Growing Pains Solution

Questions 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:
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. EFN Formula Method – which is simple to use but does not allow the inclusion of feedback effects.

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?

EFN = (Ao/So)*(Change in sales) – (Lo/So)*(Change in Sales) – Net Margin*(So + Change in sales)*Retention Rate where, So = Current sales; New Sales = S1 = (So + Change in sales)
Retention Rate = 1 – Payout Ratio

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 | = | 38.1% | 1 – ROE x Retention Rate | |

Where ROE = 46% and Retention rate = 60%.

The assumptions necessary when calculating the sustainable growth rate include:

The firm will maintain a constant debt-equity ratio.
The Net Profit margin will be constant.
Total asset turnover will be constant
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. A constant debt-equity ratio is a matter of management policy and could be met quite easily.

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?

Growth RateEFN (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)

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%?

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:

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.

How critical is the financial condition of Oats’ R’ Us? Is Vicky justified in being concerned about the need for financial planning? Explain why.

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.

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)