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Read pp.574 576 of the text book (including foot notes) for the important
concepts on strategic planning (may come out in the theory portion of the exam)
such as mission statement, corporate scope, financial plan, etc.
After determining the forecasted growth rate based one of the five factors
discussed or combination thereof, we can now forecast the income
statement and balance sheet.
The most commonly known method is the percent of sales method. In this
method, income statement and balance sheets accounts will be presented as
a % of sales (can be the current years sales or average of past years sales),
as follows:
b) Assets: Both current assets and fixed assets may be dependent on sales.
Thus if sales increase, current assets and fixed assets will increase.
Current assets and fixed assets can be presented as a percentage of
sales. However, there are instances wherein sales may not be dependent
or directly dependent with sales. If this happens, a different computation
will be used.
Notes payable and long-term liabilities (such as bonds payable) are not
dependent on sales. It means that they are not directly affected when
sales change, specifically when sales increase. This may be called as
discretionary liabilities (part of discretionary funds) since these amounts
are influenced by management decisions. Hence, notes payable and
long-term payables may not be represented as a percentage of sales.
As for retained earnings, although this is affected by sales, but since the
increase or decrease in this account is not directly related or directly
proportional with the increase or decrease in sales, this cannot be
presented also as a percentage of sales. Retained earnings increase by
the amount of net income less dividends (or amount plowed back).
Sample Illustration: JMV Company has the following current IS and BS
information
JMV Corporation
IS
Sales P1,000
Costs 800
Taxable income 200
Tax (34%) 68
Net income P 132
Dividends P 44
Plowback (P132-44) 88
Payout ratio (44/132) 33.33%
JMV Corporation
Pro Forma or Forecasted IS
Sales(P1,000x1.25) P1,250
Costs(P1,250x0.80*) 1,000
Taxable income 250
Tax (34%) 85
Net income P 165
Dividends(33.33%xP165) P 55
Plowback (P165-55) 110
JMV Corporation
BS
ASSETS LIABILITIES AND EQUITY
% of % of
Sales Sales
Current Assets P1,200 120% Current Liabilities
Fixed Assets 1,800 180% AP P 300 30%
Total Assets P3,000 300% NP 100 n/a
Total CL 400 n/a
Long-term Liabilities 800 n/a
Owners Equity
CS 800 n/a
RE 1,000 n/a
Total SHE 1,800 n/a
Total L & E P3,000 n/a
JMV Corporation
Pro Forma BS
ASSETS LIABILITIES AND EQUITY
Change Change
from from
previous previous
year year
Current Assets P1,500 P300 Current Liabilities
Fixed Assets 2,250 450 AP P 375 P75
Total Assets P3,750 P750 NP 100 0
Total CL 400 P75
Long-term Liabilities 800 0
Owners Equity
CS 800 0
RE 1,000 110
Total SHE 1,800 110
Total L & E P3,000 185
The difference between the increase on the asset side of P750 and the increase in the
liabilities and equity side of P185 amounting to P565 (P750 185) is the additional
financing needed (AFN). AFN refers to the additional funds or financing required to
support increase in assets due to increase in sales after using available retained
earnings and spontaneous liabilities. This is sometimes called s the external
financing needed (EFN) or discretionary financing needed (DFN). AFN comes in the
form of either short-term interest bearing liability (notes payable), long-term debt or
common stock.
= P575
Please take note of the following:
The capital intensity ratio is the ratio of total assets to sales. This measures
the increase in the total assets required per P1 increase in sales. The higher
the capital intensity ratio, the higher the assets should increase per increase
in sales and vice-versa. In the example, since capital intensity ratio is P3,
P1 peso increase in sales needs P3 increase in assets. If total assets amount
to P5,000, capital ratio will become P5 (P5,000/P1,000), and P1 peso
increase in sales needs P5 increase in total assets. This will increase the
AFN.
Growth rate also affects the AFN, the higher the growth rate (all other things
held constant), the higher the increase in total assets, the higher the AFN.
As for the ratio of AP and accruals to sales, the higher the ratio, the lower
the AFN. The higher the ratio, the more funds will be available, the lower
the additional funds needed. In the example, the ratio of AP and Accruals to
sales is P0.30. If the total amount of AP and Accruals is P500, then the
ratio will be P0.50 (P500/P1000). Per P1 increase in sales, financing from
AP and accruals will increase by P0.50 (instead of P0.30) per P1 increase in
sales, thus reducing the required AFN.
For the NPM or ROS, the higher the NPM or ROS, the lower the AFN since
higher ratio means higher net income available for plowback assuming
constant dividend payout, due to higher funds available from RE.
For the plowback ratio, considering all other things held constant, the
higher the plowback ratio, the higher the increase in retained earnings, the
lower the AFN.
Part 5 Special growth rates: Internal Growth Rate and Sustainable Growth Rate
As mentioned in the earlier part, forecasts start with sales and the estimated
growth in sales. There are various bases of the growth rates, as discussed
earlier.
There are two special growth rates that we will be discussing and needs to
be clarified, as follows:
1) Internal growth rate: as the name implies, this is the maximum growth
rate that the company can achieve as reflected in its sales wherein no
additional or external or discretionary funding needed. Meaning this is
the maximum growth rate wherein growth is supported only by internal
source (RE) and at times including spontaneous liabilities. It is the
growth rate wherein AFN is zero. Hence to compute for this, the formula
is:
Using our first example above (JMV Company), the internal growth rate:
g = 3.37%
To check, you may substitute 3.37% as the growth rate in the AFN
equation, the answer will be zero (with some minor rounding-off
differences).
The first equation is a more complicated but an exact ratio (using the
year-end Total Assets). The second equation is a simple one but is less
exact than the first one and uses the beginning total assets.
2) Sustainable growth rate: This is the maximum growth rate which the
company can achieve without using external equity financing and
maintaining a constant debt-to-equity ratio or without changing leverage:
First:
Sustainable growth rate = ROE x plowback
1 (ROE x plowback)
Second:
Sustainable growth rate = ROE x plowback
The first equations is the one which results into a more exact result and
uses the ending equity.
The second equation is quite familiar to you because this is the growth
rate formula that we usually use specially in getting the dividend growth
rate. However, in terms of AFN, the formula results to less exact results
and necessitate the use of the beginning equity in the computation.
Other details of the computations of the sustainable growth rate will not
be discussed anymore and will not be included in the exam. This is just
for your information and future use.
As mentioned above for assets, fixed assets are at times not directly
dependent on sales. One issue is on the capacity usage. In the earlier
example, we assume that the fixed assets are used at full capacity. Let us
examine the capacity intensity ratio below:
To distinguish only the ratio for fixed assets, we can breakdown the capacity
intensity ratio in to the CA and Fixed assets to sales ratio, as follows:
Hence, per P1 peso increase in sales, fixed assets should increase by P1.80
(assuming that the fixed assets are used at their full capacity). If the
increase in sales is 25%, then increase in the amount of sales is P250 (25%
x P1,000), from P1,000 to P1,250. This P250 increase in sales needs to be
supported by P450 (P1.80 x P250) increase in assets.
However, if the current sales of P1,000 is only the effect of 90% utilization of
the fixed assets amounting to P1,800, this means that the 10% can still be
used to increase sales without further spending for additional investment or
payment in fixed assets.
This means that if the company fully utilizes the P1,800 fixed assets, it will
generate not only P1,000 sales but P1,111 of sales. Hence, we only need to
pay for or invest in assets amounting to the equivalent sales from P1,112 to
P1,250 target new sales or a total of P139 (P1,250 P1,111).
Thus, we need to compute for the new or target fixed assets to sales ratio
based on full capacity sales, as follows:
To get the increase in FA due to the increase in sales (using the incremental
approach), please refer to below:
Adjusted increase in FA due to the increase in sales using full capacity =
Target FA to Full Capacity Sales Ratio x Increase in Sales (which need
additional FA)
= P1.62 x P139 (P1,250 1,111) = P225
Another way of computing for the adjusted increase in FA is using the total
approach. Please refer to below:
Note: Please be reminded that our new or target sales is always based on
the current or given sales x the growth rate regardless whether the
current or given sales is based on the current or full capacity of fixed
assets. Thus, the new or target sales will still be P1,250 (P1,000 x 25%).
You may also compute for the new AFN using the incremental approach. The
main difference is on the FA. The difference between the forecasted FA based
on the full and forecasted FA based on the normal capacity is the reduction in
the AFN. Please refer to the computation below for the difference between the
Forecasted FA based on the full and normal capacity.
Take note that there is a decrease in the required FA if you use the full
capacity, the total increase in sales of P250 (from P1,000 to P1,250) does
not necessitate increase in FA. Only the P139 sales (P1,250 P1,111)
needs the increase in FA when using the full capacity.
Using the original figures from the example above (JMV Corporation), assuming that
the company operates at full capacity, the capital intensity ratios are as follows:
If the company only operates at 90% capacity, the capital intensity ratios are as
follows:
*Note: New Total Assets = P1,500 (New CA) + P2,025 (New FA based on full
capacity)
Part 7 Variation of Percentage of Sales
So far, using the percentage of sales method, we use the ratio of the IS and
BS accounts and the sales for the current year to project or forecast IS and
BS (Pro Forma Statements). But there may be variations of this one. Like
the example of Brigham on pp. 583 to 584, the ratios used to project the
2013 FS (e.g. operating expense to sales, inventory to sales, AR to sales,
debt ratio, payout ratio) are not merely the 2012 ratios. The 2013 ratios
used are figures in between the 2012 ratios and industry ratios. It is the
prerogative of each company on what ratios to use, as long as these will give
them the best estimates for the pro-forma FS. In the example, only cash, FA
and accounts payable used the ratios for 2012. The other accounts used
the in between ratios of 2012 and the industry ratios.