYZ Corporation
Partial Pro Forma Balance Sheet
$
Change
from
previous year
Assets
Liabilities
Current Assets
Current Liabilities
Cash
200
40
Accounts payable
375
75
Accounts Receivable
550
110
Notes payable
325
225
Inventory
750
150
700
300
1500
300
1140
340
Common stock and paid
in surplus
800
0
Retained Earnings
1110
110
Total
1910
110
Total liabilities and owner's
3750
750
Total
Fixed Assets
New plant
equipment
Total Assets
S.B.Khatri- FM
Total
Long term Debt
Owner's Equity
and
2250
3750
450
750
Page 4
equity
•
•
•
•
•
•
•
•
Here, what have we used as plug ?
Plug – Combo of short and long term debt
This is just one possible strategy
While planning, we should investigate many of such scenarios
Now what can be the use of Ratio analysis here ?
We would surely like to examine the CURRENT RATIO and TOTAL DEBT RATIO
Now we can form projected statement of cash flows too.
TRY IT !
Scenario 2 - What if XYZ is using operating at only 70 % capacity ?
• It would mean that sales of $ 1000 is only 70 % of the full capacity sales.
• Then, what is full capacity sales ?
• $1000/ 0.70 = $ 1429
• That means sales could increase by almost 43 % before any new fixed assets would be needed.
• For our previous example, we assumed that sales would increase by only 25 % < 43 %.
• Now what shall be EFN ? Will it still be $ 565 ?
• Hint : Now XYZ wont need $ 450 in net new assets investment.
• EFN = $ 565 - $ 450 = $ 115
• Lessons Learnt :
• It is inappropriate to blindly manipulate financial statement information in the planning process.
• Results depend critically on the assumptions made about the relationships between sales and assets
need.
• Projected growth rates play an important role in the planning process.
2. Below are the most recent financial statements for the G. T. Seaver Corporation:
Seaver expects sales to increase
by 15% in the coming year.
Assume that all variables will
grow at the same rate as sales.
Prepare the pro forma income
statement and balance sheet.
Reconcile these statements
using dividends as the "plug"
figure.
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Increasing income statement and balance sheet items by 15% results in the following statements:
The figures in parentheses indicate the increase in the respective balance sheet items. The increase of $9,750 in
equity is inconsistent with the net income of $27,600 from the pro forma income statement. If these figures are
reconciled using dividends as the "plug" figure, then total cash dividends for the year must be ($27,600 - $9,750)
= $17,850.
3. Reconcile the pro forma statements in the solution to Problem 2, using long-term debt as the "plug" figure,
under the assumption that Seaver Corporation pays no dividends.
If dividends are zero, then retained earnings are $27,600 and equity on the pro forma balance sheet is equal to
($65,000 + $27,600) = $92,600. Equity plus current liabilities equals ($92,600 + $11,500) = $104,100, so longterm debt is ($115,000 - $104,100) = $10,900. Seaver must pay off ($25,000 - $10,900) = $14,100 of long-term
debt. The pro forma balance sheet appears as follows:
4. Reconcile the pro forma statements in the solution to Problem 2, using long-term debt as the "plug" figure,
under the assumption that Seaver Corporation has a payout ratio of 80%.
Dividends are ($27,600 × .80) = $22,080, and retained earnings are ($27,600 - $22,080) = $5,520. Equity on the
pro forma balance sheet is ($65,000 + $5,520) = $70,520. Equity plus current liabilities is ($70,520 + $11,500) =
$82,020. Long-term debt must be ($115,000 - $82,020) = $32,980, so Seaver must borrow ($32,980 - $25,000) =
$7,980. The pro forma balance sheet appears below:
S.B.Khatri- FM
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5. The most recent income statement and balance sheet for the T. McGraw Corporation are as follows:
McGraw is forecasting a 20% increase
in sales for the coming year; assets
vary directly with sales, while
liabilities and equity do not. Compute
the following for McGraw: profit
margin (PM), retention ratio (R),
return on assets (ROA), return on
equity (ROE) and debt/equity ratio
(D/E).
PM
=$1,650/$10,000 = 16.5%
R
= $660/$1,650 = 40%
ROA =$1,650/$15,000 = 11%
ROE =
$1,650/$9,000 = 18.333%
D/E =
$6,000/$9,000 = 66.667%
6. Use the ratios computed in the solution to Problem 5 to calculate the EFN for by T. McGraw Co.
The increase in assets to be financed is: $15,000 × .20 = $3,000. To compute the financing available in the form
of retained earnings, we first compute projected sales:
Sales × (1 + g) = $10,000 × 1.20 = $12,000
Projected net income equals profit margin times projected sales: .165 × $12,000 = $1,980. The projected addition
to retained earnings is the retention ratio times projected net income:
.40 × $1,980 = $792
Therefore, the external financing needed is: EFN = $3,000 - $792 = $2,208.
7. Use pro forma statements to verify the results in the solution to Problem 6.
S.B.Khatri- FM
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