Relation Between Sales And Capital Requirements

The forecast made by constructing pro forma financial statements, under certain condition it is easier to use a simple forecasting formula:

Additional Required Spontaneous Increase funds = increase - increase in - retained needed in assets liabilities earnings

Here

AFN = additional funds needed.

A/S = assets that must increase if sales are to increase, expressed as a percentage of sales, or required dollar increase in assets per $1 increase ins sales. A/S = 6.9%, or 0.69, for RSP from Column 1 of Table 5-9.

L/S = liabilities that increase spontaneously with sales, expressed as a percentage of sales, or spontaneously generated financing as a percentage financing per $1 increase of sales, L/S = 13.0%, or 0.130, for RSP.

S = total sales projected for next year. Note that S designates last year's sales. S = $750 million for RSP.

S = change in sales = S - S = $750 million for RSP

M = profit margin, or rate of profits per $1 of sales, M 4 percent, or 0.04, for RSP.

d = percentage of earnings paid out in dividends, or the dividend payout ratio, d = 40 percent, or 0.40, for RPS. Notice that 1 - d = 1.0 - 0.4 = 0.6, or 60 percent, is the percentage earnings that XY retains, or its retention ratio.

Inserting values for RPS into this equation, we find the additional funds needed to be $122 million. AFN = 0.69( S) - 0.13( S) - 0.04(S )(1 - 0.4)

= 0.690($250.0 million)- 0.13($250.0 million)- 0.04(750 million)(0.6)

= $172.5 million - $32.5 million - $18.0 million

= $122.0 million

To increase sales by $250 million, RPS must increase assets by 172.5 million of new assets must be financed in some manner. The higher RPS s sales growth rate, the greater will be its need for external financing. We can use Equation (see above), which is plotted in Figure 5-6, to quantify this relationship.

FIGURE 5-6 Relationship Between Growth in Sales and Financial Requirements, Assuming S = $500 Million (millions of dollars)

Source: Eugene F. Brigham, Alfred L. Kahl, William F. Rentz, and Louis C. Gapenski, Canadian Financial Management, 4th ed., Toronto: Harcourt Brace & Company, Canada, 1994, p. 819. Similarly, the larger RPS s dividend payout ratio, the ( greater its need for external funds.

The percentage of sales method cannot be used if economies of scale exist in the use of assets, if some assets must be added in "lumpy" increments, or if excess capacity is present. In these situations can be used linear regression and specific-item forecasting techniques to forecast asset requirements.

The percentage of sales method can be done with a hand calculator. However, most well-managed firms use some type of computerized financial planning model. Such models can be programmed to show the effects of different sales levels, different ratios of sales to operating assets, and different assumptions about sales prices and input costs.

Pro forma balance sheet and income statements are generated under the different financing plans, and earnings per share are projected, along with such risk measures as the current ratio, the debt/assets ratio, and the times-interest-earned ratio. Thus, such computerized planning models are playing an ever-increasing role in corporate management.

) FIGURE 5-7 RPS Corporation: Linear Regression Model (millions of dollars)

Source: Eugene F. Brigham, Alfred L. Kahl, William F. Rentz, and Louis C. Gapenski, Canadian Financial Management, 4th ed., Toronto: Harcourt Brace & Company, Canada, 1994, p. 817.


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