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In Their Own Words ROBERT C. HIGGINS ON SUSTAINABLE GROWTH Most financial officers know intuitively that it takes money to make money. Rapid sales growth requires increased assets in the form of accounts receivable, inventory, and fixed plant, which, in turn, require money to pay for assets. They also know that if their company does not have the money when needed, it can literally “grow broke.” The sustainable growth equation states these intuitive truths explicitly. Sustainable growth is often used by bankers and other external analysts to assess a companys creditworthiness. They are aided in this exercise by several sophisticated computer software packages that provide detailed analyses of the companys past financial performance, including its annual sustainable growth rate. Bankers use this information in several ways. Quick comparison of a companys actual growth rate to its sustainable rate tells the banker what issues will be at the top of managements financial agenda. If actual growth consistently exceeds sustainable growth, managements problem will be where to get the cash to finance growth. The banker thus can anticipate interest in loan products. Conversely, if sustainable growth consistently exceeds actual, the banker had best be prepared to talk about investment products because managements problem will be what to do with all the cash that keeps piling up in the till. Bankers also find the sustainable growth equation useful for explaining to financially inexperienced small business owners and overly optimistic entrepreneurs that, for the long-run viability of their business, it is necessary to keep growth and profitability in proper balance. Finally, comparison of actual to sustainable growth rates helps a banker understand why a loan applicant needs money and for how long the need might continue. In one instance, a loan applicant requested $100,000 to pay off several insistent suppliers and promised to repay in a few months when he collected some accounts receivable that were coming due. A sustainable growth analysis revealed that the firm had been growing at four to six times its sustainable growth rate and that this pattern was likely to continue in the foreseeable future. This alerted the banker that impatient suppliers were only a symptom of the much more fundamental disease of overly rapid growth, and that a $100,000 loan would likely prove to be only the down payment on a much larger, multiyear commitment. Robert C. Higgins is Professor of Finance at the University of Washington. He pioneered the use of sustainable growth as a tool for financial analysis. The final plan will therefore implicitly contain different goals in different areas and also satisfy many constraints. For this reason, such a plan need not be a dispassionate assessment of what we think the future will bring; it may instead be a means of reconciling the planned activities of different groups and a way of setting common goals for the future. However it is done, the important thing to remember is that financial planning should not become a purely mechanical exercise. If it does, it will probably focus on the wrong things. Nevertheless, the alternative to planning is stumbling into the future. Perhaps the immortal Yogi Berra (the baseball catcher, not the cartoon character), said it best: “Ya gotta watch out if you dont know where youre goin. You just might not get there.” 7 Summary and Conclusions This chapter focuses on working with information contained in financial statements. Specifically, we studied standardized financial statements, ratio analysis, and long-term financial planning.1. We explained that differences in firm size make it difficult to compare financial statements, and we discussed how to form common-size statements to make comparisons easier and more meaningful. 2. Evaluating ratios of accounting numbers is another way of comparing financial statement information. We defined a number of the most commonly used ratios, and we discussed the famous Du Pont identity. 3. We showed how pro forma financial statements can be generated and used to plan for future financing needs. After you have studied this chapter, we hope that you have some perspective on the uses and abuses of financial statement information. You should also find that your vocabulary of business and financial terms has grown substantially. Concept Questions 1. Financial Ratio Analysis A financial ratio by itself tells us little about a company because financial ratios vary a great deal across industries. There are two basic methods for analyzing financial ratios for a company: Time trend analysis and peer group analysis. In time trend analysis, you find the ratios for the company over some period, say five years, and examine how each ratio has changed over this period. In peer group analysis, you compare a companys financial ratios to those of its peers. Why might each of these analysis methods be useful? What does each tell you about the companys financial health? 2. Industry-Specific Ratios So-called “same-store sales” are a very important measure for companies as diverse as McDonalds and Sears. As the name suggests, examining same-store sales means comparing revenues from the same stores or restaurants at two different points in time. Why might companies focus on same-store sales rather than total sales? 3. Sales Forecast Why do you think most long-term financial planning begins with sales forecasts? Put differently, why are future sales the key input? 4. Sustainable Growth In the chapter, we used Rosengarten Corporation to demonstrate how to calculate EFN. The ROE for Rosengarten is about 7.3 percent, and the plowback ratio is about 67 percent. If you calculate the sustainable growth rate for Rosengarten, you will find it is only 5.14 percent. In our calculation for EFN, we used a growth rate of 25 percent. Is this possible? (Hint: Yes. How?) 5. EFN and Growth Rate Broslofski Co. maintains a positive retention ratio and keeps its debt equity ratio constant every year. When sales grow by 20 percent, the firm has a negative projected EFN. What does this tell you about the firms sustainable growth rate? Do you know, with certainty, if the internal growth rate is greater than or less than 20 percent? Why? What happens to the projected EFN if the retention ratio is increased? What if the retention ratio is decreased? What if the retention ratio is zero? 6. Common-Size Financials One tool of financial analysis is common-size financial statements. Why do you think common-size income statements and balance sheets are used? Note that the accounting statement of cash flows is not converted into a common-size statement. Why do you think this is? 7. Asset Utilization and EFN One of the implicit assumptions we made in calculating the external funds needed was that the company was operating at full capacity. If the company is operating at less than full capacity, how will this affect the external funds needed? 8. Comparing ROE and ROA Both ROA and ROE measure profitability. Which one is more useful for comparing two companies? Why? 9. Ratio Analysis Consider the ratio EBITD/Assets. What does this ratio tell us? Why might it be more useful than ROA in comparing two companies?10. Return on Investment A ratio that is becoming more widely used is return on investment. Return on investment is calculated as net income divided by long-term liabilities plus equity. What do you think return on investment is intended to measure? What is the relationship between return on investment and return on assets? Use the following information to answer the next five questions: A small business called The Grandmother Calendar Company began selling personalized photo calendar kits. The kits were a hit, and sales soon sharply exceeded forecasts. The rush of orders created a huge backlog, so the company leased more space and expanded capacity, but it still could not keep up with demand. Equipment failed from overuse and quality suffered. Working capital was drained to expand production, and, at the same time, payments from customers were often delayed until the product was shipped. Unable to deliver on orders, the company became so strapped for cash that employee paychecks began to bounce. Finally, out of cash, the company ceased operations entirely three years later. 11. Product Sales Do you think the company would have suffered the same fate if its product had been less popular? Why or why not? 12. Cash Flow The Grandmother Calendar Company clearly had a cash flow problem. In the context of the cash flow analysis we developed in Chapter 2, what was the impact of customers not paying until orders were shipped? 13. Corporate Borrowing If the firm was so successful at selling, why wouldnt a bank or some other lender step in and provide it with the cash it needed to continue? 14. Cash Flow Which was the biggest culprit here: Too many orders, too little cash, or too little production capacity? 15. Cash Flow What are some actions a small company like The Grandmother Calendar Company can take (besides expansion of capacity) if it finds itself in a situation in which growth in sales outstrips production? Questions and Problems connect BASIC (Questions 110) 1. Du Pont Identity If Roten, Inc., has an equity multiplier of 1.35, total asset turnover of 2.15, and a profit margin of 5.8 percent, what is its ROE? 2. Equity Multiplier and Return on Equity Thomsen Company has a debtequity ratio of .90. Return on assets is 10.1 percent, and total equity is $645,000. What is the equity multiplier? Return on equity? Net income? 3. Using the Du Pont Identity Y3K, Inc., has sales of $3,100, total assets of $1,580, and a debtequity ratio of 1.20. If its return on equity is 16 percent, what is its net income? 4. EFN The most recent financial statements for Martin, Inc., are shown here: Assets and costs are proportional to sales. Debt and equity are not. A dividend of $1,841.40 was paid, and Martin wishes to maintain a constant payout ratio. Next years sales are projected to be $30,960. What external financing is needed? 5. Sales and Growth The most recent financial statements for Fontenot Co. are shown here: Assets and costs are proportional to sales. The company maintains a constant 30 percent dividend payout ratio and a constant debtequity ratio. What is the maximum increase in sales that can be sustained assuming no new equity is issued? 6. Sustainable Growth If the Layla Corp. has a 15 percent ROE and a 10 percent payout ratio, what is its sustainable growth rate? 7. Sustainable Growth Assuming the following ratios are constant, what is the sustainable growth rate? Total asset turnover = 1.90 Profit margin = 8.1% Equity multiplier = 1.25 Payout ratio = 30% 8. Calculating EFN The most recent financial statements for Bradley, Inc., are shown here (assuming no income taxes): Assets and costs are proportional to sales. Debt and equity are not. No dividends are paid. Next years sales are projected to be $6,669. What is the external financing needed? 9. External Funds Needed Cheryl Colby, CFO of Charming Florist Ltd., has created the firms pro forma balance sheet for the next fiscal year. Sales are projected to grow by 10 percent to $390 million. Current assets, fixed assets, and short-term debt are 20 percent, 120 percent, and 15 percent of sales, respectively. Charming Florist pays out 30 percent of its net income in dividends. The company currently has $130 million of long-term debt and $48 million in common stock par value. The profit margin is 12 percent. 1. Construct the current balance sheet for the firm using the projected sales figure. 2. Based on Ms. Colbys sales growth forecast, how much does Charming Florist need in external funds for the upcoming fiscal year?3. Construct the firms pro forma balance sheet for the next fiscal year and confirm the external funds needed that you calculated in part (b). 10. Sustainable Growth Rate The Steiben Company has an ROE of 10.5 percent and a payout ratio of 40 percent. 1. What is the companys sustainable growth rate? 2. Can the companys actual growth rate be different from its sustainable growth rate? Why or why not? 3. How can the company increase its sustainable growth rate? INTERMEDIATE (Questions 1123) 11. Return on Equity Firm A and Firm B have debttotal asset ratios of 40 percent and 30 percent and returns on total assets of 12 percent and 15 percent, respectively. Which firm has a greater return on equity? 12. Ratios and Foreign Companies Prince Albert Canning PLC had a net loss of 15,834 on sales of 167,983. What was the companys profit margin? Does the fact that these figures are quoted in a foreign currency make any difference? Why? In dollars, sales were $251,257. What was the net loss in dollars? 13. External Funds Needed The Optical Scam Company has forecast a 20 percent sales growth rate for next year. The current financial statements are shown here: 1. Using the equation from the chapter, calculate the external funds needed for next year. 2. Construct the firms pro forma balance sheet for next year and confirm the external funds needed that you calculated in part (a). 3. Calculate the sustainable growth rate for the company. 4. Can Optical Scam eliminate the need for external funds by changing its dividend policy? What other options are available to the company to meet its growth objectives?14. Days Sales in Receivables A company has net income of $205,000, a profit margin of 9.3 percent, and an accounts receivable balance of $162,500. Assuming 80 percent of sales are on credit, what is the companys days sales in receivables? 15. Ratios and Fixed Assets The Le Bleu Company has a ratio of long-term debt to total assets of .40 and a current ratio of 1.30. Current liabilities are $900, sales are $5,320, profit margin is 9.4 percent, and ROE is 18.2 percent. What is the amount of the firms net fixed assets? 16. Calculating the Cash Coverage Ratio Titan Inc.s net income for the most recent year was $9,450. The tax rate was 34 percent. The firm paid $2,360 in total interest expense and deducted $3,480 in depreciation expense. What was Titans cash coverage ratio for the year? 17. Cost of Goods Sold Guthrie Corp. has current liabilities of $270,000, a quick ratio of 1.1, inventory turnover of 4.2, and a current ratio of 2.3. What is the cost of goods sold for the company? 18. Common-Size and CommonBase Year Financial Statements In addition to common- size financial statements, commonbase year financial statements are often used. Commonbase year financial statements are constructed by dividing the current year account value by the base year account value. Thus, the result shows the growth rate in the account. Using the following financial statements, construct the common-size balance sheet and commonbase year balance sheet for the company. Use 2009 as the base year. Use the following information for Problems 19, 20, and 22: The discussion of EFN in the chapter implicitly assumed that the company was operating at full capacity. Often, this is not the case. For example, assume that Rosengarten was operating at 90 percent capacity. Full-capacity sales would be $1,000/.90 = $1,111. The balance sheet shows $1,800 in fixed assets. The capital intensity ratio for the company is Capital intensity ratio = Fixed assets/Full-capacity sales = $1,800/$1,111 = 1.62 This means that Rosengarten needs $1.62 in fixed assets for every dollar in sales when it reaches full capacity. At the projected sales level of $1,250, it needs $1,250 1.62 = $2,025 infixed assets, which is $225 lower than our projection of $2,250 in fixed assets. So, EFN is only $565 225 = $340. 19. Full-Capacity Sales Thorpe Mfg., Inc., is currently operating at only 85 percent of fixed asset capacity. Current sales are $630,000. How much can sales increase before any new fixed assets are needed? 20. Fixed Assets and Capacity Usage For the company in the previous problem, suppose fixed assets are $580,000 and sales are projected to grow to $790,000. How much in new fixed assets are required to support this growth in sales? 21. Calculating EFN The most recent financial statements for Moose Tours, Inc., appear below. Sales for 2010 are projected to grow by 20 percent. Interest expense will remain constant; the tax rate and the dividend payout rate will also remain constant. Costs, other expenses, current assets, fixed assets, and accounts payable increase spontaneously with sales. If the firm is operating at full capacity and no new debt or equity is issued, what external financing is needed to support the 20 percent growth rate in sales? 22. Capacity Usage and Growth In the previous problem, suppose the firm was operating at only 80 percent capacity in 2009. What is EFN now? 23. Calculating EFN In Problem 21, suppose the firm wishes to keep its debtequity ratio constant. What is EFN now? CHALLENGE (Questions 2430) 24. EFN and Internal Growth Redo Problem 21 using sales growth rates of 15 and 25 percent in addition to 20 percent. Illustrate graphically the relationship between EFN and the growth rate, and use this graph to determine the relationship between them. 25. EFN and Sustainable Growth Redo Problem 23 using sales growth rates of 30 and 35percent in addition to 20 percent. Illustrate graphically the relationship between EFN and the growth rate, and use this graph to determine the relationship between them. 26. Constraints on Growth Bulla Recording, Inc., wishes to maintain a growth rate of 12 percent per year and a debtequity ratio of .30. Profit margin is 5.9 percent, and the ratio of total assets to sales is constant at .85. Is this growth rate possible? To answer, determine what the dividend payout ratio must be. How do you interpret the result? 27. EFN Define the following: Show that EFN can be written as: EFN = PM(S)b + A PM(S)b g Hint: Asset needs will equal A g. The addition to retained earnings will equal PM(S)b (1 + g). 28. Sustainable Growth Rate Based on the results in Problem 27, show that the internal and sustainable growth rates can be calculated as shown in Equations 3.23 and 3.24. Hint: For the internal growth rate, set EFN equal to zero and solve for g. 29. Sustainable Growth Rate In the chapter, we discussed one calculation of the sustainable growth rate as: In practice, probably the most commonly used calculation of the sustainable growth rate is ROE b. This equation is identical to the sustainable growth rate equation presented in the chapter if the ROE is calculated using the beginning of period equity. Derive this equation from the equation presented in the chapter. 30. Sustainable Growth Rate Use the sustainable growth rate equations from the previous problem to answer the following questions. No Return, Inc., had total assets of $310,000 and equity of $183,000 at the beginning of the year. At the end of the year, the company had total assets of $355,000. During the year the company sold no new equity. Net income for the year was $95,000 and dividends were $68,000. What is the sustainable growth rate for the company? What is the sustainable growth rate if you calculate ROE based on the beginning of period equity? S&P Problems 1. Calculating the Du Pont Identity Find the annual income statements and balance sheets for Dow Chemical (DOW) and AutoZone (AZO). Calculate the Du Pont identity for each company for the most recent three years. Comment on the changes in each component of the Du Pont identity for each company over this period and compare the components between the two companies. Are the results what you expected? Why or why not?2. Ratio Analysis Find and download the “Profitability” spreadsheet for Southwest Airlines (LUV) and Continental Airlines (CAL). Find the ROA (Net ROA), ROE (Net ROE), PE ratio (P/Ehigh and P/Elow), and the market-to-book ratio (Price/Bookhigh and Price/Booklow) for each company
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