Lecture 3

Financial Planning
 Responsibilities of the Financial Manager
F
i
n
a
1. Managing the
n working capital 2. Estimating the
c seasonal fund needs
i
a
l 3. Long-term financial
planning: forecasting long-
M
a term fund requirements
n
a
g
e 4. Determining appropriate
r investment mix
6. Determining the
amount of dividends 5. Determining appropriate
to be paid financing mix
2
 Objectives
• Understand the financial planning process and
how decisions are interrelated
• Be able to develop a financial plan using the
percentage of sales approach
• Understand the four major decision areas
involved in long-term financial planning
• Understand how capital structure policy and
dividend policy affect a firm’s ability to grow
 Coverage
• What is Financial Planning?
• Financial Planning Models
• The Percentage of Sales Approach
• External Financing and Growth
• Short-term financial planning
• Some Caveats Regarding Financial Planning
Models
 Elements of Financial Planning
• Investment in new assets – determined by
capital budgeting decisions
• Degree of financial leverage – determined by
capital structure decisions
• Cash paid to shareholders – determined by
dividend policy decisions
• Liquidity requirements – determined by net
working capital decisions
 Financial Planning Process
• Planning Horizon – divide decisions into short-run
decisions (usually next 12 months) and long-run
decisions (usually 2 – 5 years)
• Aggregation – combine capital budgeting decisions
into one big project
• Assumptions and Scenarios
– Make realistic assumptions about important variables
– Run several scenarios where you vary the assumptions by
reasonable amounts
– Determine at least a worst case, normal case and best case
scenario
 Role of Financial Planning
• Examine interactions – help management see the
interactions between decisions
• Explore options – give management a systematic
framework for exploring its opportunities
• Avoid surprises – help management identify possible
outcomes and plan accordingly
• Ensure feasibility and internal consistency – help
management determine if goals can be accomplished
and if the various stated (and unstated) goals of the
firm are consistent with one another
 Financial Planning Model Ingredients
• Sales Forecast – many cash flows depend directly on the level
of sales (often estimated sales growth rate)
• Pro Forma Statements – setting up the plan as projected
financial statements allows for consistency and ease of
interpretation
• Asset Requirements – the additional assets that will be
required to meet sales projections
• Financial Requirements – the amount of financing needed to
pay for the required assets
• Plug Variable – determined by management decisions about
what type of financing will be used (makes the balance sheet
balance)
• Economic Assumptions – explicit assumptions about the
coming economic environment
 Example: Historical Financial Statements

ABC Ltd.
ABC Ltd.
Balance Sheet Income Statement
December 31, 2015 For Year Ended
Assets 1000 Debt 400 December 31, 2015
Revenues 2000
Equity 600
Costs 1600
Total 1000 Total 1000 Net Income 400
 Example: Pro Forma Income Statement

• Initial Assumptions
ABC Ltd.
– Revenues will grow at
15% (2000*1.15) Pro Forma Income
– All items are tied directly Statement
to sales and the current For Year Ended 2016
relationships are optimal
Revenues 2,300
– Consequently, all other
items will also grow at
15% Costs 1,840

Net Income 460

 Example: Pro Forma Balance Sheet
ABC Ltd.
• Case I Pro Forma Balance Sheet
– Dividends are the plug Case I
variable, so equity increases
at 15% Assets 1,150 Debt 460
– Dividends = 460 – 90 = 370 Equity 690
• Case II Total 1,150 Total 1,150
– Debt is the plug variable and ABC Ltd.
no dividends are paid
– Debt = 1,150 – (600+460) = 90 Pro Forma Balance Sheet
– Repay 400 – 90 = 310 in debt Case II
Assets 1,150 Debt 90
Equity 1,060
Total 1,150 Total 1,150
 Percentage of Sales Approach
• This is a financial planning method in which
accounts are varied depending on a firm’s
predicted sales level

12
Percent of Sales Approach (Cont…)
• Some items vary directly with sales, while others do not
• Income Statement
– Costs may vary directly with sales - if this is the case, then the profit
margin is constant
– Depreciation and interest expense may not vary directly with sales – if
this is the case, then the profit margin is not constant
– Dividends are a management decision and generally do not vary
directly with sales – this affects additions to retained earnings
• Balance Sheet
– Initially assume all assets, including fixed, vary directly with sales
– Accounts payable will also normally vary directly with sales
– Notes payable, long-term debt and equity generally do not because
they depend on management decisions about capital structure
– The change in the retained earnings portion of equity will come from
the dividend decision
 Example 1: Income Statement
TNT Ltd TNT Ltd
Income Statement, 2015 Pro Forma Income Statement,
2016
% of
Sales 5,500
Sales
Sales 5,000 Costs 3,300

Costs 3,000 60% EBT 2,200

Taxes 880
EBT 2,000 40%
Net Income 1,320
Taxes 800 16%
(40%)
Dividends 660
Net Income 1,200 24%
Add. To RE 660
Dividends 600
Assume Sales grow at 10%
Add. To RE 600 Dividend Payout Rate = 50%
 Example: Balance Sheet
TNT Ltd – Balance Sheet
Current % of Pro Current % of Pro
Sales Forma Sales Forma
ASSETS Liabilities & Owners’ Equity
Current Assets Current Liabilities
Cash 500 10% 550 A/P 900 18% 990
A/R 2,000 40 2,200 N/P 2,500 n/a 2,500
Inventory 3,000 60 3,300 Total 3,400 n/a 3,490
Total 5,500 110 6,050 LT Debt 2,000 n/a 2,000
Fixed Assets Owners’ Equity
Net P&E 4,000 80 4,400 CS 2,000 n/a 2,000
Total Assets 9,500 190 10,450 RE 2,100 n/a 2,760
Total 4,100 n/a 4,760
Total L & OE 9,500 10,250
 Example: External Financing
Needed
• The firm needs to come up with an additional
Tshs 200 million in debt or equity to make the
balance sheet balance
• TA – TL & OE = 10,450 – 10,250 = 200
• Choose plug variable
• Borrow more short-term (Notes Payable)
• Borrow more long-term (LT Debt)
• Sell more common stock (CS)
• Decrease dividend payout, which increases the
Additions To Retained Earnings
 Example: Operating at Less than Full
Capacity
• Suppose that the company is currently operating at 80%
capacity.
– Full Capacity sales = 5000 /0.8 = 6,250
– Estimated sales = 5,500, so would still only be operating at 88%
– Therefore, no additional fixed assets would be required.
– Pro forma Total Assets = 6,050 + 4,000 = 10,050
– Total Liabilities and Owners’ Equity = 10,250
• Choose plug variable
– Repay some short-term debt (decrease Notes Payable)
– Repay some long-term debt (decrease LT Debt)
– Buy back stock (decrease CS)
– Pay more in dividends (reduce Additions To Retained Earnings)
– Increase cash account
 The Percentage of Sales Approach – Example 2
Income Statement
(Projected growth = 30%)
Original Proforma
Sales Tshs 2000 Tshs ….
Costs 1700 2210
EBT 300 ….
Taxes (34%) 102 132.6
Net Income Tshs 198 Tshs 257.4

Dividends 66 85.8
Add. To R/E ….. ….
18
 The Percentage of Sales Approach (Cont…)
Income Statement
(Projected growth = 30%)
Original Proforma
Sales Tshs 2000 2600 (+30%)
Costs 1700 2210 (= 85% of sales)
EBT 300 390
Taxes (34%) 102 132.6
Net Income 198 257.4

Dividends 66 85.8 (= 1/3 of net)

Add. To R/E 132 171.6 (= 2/3 of net)

19
 The Percentage of Sales Approach (concluded)

Preliminary Balance Sheet

Assets Liabilities & Owners’ Equity
Original % of Sales Original % of Sales
Cash Tshs 100 …. A/P Tshs 60 ….
A/R 120 6% N/P 140 n/a
Inv 140 7% Total 200 n/a
Total 360 …. LTD 200 n/a
NFA 640 32% C/S 10 n/a
R/E 590 n/a
600 n/a
Total Tshs 1000 50% Total Tshs 1000 n/a

20
 The Percentage of Sales Approach (concluded)
• Preliminary Balance Sheet
Original % of Sales Original % of Sales
Cash Tshs 100 5% A/P Tshs 60 3%
A/R 120 6% N/P 140 n/a
Inv 140 7% Total 200 n/a
Total 360 18% LTD 200 n/a
NFA 640 32% C/S 10 n/a
R/E 590 n/a
600 n/a
Total Tshs 1000 50% Total Tshs 1000 n/a

Note that the ratio of total assets to sales is Tshs 1000/2000 = 0.50.
This is the capital intensity ratio. It equals 1/(total asset turnover).
21
 Proforma Statements
• The Percentage of Sales Approach (continued)
(+/-) (+/-)
Cash Tshs …. …. A/P Tshs …. ….
A/R …. …. N/P …. ….
Inv 182 42 …. ….
Total …. Tshs 108 LTD 200 ….
NFA 832 192 C/S 10
R/E 761.6 ….
771.6 ….
Total Tshs …. Tshs …. Total Tshs Tshs 1189.6 ….

Financing needs are Tshs ….., but internally generated sources are
only Tshs ….. The difference is external financing needed:
EFN = Tshs ….. – ….. = Tshs ________ 22
 Proforma Statements
• The Percentage of Sales Approach (continued)
(+/-) (+/-)
Cash Tshs 130 Tshs 30 A/P Tshs 78 Tshs 18
A/R 156 36 N/P 140 0
Inv 182 42 218 18
Total 468 Tshs 108 LTD 200 0
NFA 832 192 C/S 10 0
R/E 761.6 171.6
771.6 171.6
Total Tshs 1300 Tshs 300 Total Tshs Tshs 1189.6 189.6
Financing needs are Tshs 300, but internally generated sources are
only Tshs 189.60. The difference is external financing needed:
EFN = Tshs 300 - 189.60 = Tshs 110.4
23
 Pro Forma Statements (concluded)
• One possible financing strategy:
1.Borrow short-term first
2.If needed, borrow long-term next
3.Sell equity as a last resort

• Constraints:
1.Current ratio must not fall below 2.0.
2.Total debt ratio must not rise above 0.40.
24
 The Percentage of Sales Approach: A Financing
Plan
• Given the following information, determine maximum allowable
borrowing for the firm:
1. Tshs 468/CL = 2.0 implies maximum CL = Tshs …..
Maximum short-term borrowing = Tshs 234 – Tshs ….. = Tshs ….
2. 0.40 Tshs 1300 = Tshs …. = maximum debt
Tshs 520 – …. = Tshs …. = maximum long-term debt
Maximum long-term borrowing = Tshs 286 – …. = Tshs ….
3. Total new borrowings = Tshs 16 + 86 = Tshs ….
Shortage = Tshs …. – 102 = Tshs ….

25
 The Percentage of Sales Approach: A Financing
Plan
• Given the following information, determine maximum allowable borrowing for
the firm:
1. Tshs 468/CL = 2.0 implies maximum CL = Tshs 234
Maximum short-term borrowing = Tshs 234 – Tshs 218 = Tshs 16
2. 0.40 Tshs 1300 = Tshs 520 = maximum debt
Tshs 520 – 234 = Tshs 286 = maximum long-term debt
Maximum long-term borrowing = Tshs 286 – 200 = Tshs 86
3. Total new borrowings = Tshs 16 + 86 = Tshs 102
Shortage = Tshs 110.4 – 102 = Tshs 8.4
• A possible plan:
New short-term debt = Tshs 16.0
New long-term debt = 86.0
New equity = 8.4
Tshs 110.4
26
 Proforma Statements
• The Percentage of Sales Approach: A Financial Plan
(Concluded)
(+/-) (+/-)
Cash Tshs 130 Tshs 30 A/P Tshs 78 Tshs 18
A/R 156 36 N/P 156 16
Inv 182 42 234 34
Total 468 Tshs 108 LTD 286 86
NFA 832 192 C/S 18.4 8.4
R/E 761.6 171.6
831 266
Total Tshs 1300 Tshs 300 Total Tshs 1189.6 300

Note: Current Ratio = 2.0

Total Debt Ratio = 40%
27
 The Percentage of Sales Approach: A Financing
Plan
• Given the following information, determine maximum allowable borrowing for
the firm:
1. Tshs 468/CL = 2.0 implies maximum CL = Tshs 234
Maximum short-term borrowing = Tshs 234 – Tshs 218 = Tshs 16
2. 0.40 Tshs 1300 = Tshs 520 = maximum debt
Tshs 520 – 234 = Tshs 286 = maximum long-term debt
Maximum long-term borrowing = Tshs 286 – 200 = Tshs 86
3. Total new borrowings = Tshs 16 + 86 = Tshs 102
Shortage = Tshs 110.4 – 102 = Tshs 8.4
• Another possible plan:
New short-term debt = Tshs 8.0
New long-term debt = 43.0
New equity = 59.4
Tshs 110.4
28
 Proforma Statements
• The Percentage of Sales Approach: A Financial Plan
(Concluded)
(+/-) (+/-)
Cash Tshs 130 Tshs 30 A/P Tshs 78 Tshs 18
A/R 156 36 N/P 148 8
Inv 182 42 226 26
Total 468 Tshs 108 LTD 243 43
NFA 832 192 C/S 69.4 59.4
R/E 761.6 171.6
831 231
Total Tshs 1300 Tshs 300 Total Tshs 1189.6 300

Note: Current Ratio = 2.07

Total Debt Ratio = 36%
29
 The Percentage of Sales Approach: What About
Capacity?
So far, 100% capacity has been assumed. Suppose that, instead, current
capacity use is 80%.
1. At 80% capacity:
 Tshs 2000 = .80 full capacity sales
 Tshs 2000/.80 = Tshs ……… = full capacity sales
2. At full capacity, fixed assets to sales will be:
 Tshs 640/Tshs ……. = 25.60%
3. So, NFA will need to be just:
 25.60% Tshs 2600 = Tshs ….. , not Tshs 832
 Tshs 832 – Tshs 665.60 = Tshs …….. less than originally projected
• 4. In this case, original EFN is substantially overstated:
 New EFN = Tshs ….. – Tshs ….. = Tshs …..

30
 The Percentage of Sales Approach: What About
Capacity?
So far, 100% capacity has been assumed. Suppose that, instead,
current capacity use is 80%.
1. At 80% capacity:
 Tshs 2000 = .80 full capacity sales
 Tshs 2000/.80 = Tshs 2500 = full capacity sales
2. At full capacity, fixed assets to sales will be:
 Tshs 640/Tshs 2500 = 25.60%
3. So, NFA will need to be just:
 25.60% Tshs 2600 = Tshs 665.60, not Tshs 832
 Tshs 832 – Tshs 665.60 = Tshs 166.40 less than originally
projected
4. In this case, original EFN is substantially overstated:
 New EFN = Tshs 110.40 – Tshs 166.40 = –Tshs 56
31
 The Percentage of Sales Approach: General
Formulas
• Given a sales forecast and an estimated profit margin, what
addition to retained earnings can be expected?
Let:
S = previous period’s sales
g = projected increase in sales
PM = profit margin
b = earnings retention (“plowback”) ratio
• The expected addition to retained earnings is:
S(1 + g) PM b
This represents the level of internal financing the firm is
expected to generate over the coming period.

32
 The Percentage of Sales Approach: General
Formulas (concluded)
• What level of asset investment is needed to support a given level
of sales growth? For simplicity, assume we are at full capacity.
Then the indicated increase in assets required equals
Axg
where A = ending total assets from the previous period.
• If the required increase in assets exceeds the internal funding
available (i.e., the increase in retained earnings), then the
difference is the
External Financing Needed (EFN).

33
 Other methods of determining financial
requirements
• The other common methods of determining
financial requirements (financial forecasting)
are:
– Sustainable growth model
• Steady state model
• Unbalanced growth
– Simple linear regression model
– Multiple linear regression model
– Curvilinear model
34
 Growth and External Financing
• At low growth levels, internal financing
(retained earnings) may exceed the required
investment in assets
• As the growth rate increases, the internal
financing will not be enough and the firm will
have to go to the capital markets for money
• Examining the relationship between growth
and external financing required is a useful tool
in long-range planning
 Sustainable Growth Modeling
• This is a powerful tool for checking the consistency
between sales growth goals, operating efficiency, and
financial objectives.
• In order for companies to avoid risking financial
distress the trick is to determine what sales growth
rate is consistent with the realities of the company
and of the financial market place.
• Thus, SGR is defined as:
– the maximum annual percentage increase in sales that can
be achieved based on target operating, debt, and
dividend-payout ratios.
• If actual growth exceeds the SGR, something must
give, and frequently it is the debt ratio.
36
 Sustainable growth rate (SGR)
• Note that by modeling the process of growth, we are able to
make intelligent trade-offs.
• There are two variations of the model
– A steady state model (where the equity base and sales grow
in concert). It assumes that:
• the future is exactly like the past with respect to balance
sheet and performance ratios.
• The firm engages in no external equity financing with the
equity account building only through earnings retention
– Unbalanced growth – where the ratios and growth change from
year to year (the SGR is determined year by year).
• Given a desired growth in sales, through simulation, one is
able to determine the operating and financial variables
necessary to achieve it.

37
 A Steady State Model (Cont.)
• In a steady state environment, the variables necessary to determine
the sustainable growth rate (SGR) are:
A/S = the total assets-to-sales ratio
NP/S = the net profit margin (net profits divided by sales)
b = the retention rate of earnings (1-b is the dividend-payout ratio)
D/Eq = the debt-to-equity ratio
S0 = the most recent annual sales (beginning sales)
S = the absolute change in sales from the most recent annual sales
• Note that the first four variables (A/S, NP/S, b, and D/Eq) are target
variables
– With these variables we can derive the sustainable growth rate (SGR)
• The total assets-to-sales ratio (i.e. A/S) is a measure of operating
efficiency - the reciprocal of the traditional asset turnover ratio. The
lower the ratio the more efficient the utilization of assets
38
 A Steady State Model (Cont.)
• In turn, the asset-to-sales ratio is a composite
of:
1. Receivable management, as depicted by the
average collection period;
2. Inventory management, as indicated by the
inventory turnover ratio;
3. Fixed-asset management, as reflected by the
throughput of product through the plant; and
4. Liquidity management, as suggested by the
proportion of and return on liquid assets.
39
 A Steady State Model (Cont.)
• The net profit margin (i.e. NP/S) is a relative measure of
operating efficiency, after taking account of all expenses
and income taxes.
– Note that while both the assets-to-sales ratio and the net
profit margin are affected by the external product markets,
they largely capture internal management efficiency
• The earnings retention rate and the debt ratio are
determined to keep up with dividend and capital structure
theory and practice.
– They are influenced importantly by the external financial
markets

40
 Sustainable Growth Rate
• The idea behind SGR is that an increase in assets (a use
of funds) must equal the increase in liabilities and net
worth (a source of funds)
– The increase in assets can be expressed as S(A/S)
– The increase in net worth (through retained earnings) is
b(NP/S)(S0 + S)
– The increase in total debt is simply the net worth increase
multiplied by the target debt-to-equity ratio, or [b(NP/S)(S0 +
S)]D/Eq

41
 The Steady State Model
 A  NP    NP   D
S    b S0  S   b S S0  S  Eq

 S 

S   
Asset increase Re tained earnings increase Increase in debt

By rearrangement, this equation can be expressed as

 NP   D
b  1  
S  S  Eq 
Or SGR 
S  A    NP   D 
   b  1  
 S    S  Eq 
42
Model Under Changing Assumptions

  D  S  
 Eq0  New Eq  Div 1     
  Eq   A   1
SGR      1
 NP   D   S   S0 
 1    1     
  S   Eq   A  

Where:
New Eq = the amount of new equity capital raised
Div = the absolute amount of annual dividend
S/A = the sales-to-total assets ratio
43
 Growth and External Financing – Example

• Key issue:
– What is the relationship between sales growth and
financing needs?
• Recent Financial Statements
Income Statement Balance Sheet
Sales Tshs 100 Assets Tshs 50 Debt Tshs 20
Costs 90 Equity 30
Net Income 10 Total Tshs 50 Total 50

44
 Growth and External Financing (concluded)
• Assume that:
1. costs and assets grow at the same rate as sales
2. 60% of net income is paid out in dividends
3. no external financing is available (debt or equity)
Q. What is the maximum growth rate achievable?
A. The maximum growth rate is given by
Internal growth rate (IGR) = (ROA x b)/[1 – (ROA x b)]
ROA = Tshs 10/….. = …..%
b = 1 – .---- = .-----
IGR = (20% X .40)/[1 – (20% x .40)]
= .08/.92 = 8.7% ( = 8.865656…%)

45
 Growth and External Financing (concluded)

• Assume that:
1. costs and assets grow at the same rate as sales
2. 60% of net income is paid out in dividends
3. no external financing is available (debt or equity)
Q. What is the maximum growth rate achievable?
A. The maximum growth rate is given by
Internal growth rate (IGR) = (ROA x b)/[1 – (ROA x b)]
ROA = Tshs 10/50 = 20%
b = 1 – .60 = .40
IGR = (20% x .40)/[1 – (20% x .40)]
= .08/.92 = 8.7% ( = 8.865656…%)

46
 The Internal Growth Rate

• Assume sales do grow at 8.7 percent. How are the financial

statements affected?

Proforma Financial Statements

Income Statement Balance Sheet

Sales Tshs 108.70 Assets Tshs 54.35 Debt Tshs 20
Costs 97.83 Equity …
Net Income 10.87 Total Tshs 54.35 Total Tshs ….

Dividends Tshs 6.52

Add to R/E ……
47
 The Internal Growth Rate

• Assume sales do grow at 8.7 percent. How are the financial

statements affected?

Proforma Financial Statements

Income Statement Balance Sheet

Sales Tshs 108.70 Assets Tshs 54.35 Debt Tshs 20.00
Costs 97.83 Equity 34.35
Net Income 10.87 Total Tshs 54.35 Total Tshs 54.35

Dividends Tshs 6.52

Add to R/E 4.35
48
 Internal Growth Rate (concluded)

• Now assume that:

1. No external equity financing is available
2. The current debt/equity ratio is optimal
Q. What is the maximum growth rate achievable now?
A. The maximum growth rate is given by
Sustainable growth rate (SGR) = (ROE x b)/[1 – (ROE x b)]
ROE = Tshs …../….. = 1/3 (= 33.3333…%)
b = 1.00 - .60 = .40
SGR = (1/3 x .40)/[1 – (1/3 x .40)]
= 15.385% (= 15.38462…)

49
 Internal Growth Rate (concluded)

• Now assume that:

1. No external equity financing is available
2. The current debt/equity ratio is optimal
Q. What is the maximum growth rate achievable now?
A. The maximum growth rate is given by:
Sustainable growth rate (SGR) = (ROE x b)/[1 – (ROE x b)]
ROE = Tshs 10/30 = 1/3 (= 33.3333…%)
b = 1.00 – 0.60 = 0.40
SGR = (1/3 x 0.40)/[1 – (1/3 x 0.40)]
= 15.385% (= 15.38462…)

50
 The Sustainable Growth Rate
• Assume sales do grow at 15.385 percent:
Proforma Financial Statements

Income Statement Balance Sheet

Sales Tshs 115.38 Assets Tshs 57.69 Debt Tshs ….
Costs 103.85 Equity ….
Net Income 11.53 Total Tshs 57.69 Total Tshs ….

Dividends Tshs 6.92 EFN Tshs …

R/E Tshs ….

If we borrow Tshs 3.08, the debt/equity ratio will be:

Tshs ……./……. = ……. 51
 The Sustainable Growth Rate
• Assume sales do grow at 15.385 percent:
Proforma Financial Statements
Income Statement Balance Sheet
Sales Tshs 115.38 Assets Tshs 57.69 Debt Tshs 20.00
Costs 103.85 Equity 34.61
Net Income 11.53 Total Tshs 57.69 Total Tshs 54.61

Dividends Tshs 6.92 EFN Tshs 3.08

R/E Tshs 4.61

If we borrow Tshs 3.08, the debt/equity ratio will be:

Tshs 23.08/34.61 = 2/3
Is this what you expected?
52
 The Sustainable Growth Rate (concluded)

• The rate of sustainable growth depends on four factors:

1. Profitability (profit margin)

2. Dividend Policy (dividend payout)

3. Financial policy (debt-equity ratio)

4. Asset utilization (total asset turnover)

53
 Summary of Internal and Sustainable Growth
Rates
I. Internal Growth Rate
IGR = (ROA  b)/[1 - (ROA  b)]
where: ROA = return on assets = Net income/assets
b = earnings retention or “plowback” ratio
The IGR is the maximum growth rate that can be achieved with no
external financing of any kind.
II. Sustainable Growth Rate
SGR = (ROE  b)/[1 - (ROE  b)]
where: ROE = return on equity = Net income/equity
b = earnings retention or “plowback” ratio
The SGR is the maximum growth rate that can be achieved with no
external equity financing while maintaining a constant debt/equity
ratio.
54
 The Internal Growth Rate
• The internal growth rate tells us how much the firm can
grow assets using retained earnings as the only source of
financing.
ROA  b
Internal Growth Rate 
1 - ROA  b

• Using the information from TNT Ltd as an example

• ROA = 1200 / 9500 = 0.1263
• B = 0.5 ROA  b
Internal Growth Rate 
1 - ROA  b
0.1263  .5
  0.0674
1  0.1263  .5
 6.74%
This firm could grow assets at 6.74% without raising
additional external capital.
 The Internal Growth Rate
• Relying solely on internally generated funds will
increase equity (retained earnings are part of equity)
and assets without an increase in debt.
• Consequently, the firm’s leverage will decrease over
time.
• If there is an optimal amount of leverage, as we will
discuss in later chapters, then the firm may want to
borrow to maintain that optimal level of leverage.
This idea leads us to the sustainable growth rate.
 The Sustainable Growth Rate
• The sustainable growth rate tells us how much the firm
can grow by using internally generated funds and issuing
debt to maintain a constant debt ratio.
ROE  b
Sustainable Growth Rate 
1 - ROE  b

• Using TNT Ltd as an example

• ROE = 1200 / 4100 = 0.2927
• b = 0.5 ROE  b
Sustainable Growth Rate 
1 - ROE  b
0.2927  .5
  0.1714
1  0.2927  0.5
 17.14%
Note that no new equity is issued.
 The Sustainable Growth Rate
• The sustainable growth rate is substantially
higher than the internal growth rate.
• This is because we are allowing the company
to issue debt as well as use internal funds.
 Determinants of Growth
• Profit margin – operating efficiency
• Total asset turnover – asset use efficiency
• Financial leverage – choice of optimal debt ratio
• Dividend policy – choice of how much to pay to
shareholders versus reinvesting in the firm
– The first three components come from the ROE and the Du
Pont identity.
• It is important to note at this point that growth is not
the goal of a firm in and of itself.
– Growth is only important so long as it continues to
maximize shareholder value.
 Important Questions
• It is important to remember that we are
working with accounting numbers and ask
ourselves some important questions as we go
through the planning process
– How does our plan affect the timing and risk of
our cash flows?
– Does the plan point out inconsistencies in our
goals?
– If we follow this plan, will we maximize owners’
wealth?
Developing a Short-Term Financial
Plan
• Unlike a long-term financial plan that is
prepared using pro forma income statements
and balance sheets, short-term financial plan
is typically presented in the form of a cash
budget that contains details concerning the
firm’s cash receipts and disbursements.
Developing a Short-Term Financial
Plan (cont.)
• Cash budget includes the following main
elements:
– Cash receipts,
– Cash disbursements,
– Net change in cash, and
– New financing needed.
 Cash Budget - Preparation
• Prepare schedule of cash receipts - based
on sales forecasts (in terms of quantities
and prices)
• Sales forecasts can be either internally
based, externally based or both.

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 Internally based sales forecast
• Salesmen are asked to project sales for the
forthcoming period
• Product sales managers screen these estimates and
consolidate them into sales estimates for product
lines
• Estimates for the various product lines are then
combined into an overall sales estimate for the firm

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 Externally based sales forecast
• Economic analysts make forecasts of the economy and of
industry sales for several years to come
• Analytical methods (e.g. regression) are used to estimate
the association between industry sales and the economy
in general
• Given these basic predictions market share by individual
products, prices that are likely to prevail, and the
expected reception of new products are estimated.

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 Schedule of cash receipts
• After sales forecast determine cash receipt from these sales.
• With cash sales, cash is received at the time of the sale; with
credit sales, receipts do not come until later - how much later
will depend upon the billing terms given, the type of customer,
and the credit and collection policies of the firm.
• After determining expected cash receipts from expected
sales determine expected cash from other sources - e.g.
sale of fixed assets
• The bottom line for the schedule of cash receipts is: Total
cash receipts for the period

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 Schedule of cash disbursements
• Based on production schedule and other expected cash
payments
• Production schedule - may be tied up to expected sales or
based on a constant rate (over time)
• Once the production schedule has been established,
estimates can be made of materials needed, labour required,
and any other fixed assets required.
• The schedule estimates expected cash expenses and other
expenditures (i.e. cash payment for purchases, wages,
utilities, capital expenditures, taxes, dividend payments, etc)
• The bottom line is a figure denoting expected total cash
disbursements for the period
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 Net Cash Flow and Cash Balance
• Combining expected cash receipts (cash
inflows) and cash disbursements (cash
outflows) gives net cash flow for the period
• Add beginning cash balance to the net cash
flow to get the cumulative cash balance
• Subtract required ending cash balance to get
excess cash (to be invested) or cash deficit (to
be financed)

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 Cash Budget - Preparation
Cash Budget for the period, abc to xyz
Expected Total Cash Receipt xxx From the Schedule of Cash Receipts

Less Expected Total Cash Disbursements xxx From the Schedule of Cash Payments

Equal Net Cash Flow xxx

Add Beginning Cash Balance xxx Ending balance of previous period

Equal Cumulative Cash Balance xxx

Less Required Cash Balance xxx Policy Issue

Equal Excess Cash (for investment) of Cash xxx

deficit (for financing)

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 Uses of the Cash Budget
1. It is a useful tool for predicting the amount and
timing of the firm’s future financing requirements.
2. It is a useful tool to monitor and control the firm’s
operations.
• Note
– The actual cash receipts and disbursements can be
compared to budgeted estimates, bringing to light any
significant differences.
– In some cases, the differences may be caused by cost
overruns or poor collection from credit customers.
Remedial action can then be taken.
 Quick Quiz
• What is the purpose of long-range planning?
• What are the major decision areas involved in
developing a plan?
• What is the percentage of sales approach?
• How do you adjust the model when operating at
less than full capacity?
• What is the internal growth rate?
• What is the sustainable growth rate?
• What are the major determinants of growth?