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Long-Term Financial Planning and Growth

Long-Term Financial Planning and Growth

Long-Term Financial Planning and Growth


GROWTH RATES ARE IMPORTANT TOOLS for evaluating a company and, as we will see later, for valuing a company’s stock. When thinking about (and calculating) growth rates, a little common sense goes a long way. For example, in 2013, retailing giant Walmart had about 838 million square feet of stores, distribution centers, and so forth. The company expected to increase its square footage by about 4.2 percent over the next year. This doesn’t sound too outrageous, but can Walmart grow its square footage at 4.2 percent indefinitely?

We’ll get into the calculation in our next chapter, but if you assume that Walmart grows at 4.2 percent per year over the next 285 years, the company will have about 100 trillion square feet of property, which is about the total land mass of the entire United States! In other words, if Walmart keeps growing at 4.2 percent, the entire country will eventually be one big Walmart. Scary.

Sirius XM Satellite Radio is another example. The company had total revenues of about $805,000 in 2002 and $3.8 billion in 2013. This represents an annual increase of about 116 percent! How likely do you think it is that the company can continue this growth rate? If this growth continued, the company would have revenues of about $17.93 trillion in just 11 years, which is about twice the gross domestic product (GDP) of the United States. Obviously, Sirius XM Radio’s growth rate will slow substantially in the next several years. So, long-term growth rate estimates must be chosen very carefully. As a rule of thumb, for really long-term growth estimates, you should probably assume that a company will not grow much faster than the economy as a whole, which is about 1 to 3 percent (inflation-adjusted).

Proper management of growth is vital. Thus, this chapter emphasizes the importance of planning for the future and discusses some tools firms use to think about, and manage, growth.

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Learning Objectives

After studying this chapter, you should understand:


How to apply the percentage of sales method.


How to compute the external financing needed to fund a firm’s growth.


The determinants of a firm’s growth.


Some of the problems in planning for growth.

Page 92A lack of effective long-range planning is a commonly cited reason for financial distress and failure. As we discuss in this chapter, long-range planning is a means of systematically thinking about the future and anticipating possible problems before they arrive. There are no magic mirrors, of course, so the best we can hope for is a logical and organized procedure for exploring the unknown. As one member of GM’s board was heard to say, “Planning is a process that at best helps the firm avoid stumbling into the future backward.”

Financial planning establishes guidelines for change and growth in a firm. It normally focuses on the big picture. This means it is concerned with the major elements of a firm’s financial and investment policies without examining the individual components of those policies in detail.

Our primary goals in this chapter are to discuss financial planning and to illustrate the interrelatedness of the various investment and financing decisions a firm makes. In the chapters ahead, we will examine in much more detail how these decisions are made.

We first describe what is usually meant by financial planning. For the most part, we talk about long-term planning. Short-term financial planning is discussed in a later chapter. We examine what the firm can accomplish by developing a long-term financial plan. To do this, we develop a simple but useful long-range planning technique: the percentage of sales approach. We describe how to apply this approach in some simple cases, and we discuss some extensions.

To develop an explicit financial plan, managers must establish certain basic elements of the firm’s financial policy:

1. The firm’s needed investment in new assets: This will arise from the investment opportunities the firm chooses to undertake, and it is the result of the firm’s capital budgeting decisions.

2. The degree of financial leverage the firm chooses to employ: This will determine the amount of borrowing the firm will use to finance its investments in real assets. This is the firm’s capital structure policy.

3. The amount of cash the firm thinks is necessary and appropriate to pay shareholders: This is the firm’s dividend policy.

4. The amount of liquidity and working capital the firm needs on an ongoing basis: This is the firm’s net working capital decision.

As we will see, the decisions a firm makes in these four areas will directly affect its future profitability, need for external financing, and opportunities for growth.

A key lesson to be learned from this chapter is that a firm’s investment and financing policies interact and thus cannot truly be considered in isolation from one another. The types and amounts of assets a firm plans on purchasing must be considered along with the firm’s ability to raise the capital necessary to fund those investments. Many business students are aware of the classic three Ps (or even four Ps) of marketing. Not to be out-done, financial planners have no fewer than six Ps: Proper Prior Planning Prevents Poor Performance.

Financial planning forces the corporation to think about goals. A goal frequently espoused by corporations is growth, and almost all firms use an explicit, companywide growth rate as a major component of their long-term financial planning. For example, in September 2007, Toyota Motor announced that it planned to sell about 9.8 million vehicles in 2008 and 10.4 million vehicles in 2009, becoming the first auto manufacturer to sell more than 10 million vehicles in a year. Of course, Toyota’s plans didn’t come to fruition. In 2009, the company only sold 7.2 million cars, and it sold 8.6 million in 2010. In 2013, the company sold 9.98 million cars and projected sales of 10.43 million cars in 2014, again hoping to cross over 10 million cars sold in a year.

Page 93There are direct connections between the growth a company can achieve and its financial policy. In the following sections, we show how financial planning models can be used to better understand how growth is achieved. We also show how such models can be used to establish the limits on possible growth.

4.1 What Is Financial Planning?

Financial planning formulates the way in which financial goals are to be achieved. A financial plan is thus a statement of what is to be done in the future. Many decisions have long lead times, which means they take a long time to implement. In an uncertain world, this requires that decisions be made far in advance of their implementation. If a firm wants to build a factory in 2018, for example, it might have to begin lining up contractors and financing in 2016 or even earlier.


Because the subject of growth will be discussed in various places in this chapter, we need to start out with an important warning: Growth, by itself, is not an appropriate goal for the financial manager. Clothing retailer J. Peterman Co., whose quirky catalogs were made famous on the TV show Seinfeld, learned this lesson the hard way. Despite its strong brand name and years of explosive revenue growth, the company was ultimately forced to file for bankruptcy—the victim of an overly ambitious, growth-oriented expansion plan., the big online retailer, is another example. At one time, Amazon’s motto seemed to be “growth at any cost.” Unfortunately, what really grew rapidly for the company were losses. Amazon refocused its business, explicitly sacrificing growth in the hope of achieving profitability. The plan seems to be working as has become a profitable retailing giant.

As we discussed in Chapter 1, the appropriate goal for a firm is increasing the market value of the owners’ equity. Of course, if a firm is successful in doing this, then growth will usually result. Growth may thus be a desirable consequence of good decision making, but it is not an end unto itself. We discuss growth simply because growth rates are so commonly used in the planning process. As we will see, growth is a convenient means of summarizing various aspects of a firm’s financial and investment policies. Also, if we think of growth as growth in the market value of the equity in the firm, then goals of growth and increasing the market value of the equity in the firm are not all that different.


It is often useful for planning purposes to think of the future as having a short run and a long run. The short run, in practice, is usually the coming 12 months. We focus our attention on financial planning over the long run, which is usually taken to be the coming two to five years. This time period is called the planning horizon, and it is the first dimension of the planning process that must be established.

planning horizon The long-range time period on which the financial planning process focuses (usually the next two to five years).

In drawing up a financial plan, all of the individual projects and investments the firm will undertake are combined to determine the total needed investment. In effect, the smaller investment proposals of each operational unit are added up, and the sum is treated as one big project. This process is called aggregation. The level of aggregation is the second dimension of the planning process that needs to be determined.

aggregation The process by which smaller investment proposals of each of a firm’s operational units are added up and treated as one big project.

Once the planning horizon and level of aggregation are established, a financial plan requires inputs in the form of alternative sets of assumptions about important variables. For example, suppose a company has two separate divisions: one for consumer products and Page 94one for gas turbine engines. The financial planning process might require each division to prepare three alternative business plans for the next three years:

You can find growth rates at and

1. A worst case: This plan would require making relatively pessimistic assumptions about the company’s products and the state of the economy. This kind of disaster planning would emphasize a division’s ability to withstand significant economic adversity, and it would require details concerning cost cutting and even divestiture and liquidation. For example, in August 2013, Microsoft announced that previously announced “limited time” $100 price reductions on the company’s Surface tablet would become permanent. Excess inventories were blamed for the dramatic price cuts. As we mentioned in a previous chapter, Microsoft also wrote off about $900 million in excess inventory of the Surface tablet.

2. A normal case: This plan would require making the most likely assumptions about the company and the economy.

3. A best case: Each division would be required to work out a case based on optimistic assumptions. It could involve new products and expansion and would then detail the financing needed to fund the expansion. For example, Sony announced that it was holding back inventory to ensure that anyone who wanted a PS4 would get one. Unfortunately, this plan did not work, at least in Europe where retailers ran out of stock. And while we have discussed Microsoft’s inventory problems with its Surface tablet, the company ran out of inventory for its Surface 2 and Surface Pro 2 in late 2013. In fact, because of the shortage, Surface 2 tablets were selling at $100 over retail price on Amazon.

In this discussion, business activities are aggregated along divisional lines, and the planning horizon is three years. This type of planning, which considers all possible events, is particularly important for cyclical businesses (businesses with sales that are strongly affected by the overall state of the economy or business cycles).


Because a company is likely to spend a lot of time examining the different scenarios that will become the basis for its financial plan, it seems reasonable to ask what the planning process will accomplish.

Examining Interactions As we discuss in greater detail in the following pages, the financial plan must make explicit the linkages between investment proposals for the different operating activities of the firm and its available financing choices. In other words, if the firm is planning on expanding and undertaking new investments and projects, where will the financing be obtained to pay for this activity?

Exploring Options The financial plan allows the firm to develop, analyze, and compare many different scenarios in a consistent way. Various investment and financing options can be explored, and their impact on the firm’s shareholders can be evaluated. Questions concerning the firm’s future lines of business and optimal financing arrangements are addressed. Options such as marketing new products or closing plants might be evaluated.

Avoiding Surprises Financial planning should identify what may happen to the firm if different events take place. In particular, it should address what actions the firm will take if things go seriously wrong or, more generally, if assumptions made today about the future are seriously in error. As physicist Niels Bohr once observed, “Prediction is very difficult, particularly when it concerns the future.” Thus, one purpose of financial planning is to avoid surprises and develop contingency plans.

Page 95For example, when Tesla Motors announced its new Model X in February 2012, the company promised that production would begin in 2013. In 2013, when production had yet to start, Tesla pushed backed production until late 2014. A company spokesperson stated that production was being delayed “to allow ourselves to focus on production and enhancements in Model S.” Of course, even though production of the Model S had begun on time several years earlier, production of that model was below expectations for at least a year. Thus, a lack of proper planning can be a problem for even the most hi-tech companies.

Ensuring Feasibility and Internal Consistency Beyond a general goal of creating value, a firm will normally have many specific goals. Such goals might be couched in terms of market share, return on equity, financial leverage, and so on. At times, the linkages between different goals and different aspects of a firm’s business are difficult to see. Not only does a financial plan make explicit these linkages, but it also imposes a unified structure for reconciling goals and objectives. In other words, financial planning is a way of verifying that the goals and plans made for specific areas of a firm’s operations are feasible and internally consistent. Conflicting goals will often exist. To generate a coherent plan, goals and objectives will therefore have to be modified, and priorities will have to be established.

For example, one goal a firm might have is 12 percent growth in unit sales per year. Another goal might be to reduce the firm’s total debt ratio from 40 to 20 percent. Are these two goals compatible? Can they be accomplished simultaneously? Maybe yes, maybe no. As we will discuss, financial planning is a way of finding out just what is possible—and, by implication, what is not possible.

Conclusion Probably the most important result of the planning process is that it forces managers to think about goals and establish priorities. In fact, conventional business wisdom holds that financial plans don’t work, but financial planning does. The future is inherently unknown. What we can do is establish the direction in which we want to travel and make some educated guesses about what we will find along the way. If we do a good job, we won’t be caught off guard when the future rolls around.

Concept Questions

4.1a What are the two dimensions of the financial planning process?

4.1b Why should firms draw up financial plans?

4.2 Financial Planning Models: A First Look

Just as companies differ in size and products, the financial planning process will differ from firm to firm. In this section, we discuss some common elements in financial plans and develop a basic model to illustrate these elements. What follows is just a quick overview; later sections will take up the various topics in more detail.


Most financial planning models require the user to specify some assumptions about the future. Based on those assumptions, the model generates predicted values for many other variables. Models can vary quite a bit in complexity, but almost all have the elements we discuss next.

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Page 96Sales Forecast Almost all financial plans require an externally supplied sales forecast. In our models that follow, for example, the sales forecast will be the “driver,” meaning that the user of the planning model will supply this value, and most other values will be calculated based on it. This arrangement is common for many types of business; planning will focus on projected future sales and the assets and financing needed to support those sales.

Frequently, the sales forecast will be given as the growth rate in sales rather than as an explicit sales figure. These two approaches are essentially the same because we can calculate projected sales once we know the growth rate. Perfect sales forecasts are not possible, of course, because sales depend on the uncertain future state of the economy. To help a firm come up with its projections, some businesses specialize in macroeconomic and industry projections.

As we discussed previously, we frequently will be interested in evaluating alternative scenarios, so it isn’t necessarily crucial that the sales forecast be accurate. In such cases, our goal is to examine the interplay between investment and financing needs at different possible sales levels, not to pinpoint what we expect to happen.

Pro Forma Statements A financial plan will have a forecast balance sheet, income statement, and statement of cash flows. These are called pro forma statements, or pro formas for short. The phrase pro forma literally means “as a matter of form.” In our case, this means the financial statements are the form we use to summarize the different events projected for the future. At a minimum, a financial planning model will generate these statements based on projections of key items such as sales.

In the planning models we will describe, the pro formas are the output from the financial planning model. The user will supply a sales figure, and the model will generate the resulting income statement and balance sheet.

Asset Requirements The plan will describe projected capital spending. At a minimum, the projected balance sheet will contain changes in total fixed assets and net working capital. These changes are effectively the firm’s total capital budget. Proposed capital spending in different areas must thus be reconciled with the overall increases contained in the long-range plan.

Financial Requirements The plan will include a section about the necessary financing arrangements. This part of the plan should discuss dividend policy and debt policy. Sometimes firms will expect to raise cash by selling new shares of stock or by borrowing. In this case, the plan will have to consider what kinds of securities have to be sold and what methods of issuance are most appropriate. These are subjects we consider in Part 6 of our book, where we discuss long-term financing, capital structure, and dividend policy.

The Plug After the firm has a sales forecast and an estimate of the required spending on assets, some amount of new financing will often be necessary because projected total assets will exceed projected total liabilities and equity. In other words, the balance sheet will no longer balance.

Because new financing may be necessary to cover all of the projected capital spending, a financial “plug” variable must be selected. The plug is the designated source or sources of external financing needed to deal with any shortfall (or surplus) in financing and thereby bring the balance sheet into balance.

For example, a firm with a great number of investment opportunities and limited cash flow may have to raise new equity. Other firms with few growth opportunities and ample cash flow will have a surplus and thus might pay an extra dividend. In the first case, external equity is the plug variable. In the second, the dividend is used.

Page 97Economic Assumptions The plan will have to state explicitly the economic environment in which the firm expects to reside over the life of the plan. Among the more important economic assumptions that will have to be made are the level of interest rates and the firm’s tax rate.


We can begin our discussion of long-term planning models with a relatively simple example. The Computerfield Corporation’s financial statements from the most recent year are as follows:

Unless otherwise stated, the financial planners at Computerfield assume that all variables are tied directly to sales and current relationships are optimal. This means that all items will grow at exactly the same rate as sales. This is obviously oversimplified; we use this assumption only to make a point.

Suppose sales increase by 20 percent, rising from $1,000 to $1,200. Planners would then also forecast a 20 percent increase in costs, from $800 to $800 × 1.2 = $960. The pro forma income statement would thus be:

The assumption that all variables will grow by 20 percent lets us easily construct the pro forma balance sheet as well:

Notice that we have simply increased every item by 20 percent. The numbers in parentheses are the dollar changes for the different items.

Now we have to reconcile these two pro formas. How, for example, can net income be equal to $240 and equity increase by only $50? The answer is that Computerfield must have paid out the difference of $240 − 50 = $190, possibly as a cash dividend. In this case, dividends are the plug variable.

Suppose Computerfield does not pay out the $190. In this case, the addition to retained earnings is the full $240. Computerfield’s equity will thus grow to $250 (the starting amount) plus $240 (net income), or $490, and debt must be retired to keep total assets equal to $600.

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Page 98With $600 in total assets and $490 in equity, debt will have to be $600 − 490 = $110. Because we started with $250 in debt, Computerfield will have to retire $250 − 110 = $140 in debt. The resulting pro forma balance sheet would look like this:

In this case, debt is the plug variable used to balance projected total assets and liabilities.

This example shows the interaction between sales growth and financial policy. As sales increase, so do total assets. This occurs because the firm must invest in net working capital and fixed assets to support higher sales levels. Because assets are growing, total liabilities and equity (the right side of the balance sheet) will grow as well.

The thing to notice from our simple example is that the way the liabilities and owners’ equity change depends on the firm’s financing policy and its dividend policy. The growth in assets requires that the firm decide on how to finance that growth. This is strictly a managerial decision. Note that in our example, the firm needed no outside funds. This won’t usually be the case, so we explore a more detailed situation in the next section.

Concept Questions

4.2a What are the basic components of a financial plan?

4.2b Why is it necessary to designate a plug in a financial planning model?

4.3 The Percentage of Sales Approach

In the previous section, we described a simple planning model in which every item increased at the same rate as sales. This may be a reasonable assumption for some elements. For others, such as long-term borrowing, it probably is not: The amount of long-term borrowing is something set by management, and it does not necessarily relate directly to the level of sales.

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In this section, we describe an extended version of our simple model. The basic idea is to separate the income statement and balance sheet accounts into two groups—those that vary directly with sales and those that do not. Given a sales forecast, we will then be able to calculate how much financing the firm will need to support the predicted sales level.

The financial planning model we describe next is based on the percentage of sales approach. Our goal here is to develop a quick and practical way of generating pro forma statements. We defer discussion of some “bells and whistles” to a later section.

percentage of sales approach A financial planning method in which accounts are varied depending on a firm’s predicted sales level.


We start out with the most recent income statement for the Rosengarten Corporation, as shown in Table 4.1. Notice we have still simplified things by including costs, depreciation, and interest in a single cost figure.

Rosengarten has projected a 25 percent increase in sales for the coming year, so we are anticipating sales of $1,000 × 1.25 = $1,250. To generate a pro forma income statement, we assume that total costs will continue to run at $800/1,000 = 80% of sales. With this assumption, Rosengarten’s pro forma income statement is shown in Table 4.2. The effect here of assuming that costs are a constant percentage of sales is to assume that the profit margin is constant. To check this, notice that the profit margin was $132/1,000 = 13.2%. In our pro forma, the profit margin is $165/1,250 = 13.2%, so it is unchanged.

Page 99TABLE 4.1 Rosengarten Corporation Income Statement

TABLE 4.2 Rosengarten Corporation Pro Forma Income Statement

Next, we need to project the dividend payment. This amount is up to Rosengarten’s management. We will assume Rosengarten has a policy of paying out a constant fraction of net income in the form of a cash dividend. For the most recent year, the dividend payout ratio was this:

dividend payout ratio The amount of cash paid out to shareholders divided by net income.

We can also calculate the ratio of the addition to retained earnings to net income:

Addition to retained earnings/Net income = $88/132 = 66 2/3%

This ratio is called the retention ratio or plowback ratio, and it is equal to 1 minus the dividend payout ratio because everything not paid out is retained. Assuming that the payout ratio is constant, here are the projected dividends and addition to retained earnings:

retention ratio The addition to retained earnings divided by net income. Also called the plowback ratio.


To generate a pro forma balance sheet, we start with the most recent statement, as shown in Table 4.3.

On our balance sheet, we assume that some items vary directly with sales and others do not. For items that vary with sales, we express each as a percentage of sales for the year just completed. When an item does not vary directly with sales, we write “n/a” for “not applicable.”

Page 100TABLE 4.3 Rosengarten Corporation Balance Sheet

For example, on the asset side, inventory is equal to 60 percent of sales (= $600/1,000) for the year just ended. We assume this percentage applies to the coming year, so for each $1 increase in sales, inventory will rise by $.60. More generally, the ratio of total assets to sales for the year just ended is $3,000/1,000 = 3, or 300%.

This ratio of total assets to sales is sometimes called the capital intensity ratio. It tells us the amount of assets needed to generate $1 in sales; so the higher the ratio is, the more capital-intensive is the firm. Notice also that this ratio is just the reciprocal of the total asset turnover ratio we defined in the last chapter.

capital intensity ratio A firm’s total assets divided by its sales, or the amount of assets needed to generate $1 in sales.

For Rosengarten, assuming that this ratio is constant, it takes $3 in total assets to generate $1 in sales (apparently Rosengarten is in a relatively capital-intensive business). Therefore, if sales are to increase by $100, Rosengarten will have to increase total assets by three times this amount, or $300.

On the liability side of the balance sheet, we show accounts payable varying with sales. The reason is that we expect to place more orders with our suppliers as sales volume increases, so payables will change “spontaneously” with sales. Notes payable, on the other hand, represent short-term debt such as bank borrowing. This item will not vary unless we take specific actions to change the amount, so we mark it as “n/a.”

Similarly, we use “n/a” for long-term debt because it won’t automatically change with sales. The same is true for common stock and paid-in surplus. The last item on the right side, retained earnings, will vary with sales, but it won’t be a simple percentage of sales. Instead, we will explicitly calculate the change in retained earnings based on our projected net income and dividends.

We can now construct a partial pro forma balance sheet for Rosengarten. We do this by using the percentages we have just calculated wherever possible to calculate the projected amounts. For example, net fixed assets are 180 percent of sales; so, with a new sales level of $1,250, the net fixed asset amount will be 1.80 × $1,250 = $2,250, representing an increase of $2,250 − 1,800 = $450 in plant and equipment. It is important to note that for items that don’t vary directly with sales, we initially assume no change and simply write in the original amounts. The result is shown in Table 4.4. Notice that the change in retained earnings is equal to the $110 addition to retained earnings we calculated earlier.

Page 101TABLE 4.4

Inspecting our pro forma balance sheet, we notice that assets are projected to increase by $750. However, without additional financing, liabilities and equity will increase by only $185, leaving a shortfall of $750 − 185 = $565. We label this amount external financing needed (EFN).


Our financial planning model now reminds us of one of those good news–bad news jokes. The good news is we’re projecting a 25 percent increase in sales. The bad news is that this isn’t going to happen unless Rosengarten can somehow raise $565 in new financing.

This is a good example of how the planning process can point out problems and potential conflicts. If, for example, Rosengarten has a goal of not borrowing any additional funds and not selling any new equity, then a 25 percent increase in sales is probably not feasible.

If we take the need for $565 in new financing as given, we know that Rosengarten has three possible sources: short-term borrowing, long-term borrowing, and new equity. The choice of some combination among these three is up to management; we will illustrate only one of the many possibilities.

Suppose Rosengarten decides to borrow the needed funds. In this case, the firm might choose to borrow some over the short term and some over the long term. For example, current assets increased by $300, whereas current liabilities rose by only $75. Rosengarten could borrow $300 − 75 = $225 in short-term notes payable and leave total net working capital unchanged. With $565 needed, the remaining $565 − 225 = $340 would have to come from long-term debt. Table 4.5 shows the completed pro forma balance sheet for Rosengarten.

Page 102TABLE 4.5

We have used a combination of short- and long-term debt as the plug here, but we emphasize that this is just one possible strategy; it is not necessarily the best one by any means. There are many other scenarios we could (and should) investigate. The various ratios we discussed in Chapter 3 come in handy here. For example, with the scenario we have just examined, we would surely want to examine the current ratio and the total debt ratio to see if we were comfortable with the new projected debt levels.

Now that we have finished our balance sheet, we have all of the projected sources and uses of cash. We could finish off our pro formas by drawing up the projected statement of cash flows along the lines discussed in Chapter 3. We will leave this as an exercise and instead investigate an important alternative scenario.


The assumption that assets are a fixed percentage of sales is convenient, but it may not be suitable in many cases. In particular, note that we effectively assumed that Rosengarten was using its fixed assets at 100 percent of capacity because any increase in sales led to an increase in fixed assets. For most businesses, there would be some slack or excess capacity, and production could be increased by perhaps running an extra shift. According to the Federal Reserve, the overall capacity utilization for U.S. manufacturing companies in November 2013 was 76.8 percent, up from a low of 64.4 percent in June 2009.

For example, in January 2012, Volkswagen announced that it would spend $7 billion in North America over the next five years with the goal of selling one million vehicles in the U.S. by 2018. At about the same time, General Motors (GM) announced plans to close two Australian plants and reached a deal to close the company’s Opel plant in Germany. About six months before, Ford announced that it was closing its two largest Australian plants as well. Evidently GM and Ford had excess capacity, whereas Volkswagen did not.

In another example, in November 2013, ketchup maker Heinz announced that it was closing three factories in North America. The company stated that it would increase production at other plants to compensate for the closings. Apparently, Heinz had significant excess capacity at its production facilities.

Page 103If we assume that Rosengarten is operating at only 70 percent of capacity, then the need for external funds will be quite different. When we say “70 percent of capacity,” we mean that the current sales level is 70 percent of the full-capacity sales level:

This tells us that sales could increase by almost 43 percent—from $1,000 to $1,429—before any new fixed assets would be needed.

In our previous scenario, we assumed it would be necessary to add $450 in net fixed assets. In the current scenario, no spending on net fixed assets is needed because sales are projected to rise only to $1,250, which is substantially less than the $1,429 full-capacity level.

As a result, our original estimate of $565 in external funds needed is too high. We estimated that $450 in new net fixed assets would be needed. Instead, no spending on new net fixed assets is necessary. Thus, if we are currently operating at 70 percent capacity, we need only $565 − 450 = $115 in external funds. The excess capacity thus makes a considerable difference in our projections.

EXAMPLE 4.1 EFN and Capacity Usage

Suppose Rosengarten is operating at 90 percent capacity. What would sales be at full capacity? What is the capital intensity ratio at full capacity? What is EFN in this case?

Full-capacity sales would be $1,000/.90 = $1,111. From Table 4.3, we know that fixed assets are $1,800. At full capacity, the ratio of fixed assets to sales is this:

So, Rosengarten needs $1.62 in fixed assets for every $1 in sales once it reaches full capacity. At the projected sales level of $1,250, then, it needs $1,250 × 1.62 = $2,025 in fixed assets. Compared to the $2,250 we originally projected, this is $225 less, so EFN is $565 − 225 = $340.

Current assets would still be $1,500, so total assets would be $1,500 + 2,025 = $3,525. The capital intensity ratio would thus be $3,525/1,250 = 2.82, which is less than our original value of 3 because of the excess capacity.

These alternative scenarios illustrate that it is inappropriate to blindly manipulate financial statement information in the planning process. The results depend critically on the assumptions made about the relationships between sales and asset needs. We return to this point a little later.

One thing should be clear by now. Projected growth rates play an important role in the planning process. They are also important to outside analysts and potential investors. Our nearby Work the Web box shows you how to obtain growth rate estimates for real companies.

Concept Questions

4.3a What is the basic idea behind the percentage of sales approach?

4.3b Unless it is modified, what does the percentage of sales approach assume about fixed asset capacity usage?


Page 104Calculating company growth rates can involve detailed research, and a major part of a stock analyst’s job is to estimate them. One place to find earnings and sales growth rates on the Web is Yahoo! Finance at We pulled up a quote for 3M Company and followed the “Analyst Estimates” link. Here is an abbreviated look at the results:

As shown, analysts expect, on average, revenue (sales) of $31.02 billion in 2013, growing to $32.61 billion in 2014, an increase of 5.1 percent. We also have the following table comparing 3M to some benchmarks:

As you can see, the estimated earnings growth rate for 3M is lower than the industry growth rate over the next five years. What does this mean for 3M stock? We’ll get to that in a later chapter.


1. One of the things shown here is the projected sales growth for 3M during 2014 at the time this was captured from . How does the current sales projection or the actual sales number differ from this projection? Can you think of any reasons for the difference?

2. On the same Web page, you can find the earnings history for 3M. How close have analysts been to estimating 3M earnings? In other words, what has the “surprise” been in 3M earnings?

4.4 External Financing and Growth

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Page 105External financing needed and growth are obviously related. All other things staying the same, the higher the rate of growth in sales or assets, the greater will be the need for external financing. In the previous section, we took a growth rate as given, and then we determined the amount of external financing needed to support that growth. In this section, we turn things around a bit. We will take the firm’s financial policy as given and then examine the relationship between that financial policy and the firm’s ability to finance new investments and thereby grow.

Once again, we emphasize that we are focusing on growth not because growth is an appropriate goal; instead, for our purposes, growth is simply a convenient means of examining the interactions between investment and financing decisions. In effect, we assume that the use of growth as a basis for planning is just a reflection of the very high level of aggregation used in the planning process.


The first thing we need to do is establish the relationship between EFN and growth. To do this, we introduce the simplified income statement and balance sheet for the Hoffman Company in Table 4.6. Notice that we have simplified the balance sheet by combining short-term and long-term debt into a single total debt figure. Effectively, we are assuming that none of the current liabilities varies spontaneously with sales. This assumption isn’t as restrictive as it sounds. If any current liabilities (such as accounts payable) vary with sales, we can assume that any such accounts have been netted out in current assets. Also, we continue to combine depreciation, interest, and costs on the income statement.

Suppose the Hoffman Company is forecasting next year’s sales level at $600, a $100 increase. Notice that the percentage increase in sales is $100/500 = 20%. Using the percentage of sales approach and the figures in Table 4.6, we can prepare a pro forma income statement and balance sheet as in Table 4.7. As Table 4.7 illustrates, at a 20 percent growth rate, Hoffman needs $100 in new assets (assuming full capacity). The projected addition to retained earnings is $52.8, so the external financing needed (EFN) is $100 − 52.8 = $47.2.

Page 106TABLE 4.6


Notice that the debt–equity ratio for Hoffman was originally (from Table 4.6) equal to $250/250 = 1.0. We will assume that the Hoffman Company does not wish to sell new equity. In this case, the $47.2 in EFN will have to be borrowed. What will the new debt– equity ratio be? From Table 4.7, we know that total owners’ equity is projected at $302.8. The new total debt will be the original $250 plus $47.2 in new borrowing, or $297.2 total. The debt–equity ratio thus falls slightly from 1.0 to $297.2/302.8 = .98.

Table 4.8 shows EFN for several different growth rates. The projected addition to retained earnings and the projected debt–equity ratio for each scenario are also given (you should probably calculate a few of these for practice). In determining the debt–equity ratios, we assumed that any needed funds were borrowed, and we also assumed any surplus funds were used to pay off debt. Thus, for the zero growth case, debt falls by $44, from $250 to $206. In Table 4.8, notice that the increase in assets required is simply equal to the original assets of $500 multiplied by the growth rate. Similarly, the addition to retained earnings is equal to the original $44 plus $44 times the growth rate.

TABLE 4.8 Growth and Projected EFN for the Hoffman Company

Page 107FIGURE 4.1 Growth and Related Financing Needed for the Hoffman Company

Table 4.8 shows that for relatively low growth rates, Hoffman will run a surplus, and its debt–equity ratio will decline. Once the growth rate increases to about 10 percent, however, the surplus becomes a deficit. Furthermore, as the growth rate exceeds approximately 20 percent, the debt–equity ratio passes its original value of 1.0.

Figure 4.1 illustrates the connection between growth in sales and external financing needed in more detail by plotting asset needs and additions to retained earnings from Table 4.8 against the growth rates. As shown, the need for new assets grows at a much faster rate than the addition to retained earnings, so the internal financing provided by the addition to retained earnings rapidly disappears.

As this discussion shows, whether a firm runs a cash surplus or deficit depends on growth. Microsoft is a good example. Its revenue growth in the 1990s was amazing, averaging well over 30 percent per year for the decade. Growth slowed down noticeably over the 2000–2010 period; nonetheless, Microsoft’s combination of growth and substantial profit margins led to enormous cash surpluses. In part because Microsoft pays a relatively small dividend, the cash really piled up; in 2014, Microsoft’s cash horde exceeded $77 billion.


Based on our preceding discussion, we see that there is a direct link between growth and external financing. In this section, we discuss two growth rates that are particularly useful in long-range planning.

The Internal Growth Rate The first growth rate of interest is the maximum growth rate that can be achieved with no external financing of any kind. We will call this the internal growth rate because this is the rate the firm can maintain with internal financing only. In Figure 4.1, this internal growth rate is represented by the point where the two lines cross. At this point, the required increase in assets is exactly equal to the addition to retained Page 108earnings, and EFN is therefore zero. We have seen that this happens when the growth rate is slightly less than 10 percent. With a little algebra (see Problem 31 at the end of the chapter), we can define this growth rate more precisely:

internal growth rate The maximum growth rate a firm can achieve without external financing of any kind.

Here, ROA is the return on assets we discussed in Chapter 3, and b is the plowback, or retention, ratio defined earlier in this chapter.

For the Hoffman Company, net income was $66 and total assets were $500. ROA is thus $66/500 = 13.2%. Of the $66 net income, $44 was retained, so the plowback ratio, b, is $44/66 = 2/3. With these numbers, we can calculate the internal growth rate:

Thus, the Hoffman Company can expand at a maximum rate of 9.65 percent per year without external financing.

The Sustainable Growth Rate We have seen that if the Hoffman Company wishes to grow more rapidly than at a rate of 9.65 percent per year, external financing must be arranged. The second growth rate of interest is the maximum growth rate a firm can achieve with no external equity financing while it maintains a constant debt–equity ratio. This rate is commonly called the sustainable growth rate because it is the maximum rate of growth a firm can maintain without increasing its financial leverage.

sustainable growth rate The maximum growth rate a firm can achieve without external equity financing while maintaining a constant debt–equity ratio.

There are various reasons why a firm might wish to avoid equity sales. For example, as we discuss in Chapter 15, new equity sales can be expensive. Alternatively, the current owners may not wish to bring in new owners or contribute additional equity. Why a firm might view a particular debt–equity ratio as optimal is discussed in Chapters 14 and 16; for now, we will take it as given.

Based on Table 4.8, the sustainable growth rate for Hoffman is approximately 20 percent because the debt–equity ratio is near 1.0 at that growth rate. The precise value can be calculated (see Problem 31 at the end of the chapter):

This is identical to the internal growth rate except that ROE, return on equity, is used instead of ROA.

For the Hoffman Company, net income was $66 and total equity was $250; ROE is thus $66/250 = 26.4 percent. The plowback ratio, b, is still 2/3, so we can calculate the sustainable growth rate as follows:

Thus, the Hoffman Company can expand at a maximum rate of 21.36 percent per year without external equity financing.

Page 109

EXAMPLE 4.2 Sustainable Growth

Suppose Hoffman grows at exactly the sustainable growth rate of 21.36 percent. What will the pro forma statements look like?

At a 21.36 percent growth rate, sales will rise from $500 to $606.8. The pro forma income statement will look like this:

We construct the balance sheet just as we did before. Notice, in this case, that owners’ equity will rise from $250 to $303.4 because the addition to retained earnings is $53.4.

As illustrated, EFN is $53.4. If Hoffman borrows this amount, then total debt will rise to $303.4, and the debt–equity ratio will be exactly 1.0, which verifies our earlier calculation. At any other growth rate, something would have to change.

Determinants of Growth In the last chapter, we saw that the return on equity, ROE, could be decomposed into its various components using the DuPont identity. Because ROE appears so prominently in the determination of the sustainable growth rate, it is obvious that the factors important in determining ROE are also important determinants of growth.

From Chapter 3, we know that ROE can be written as the product of three factors:

ROE = Profit margin × Total asset turnover × Equity multiplier

If we examine our expression for the sustainable growth rate, we see that anything that increases ROE will increase the sustainable growth rate by making the top bigger and the bottom smaller. Increasing the plowback ratio will have the same effect.

Putting it all together, what we have is that a firm’s ability to sustain growth depends explicitly on the following four factors:

1. Profit margin: An increase in profit margin will increase the firm’s ability to generate funds internally and thereby increase its sustainable growth.

Page 1102. Dividend policy: A decrease in the percentage of net income paid out as dividends will increase the retention ratio. This increases internally generated equity and thus increases sustainable growth.

3. Financial policy: An increase in the debt–equity ratio increases the firm’s financial leverage. Because this makes additional debt financing available, it increases the sustainable growth rate.

4. Total asset turnover: An increase in the firm’s total asset turnover increases the sales generated for each dollar in assets. This decreases the firm’s need for new assets as sales grow and thereby increases the sustainable growth rate. Notice that increasing total asset turnover is the same thing as decreasing capital intensity.

The sustainable growth rate is a very useful planning number. What it illustrates is the explicit relationship between the firm’s four major areas of concern: its operating efficiency as measured by profit margin, its asset use efficiency as measured by total asset turnover, its dividend policy as measured by the retention ratio, and its financial policy as measured by the debt–equity ratio.

Given values for all four of these, there is only one growth rate that can be achieved. This is an important point, so it bears restating:

If a firm does not wish to sell new equity and its profit margin, dividend policy, financial policy, and total asset turnover (or capital intensity) are all fixed, then there is only one possible growth rate.

As we described early in this chapter, one of the primary benefits of financial planning is that it ensures internal consistency among the firm’s various goals. The concept of the sustainable growth rate captures this element nicely. Also, we now see how a financial planning model can be used to test the feasibility of a planned growth rate. If sales are to grow at a rate higher than the sustainable growth rate, the firm must increase profit margins, increase total asset turnover, increase financial leverage, increase earnings retention, or sell new shares.

The two growth rates, internal and sustainable, are summarized in Table 4.9.

TABLE 4.9 Summary of Internal and Sustainable Growth Rates

Page 111


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 company’s credit-worthiness. They are aided in this exercise by several sophisticated computer software packages that provide detailed analyses of the company’s past financial performance, including its annual sustainable growth rate.

Bankers use this information in several ways. Quick comparison of a company’s actual growth rate to its sustainable rate tells the banker what issues will be at the top of management’s financial agenda. If actual growth consistently exceeds sustainable growth, management’s 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 management’s 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 to the fact 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 the Marguerite Reimers Professor of Finance, Emeritus, at the Foster School of Business at the University of Washington. He pioneered the use of sustainable growth as a tool for financial analysis.


Very commonly, the sustainable growth rate is calculated using just the numerator in our expression, ROE × b. This causes some confusion, which we can clear up here. The issue has to do with how ROE is computed. Recall that ROE is calculated as net income divided by total equity. If total equity is taken from an ending balance sheet (as we have done consistently, and is commonly done in practice), then our formula is the right one. However, if total equity is from the beginning of the period, then the simpler formula is the correct one.

In principle, you’ll get exactly the same sustainable growth rate regardless of which way you calculate it (as long as you match up the ROE calculation with the right formula). In reality, you may see some differences because of accounting-related complications. By the way, if you use the average of beginning and ending equity (as some advocate), yet another formula is needed. Also, all of our comments here apply to the internal growth rate as well.

A simple example is useful to illustrate these points. Suppose a firm has a net income of $20 and a retention ratio of .60. Beginning assets are $100. The debt–equity ratio is .25, so beginning equity is $80.

If we use beginning numbers, we get the following:

ROE = $20/80 = .25 = 25%

Sustainable growth = .60 × .25 = .15 = 15%

For the same firm, ending equity is $80 + .60 × $20 = $92. So, we can calculate this:

ROE = $20/92 = .2174 = 21.74%

Sustainable growth = .60 × .2174/(1 − .60 × .2174) = .15 = 15%

These growth rates are exactly the same (after accounting for a small rounding error in the second calculation). See if you don’t agree that the internal growth rate is 12%.

EXAMPLE 4.3 Profit Margins and Sustainable Growth

Page 112The Sandar Co. has a debt–equity ratio of .5, a profit margin of 3 percent, a dividend payout ratio of 40 percent, and a capital intensity ratio of 1. What is its sustainable growth rate? If Sandar desired a 10 percent sustainable growth rate and planned to achieve this goal by improving profit margins, what would you think?

ROE is .03 × 1 × 1.5 = 4.5 percent. The retention ratio is 1 − .40 = .60. Sustainable growth is thus .045(.60)/[1 − .045(.60)] = 2.77 percent.

For the company to achieve a 10 percent growth rate, the profit margin will have to rise. To see this, assume that sustainable growth is equal to 10 percent and then solve for profit margin, PM:

For the plan to succeed, the necessary increase in profit margin is substantial, from 3 percent to about 10 percent. This may not be feasible.

Concept Questions

4.4a How is a firm’s sustainable growth related to its accounting return on equity (ROE)?

4.4b What are the determinants of growth?

4.5 Some Caveats Regarding Financial Planning Models

Financial planning models do not always ask the right questions. A primary reason is that they tend to rely on accounting relationships and not financial relationships. In particular, the three basic elements of firm value tend to get left out—namely cash flow size, risk, and timing.

Because of this, financial planning models sometimes do not produce meaningful clues about what strategies will lead to increases in value. Instead, they divert the user’s attention to questions concerning the association of, say, the debt–equity ratio and firm growth.

The financial model we used for the Hoffman Company was simple—in fact, too simple. Our model, like many in use today, is really an accounting statement generator at heart. Such models are useful for pointing out inconsistencies and reminding us of financial needs, but they offer little guidance concerning what to do about these problems.

In closing our discussion, we should add that financial planning is an iterative process. Plans are created, examined, and modified over and over. Page 113The final plan will be a result negotiated between all the different parties to the process. In fact, long-term financial planning in most corporations relies on what might be called the Procrustes approach.1Upper-level managers have a goal in mind, and it is up to the planning staff to rework and ultimately deliver a feasible plan that meets that goal.

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.

Concept Questions

4.5a What are some important elements that are often missing in financial planning models?

4.5b Why do we say planning is an iterative process?

4.6 Summary and Conclusions

Financial planning forces the firm to think about the future. We have examined a number of features of the planning process. We described what financial planning can accomplish and the components of a financial model. We went on to develop the relationship between growth and financing needs, and we discussed how a financial planning model is useful in exploring that relationship.

Corporate financial planning should not become a purely mechanical activity. If it does, it will probably focus on the wrong things. In particular, plans all too often are formulated in terms of a growth target with no explicit linkage to value creation, and they frequently are overly concerned with accounting statements. Nevertheless, the alternative to financial planning is stumbling into the future. Perhaps the immortal Yogi Berra (the baseball catcher, not the cartoon character) put it best when he said, “Ya gotta watch out if you don’t know where you’re goin’. You just might not get there.”2


If you are using Connect Finance in your course, get online to take a Practice Test, check out study tools, and find out where you need additional practice.

Can you answer the following Connect Quiz questions?

Section 4.1

Murphy’s, Inc., is in the process of preparing a financial plan for the firm for the next five years. This five-year period is referred to as the___________.

Section 4.2

What is generally the first step in the financial planning process?

Section 4.3

A firm has current sales of $272,600 with total assets of $311,000. What is the full-capacity capital intensity ratio if the firm is currently operating at 68 percent capacity?

Section 4.4

What growth rate assumes that the debt–equity ratio is held constant?

Section 4.5

What is generally considered when compiling a financial plan?

Page 114


4.1 Calculating EFN Based on the following information for the Skandia Mining Company, what is EFN if sales are predicted to grow by 10 percent? Use the percentage of sales approach and assume the company is operating at full capacity. The payout ratio is constant.

4.2 EFN and Capacity Use Based on the information in Problem 4.1, what is EFN, assuming 60 percent capacity usage for net fixed assets? Assuming 95 percent capacity?

4.3 Sustainable Growth Based on the information in Problem 4.1, what growth rate can Skandia maintain if no external financing is used? What is the sustainable growth rate?


4.1 We can calculate EFN by preparing the pro forma statements using the percentage of sales approach. Note that sales are forecast to be $4,250 × 1.10 = $4,675.

Page 1154.2 Full-capacity sales are equal to current sales divided by the capacity utilization. At 60 percent of capacity:

With a sales level of $4,675, no net new fixed assets will be needed, so our earlier estimate is too high. We estimated an increase in fixed assets of $2,420 − 2,200 = $220. The new EFN will thus be $78.7 − 220 = −$141.3, a surplus. No external financing is needed in this case.

At 95 percent capacity, full-capacity sales are $4,474. The ratio of fixed assets to full-capacity sales is thus $2,200/4,474 = 49.17%. At a sales level of $4,675, we will thus need $4,675 × .4917 = $2,298.7 in net fixed assets, an increase of $98.7. This is $220 − 98.7 = $121.3 less than we originally predicted, so the EFN is now $78.7 − 121.3 = −$42.6, a surplus. No additional financing is needed.

4.3 Skandia retains b = 1 − .3337 = 66.63% of net income. Return on assets is $247.5/3,100 = 7.98%. The internal growth rate is thus:

Return on equity for Skandia is $247.5/800 = 30.94%, so we can calculate the sustainable growth rate as follows:


1. Sales Forecast [LO1] Why do you think most long-term financial planning begins with sales forecasts? Put differently, why are future sales the key input?

2. Sustainable Growth [LO3] 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?)

3. External Financing Needed [LO2] Testaburger, Inc., uses no external financing and maintains a positive retention ratio. When sales grow by 15 percent, the firm has a negative projected EFN. What does this tell you about the firm’s internal growth rate? How about the sustainable growth rate? At this same level of sales growth, what will happen to the projected EFN if the retention ratio is increased? What if the retention ratio is decreased? What happens to the projected EFN if the firm pays out all of its earnings in the form of dividends?

4. EFN and Growth Rates [LO2, 3] 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 firm’s 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?

Page 116Use the following information to answer the next six 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.

5. Product Sales [LO4] Do you think the company would have suffered the same fate if its product had been less popular? Why or why not?

6. Cash Flow [LO4] 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?

7. Product Pricing [LO4] The firm actually priced its product to be about 20 percent less than that of competitors, even though the Grandmother calendar was more detailed. In retrospect, was this a wise choice?

8. Corporate Borrowing [LO4] If the firm was so successful at selling, why wouldn’t a bank or some other lender step in and provide it with the cash it needed to continue?

9. Cash Flow [LO4] Which was the biggest culprit here: too many orders, too little cash, or too little production capacity?

10. Cash Flow [LO4] What are some of the actions that a small company like The Grandmother Calendar Company can take if it finds itself in a situation in which growth in sales outstrips production capacity and available financial resources? What other options (besides expansion of capacity) are available to a company when orders exceed capacity?


(Questions 1–15)

1. Pro Forma Statements [LO1] Consider the following simplified financial statements for the Yoo Corporation (assuming no income taxes):

The company has predicted a sales increase of 15 percent. It has predicted that every item on the balance sheet will increase by 15 percent as well. Create the pro forma statements and reconcile them. What is the plug variable here?

2. Pro Forma Statements and EFN [LO1, 2] In the previous question, assume the company pays out half of net income in the form of a cash dividend. Costs and assets vary with sales, but debt and equity do not. Prepare the pro forma statements and determine the external financing needed.

Page 1173. Calculating EFN [LO2] The most recent financial statements for Hornick, 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 year’s sales are projected to be $8,968. What is the external financing needed?

4. EFN [LO2] The most recent financial statements for Reply, Inc., are shown here:

Assets and costs are proportional to sales. Debt and equity are not. A dividend of $2,400 was paid, and the company wishes to maintain a constant payout ratio. Next year’s sales are projected to be $32,085. What is the external financing needed?

5. EFN [LO2] The most recent financial statements for Cornwall, Inc., are shown here:

Assets, costs, and current liabilities are proportional to sales. Long-term debt and equity are not. The company maintains a constant 40 percent dividend payout ratio. As with every other firm in its industry, next year’s sales are projected to increase by exactly 15 percent. What is the external financing needed?

6. Calculating Internal Growth [LO3] The most recent financial statements for Schenkel Co. are shown here:

Assets and costs are proportional to sales. Debt and equity are not. The company maintains a constant 30 percent dividend payout ratio. What is the internal growth rate?

7. Calculating Sustainable Growth [LO3] For the company in the previous problem, what is the sustainable growth rate?

Page 1188. Sales and Growth [LO2] The most recent financial statements for Alexander Co. are shown here:

Assets and costs are proportional to sales. The company maintains a constant 30 percent dividend payout ratio and a constant debt–equity ratio. What is the maximum increase in sales that can be sustained assuming no new equity is issued?

9. Calculating Retained Earnings from Pro Forma Income [LO1] Consider the following income statement for the Heir Jordan Corporation:

A 20 percent growth rate in sales is projected. Prepare a pro forma income statement assuming costs vary with sales and the dividend payout ratio is constant. What is the projected addition to retained earnings?

10. Applying Percentage of Sales [LO1] The balance sheet for the Heir Jordan Corporation follows. Based on this information and the income statement in the previous problem, supply the missing information using the percentage of sales approach. Assume that accounts payable vary with sales, whereas notes payable do not. Put “n/a” where needed.

Page 11911. EFN and Sales [LO2] From the previous two questions, prepare a pro forma balance sheet showing EFN, assuming a 15 percent increase in sales, no new external debt or equity financing, and a constant payout ratio.

12. Internal Growth [LO3] If Stone Sour Co. has an ROA of 8 percent and a payout ratio of 30 percent, what is its internal growth rate?

13. Sustainable Growth [LO3] If Gold Corp. has an ROE of 15 percent and a payout ratio of 25 percent, what is its sustainable growth rate?

14. Sustainable Growth [LO3] Based on the following information, calculate the sustainable growth rate for Kaleb’s Welding Supply:

15. Sustainable Growth [LO3] Assuming the following ratios are constant, what is the sustainable growth rate?

16. Full-Capacity Sales [LO1] Southern Mfg., Inc., is currently operating at only 92 percent of fixed asset capacity. Current sales are $690,000. How fast can sales grow before any new fixed assets are needed?


(Questions 16–26)

17. Fixed Assets and Capacity Usage [LO1] For the company in the previous problem, suppose fixed assets are $520,000 and sales are projected to grow to $790,000. How much in new fixed assets are required to support this growth in sales? Assume the company maintains its current operating capacity.

18. Growth and Profit Margin [LO3] Dante Co. wishes to maintain a growth rate of 12 percent per year, a debt–equity ratio of .85, and a dividend payout ratio of 30 percent. The ratio of total assets to sales is constant at .95. What profit margin must the firm achieve?

19. Growth and Assets [LO3] A firm wishes to maintain an internal growth rate of 6.5 percent and a dividend payout ratio of 25 percent. The current profit margin is 7 percent, and the firm uses no external financing sources. What must total asset turnover be?

20. Sustainable Growth [LO3] Based on the following information, calculate the sustainable growth rate for Hendrix Guitars, Inc.:

21. Sustainable Growth and Outside Financing [LO3] You’ve collected the following information about Draiman, Inc.:

Page 120What is the sustainable growth rate for the company? If it does grow at this rate, how much new borrowing will take place in the coming year, assuming a constant debt–equity ratio? What growth rate could be supported with no outside financing at all?

22. Sustainable Growth Rate [LO3] Gilmore, Inc., had equity of $161,000 at the beginning of the year. At the end of the year, the company had total assets of $305,000. During the year, the company sold no new equity. Net income for the year was $29,000 and dividends were $6,200. What is the sustainable growth rate for the company? What is the sustainable growth rate if you use the formula ROE × b and beginning of period equity? What is the sustainable growth rate if you use end of period equity in this formula? Is this number too high or too low? Why?

23. Internal Growth Rates [LO3] Calculate the internal growth rate for the company in the previous problem. Now calculate the internal growth rate using ROA × b for both beginning of period and end of period total assets. What do you observe?

24. Calculating EFN [LO2] The most recent financial statements for Fleury, Inc., follow. Sales for 2015 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?

Page 12125. Capacity Usage and Growth [LO2] In the previous problem, suppose the firm was operating at only 80 percent capacity in 2014. What is EFN now?

26. Calculating EFN [LO2] In Problem 24, suppose the firm wishes to keep its debt– equity ratio constant. What is EFN now?

27. EFN and Internal Growth [LO2, 3] Redo Problem 24 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. At what growth rate is the EFN equal to zero? Why is this internal growth rate different from that found by using the equation in the text?


(Questions 27–32)

28. EFN and Sustainable Growth [LO2, 3] Redo Problem 26 using sales growth rates of 30 and 35 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. At what growth rate is the EFN equal to zero? Why is this sustainable growth rate different from that found by using the equation in the text?

29. Constraints on Growth [LO3] Volbeat, Inc., wishes to maintain a growth rate of 12 percent per year and a debt–equity ratio of .35. Profit margin is 6.1 percent, and the ratio of total assets to sales is constant at 1.80. Is this growth rate possible? To answer, determine what the dividend payout ratio must be. How do you interpret the result?

30. EFN [LO2] Define the following:

Assuming all debt is constant, show that EFN can be written as follows:

Hint: Asset needs will equal A × g. The addition to retained earnings will equal PM(S)b × (1 + g).

31. Growth Rates [LO3] Based on the result in Problem 30, show that the internal and sustainable growth rates are as given in the chapter. Hint: For the internal growth rate, set EFN equal to zero and solve for g.

32. Sustainable Growth Rate [LO3] In the chapter, we discussed the two versions of the sustainable growth rate formula. Derive the formula ROE × b from the formula given in the chapter, where ROE is based on beginning of period equity. Also, derive the formula ROA × b from the internal growth rate formula.


Financial planning can be more complex than the percentage of sales approach indicates. Often, the assumptions behind the percentage of sales approach may be too simple. A more sophisticated model allows important items to vary without being a strict percentage of sales.

Consider a new model in which depreciation is calculated as a percentage of beginning fixed assets, and interest expense depends directly on the amount of debt. Debt is still the Page 122plug variable. Note that since depreciation and interest now do not necessarily vary directly with sales, the profit margin is no longer constant. Also, for the same reason, taxes and dividends will no longer be a fixed percentage of sales. The parameter estimates used in the new model are:

The model parameters can be determined by whatever methods the company deems appropriate. For example, they might be based on average values for the last several years, industry standards, subjective estimates, or even company targets. Alternatively, sophisticated statistical techniques can be used to estimate them.

The Moore Company is preparing its pro forma financial statements for the next year using this model. The abbreviated financial statements are presented below.

a. Calculate each of the parameters necessary to construct the pro forma balance sheet.

b. Construct the pro forma balance sheet. What is the total debt necessary to balance the pro forma balance sheet?

c. In this financial planning model, show that it is possible to solve algebraically for the amount of new borrowing.

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Planning for Growth at S&S Air

After Chris completed the ratio analysis for S&S Air (see Chapter 3), Mark and Todd approached him about planning for next year’s sales. The company had historically used little planning for investment needs. As a result, the company experienced some challenging times because of cash flow problems. The lack of planning resulted in missed sales, as well as periods when Mark and Todd were unable to draw salaries. To this end, they would like Chris to prepare a financial plan for the next year so the company can begin to address any outside investment requirements. The income statement and balance sheet are shown here:

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