Long Term Financial Planning - Corporate Finance by Ross

CHAPTER 4
Long-Term Financial
Planning and
Corporate Growth
T hirteenth Street Winery is a small producer of Old
World–style wines in Jordan, Ontario. Three part-
ners who still work at other “real jobs” founded the
Pension Plan. As the company expanded into the U.S.,
Australia, and New Zealand, it won numerous awards
for its quality products, while Donald Trigg became Ernst
company as a labour of love in 1998. The winery sells its & Young’s 2003 Entrepreneur of the Year.
limited production from company-owned vineyards out To achieve their diverse goals, both Vincor and
of its winery shop, open Saturdays and Sundays only. Thirteenth Street needed proper financial planning. In
In contrast, Vincor International Inc. was the eighth- the case of Vincor, rapid growth by acquisitions required
largest wine producer globally and TSX listed when it financing from profits, new debt, and later new equity
was bought by Constellation Brands for $1.5 billion in accessed by going public. For small companies like
2006. Started in 1989 by Donald Trigg with the pur- Thirteenth Street, keeping on mission requires planning
chase of a discontinued brand from Labatt’s, the com- to ensure that growth does not outrun the firm’s finan-
pany grew by acquisitions in Canada with the financial cial resources.1
backing of Gerry Schwartz and the Ontario Teachers'
A LACK OF EFFECTIVE long-range planning is a commonly cited reason for financial dis-
tress and failure. This is especially true for small businesses—a sector vital to the creation of
future jobs in Canada. As we develop in this chapter, long-range planning is a means of sys-
www.corel.com
www.gmcanada.com tematically 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 General Motors Corporation’s board
was heard to say, “Planning is a process that at best helps the firm avoid stumbling into the
future backwards.”
Financial planning establishes guidelines for change and growth in a firm. It normally focus-
es 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 inter-
relatedness of the various investment and financing decisions that a firm makes. In the chapters
ahead, we examine in much more detail how these decisions are made.
1 Our examples of Vincor International Inc. and Thirteenth Street Winery draw on S. Ryval, “Glass half full,” The Globe
and Mail,” September 28, 2001, as well as information from www.vincorinternational.com and
www.13thstreetwines.com.
CHAPTER 4: Long-Term Financial Planning and Corporate Growth 87
We begin by describing what is usually meant by financial planning. For the most part, we
talk about long-term planning. Short-term financial planning is discussed in Chapter 18. We
examine what the firm can accomplish by developing a long-term financial plan. To do this, we
develop a simple, but very 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, management must establish certain elements of the
firm’s financial policy. These basic policy elements of financial planning are:
1. The firm’s needed investment in new assets. This arises from the investment opportunities
that 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 determines the amount
of borrowing the firm uses to finance its investments in real assets. This is the firm’s capi-
tal 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 shall see, the decisions that a firm makes in these four areas directly affect its future prof-
itability, its need for external financing, and its opportunities for growth.
A key lesson from this chapter is that the firm’s investment and financing policies interact
and thus cannot truly be considered in isolation from one another. The types and amounts of
assets that the firm plans on purchasing must be considered along with the firm’s ability to raise
the necessary capital to fund those investments.
Financial planning forces the corporation to think about goals. A goal frequently espoused
by corporations is growth, and almost all firms use an explicit, company-wide growth rate as a
major component of their long-run financial planning. In November 2000, Molson Inc.
announced it was buying a new brand of beer in Brazil for around $300 million Canadian. This
was part of Molson’s strategy to develop an earnings stream in emerging markets where a
www.molson.com younger average age may produce faster sales growth. This strategy shows that growth is an
important goal for most large companies.
There are direct connections between the growth that a company can achieve and its finan-
cial policy. In the following sections, we show that financial planning models can help you better
understand how growth is achieved. We also show how such models can be used to establish lim-
its on possible growth. This analysis can help companies avoid the sometimes fatal mistake of
growing too fast.
4.1 WHAT IS FINANCIAL PLANNING?

Financial planning formulates the way financial goals are to be achieved. A financial plan is thus
a statement of what is to be done in the future. Most 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. A firm that wants to build a factory in 2005, for exam-
ple, might have to begin lining up contractors and financing in 2003, or even earlier.
Growth as a Financial Management Goal

Because we discuss the subject of growth in various places in this chapter, we start out with an
important warning: Growth, by itself, is not an appropriate goal for the financial manager. In fact,
www.cott.com as we have seen, rapid growth isn’t always even good for a firm. Cott Corp., a Toronto-based bot-
tler of private-label soft drinks, is another example of what happens when a firm grows too fast.
The company aggressively marketed its soft drinks in the early 1990s, and sales exploded.
However, despite its growth in sales, the company lost $29.4 million for the fiscal year ended
January 27, 1996.
88 PART 2: Financial Statements and Long-Term Financial Planning
Cott’s pains included the following: (1) aluminum prices rose; (2) the firm faced price com-
petition; (3) costs surged as Cott built corporate infrastructure in anticipation of becoming a
much bigger company; and (4) the firm botched expansion into the United Kingdom. Cott
quickly grabbed a 25 percent market share by undercutting the big brands, but then had to hire
an outside bottler at a cost much higher than the cost of bottling in its own plants to meet the
demand. Half the cases sold in the United Kingdom in 1995 were sold below cost, bringing a loss
to the company as a whole. Cott is now focusing on slower growth while keeping a line on oper-
ating costs.
As we discuss in Chapter 1, the appropriate goal is increasing the market value of the own-
ers’ equity. Of course, if a firm is successful in doing this, growth usually results. 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 see,
growth is a convenient means of summarizing various aspects of a firm’s financial and invest-
ment policies. Also, if we think of growth as growth in the market value of the equity in the firm,
then the goals of growth and increasing the market value of the equity in the firm are not all that
different.
Dimensions of Financial Planning

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.
planning horizon This is called the planning horizon, and it is the first dimension of the planning process that
The long-range time period must be established.2
the financial planning In drawing up a financial plan, all of the individual projects and investments that the firm
process focuses on, usually
the next two to five years. undertakes are combined to determine the total needed investment. In effect, the smaller invest-
ment proposals of each operational unit are added up and treated as one big project. This process
aggregation is called aggregation. This is the second dimension of the planning process.
Process by which smaller Once the planning horizon and level of aggregation are established, a financial plan would
investment proposals of each need inputs in the form of alternative sets of assumptions about important variables. For exam-
of a firm’s operational units
are added up and treated as ple, suppose a company has two separate divisions: one for consumer products and one for gas
one big project. turbine engines. The financial planning process might require each division to prepare three
alternative business plans for the next three years.
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,
the bottom was dropping out of the PC market in 2001. That left big manufacturers like
Compaq, Dell, and Gateway locked in a price war, fighting for market share at a time
when sales were stagnant.
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.
In this example, 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). For example, in 1995, Chrysler put together a forecast for the
www.daimlerchrysler.ca
upcoming four years. According to the likeliest scenario, Chrysler would end 1999 with cash of
$10.7 billion, showing a steady increase from $6.9 billion at the end of 1995. In the worst-case sce-
nario that was reported, however, Chrysler would end 1999 with $3.3 billion in cash, having
2 The techniques we present can also be used for short-term financial planning.
reached a low of $0 in 1997. So, how did the 1999 cash picture for Chrysler actually turn out? We’ll
never know. Just to show you how hard it is to predict the future, Chrysler merged with Daimler-
Benz, maker of Mercedes automobiles, in 1998 to form DaimlerChrysler AG.
What Can Planning Accomplish?

Because the company is likely to spend a lot of time examining the different scenarios that could
become the basis for the company’s financial plan, it seems reasonable to ask what the planning
process will accomplish.
EXAMINING INTERACTIONS As we discuss in greater detail later, the financial plan

must make explicit the linkages between investment proposals for the different operating activi-
ties of the firm and the financing choices available to the firm. In other words, if the firm is plan-
ning on expanding and undertaking new investments and projects, where will the financing be
obtained to pay for this activity?
EXPLORING OPTIONS The financial plan provides the opportunity for 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 eval-
uated. Questions concerning the firm’s future lines of business and questions of what financing
arrangements are optimal 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 would take if
things go seriously wrong or, more generally, if assumptions made today about the future are
seriously in error. Thus, one of the purposes of financial planning is to avoid surprises and devel-
www.ibm.ca
op contingency plans. For example, IBM announced in September 1995 that it was delaying ship-
ment of new mainframe computers by up to four weeks because of a shortage of a key compo-
nent—the power supply. The delay in shipments was expected to reduce revenue by $250 million
and cut earnings by as much as 20 cents a share, or about 8 percent in the current quarter.
Apparently, IBM found itself unable to meet orders when demand accelerated. Thus, a lack of
planning for sales growth can be a problem for big companies, too.
ENSURING FEASIBILITY AND INTERNAL CONSISTENCY Beyond a specific goal of

creating value, a firm normally has many specific goals. Such goals might be couched in 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 differing goals
and objectives. In other words, financial planning is a way of checking that the goals and plans
made with regard to specific areas of a firm’s operations are feasible and internally consistent.
Conflicting goals often exist. To generate a coherent plan, goals and objectives have to be modi-
fied therefore, and priorities 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 percent to 20 percent. Are these two
goals compatible? Can they be accomplished simultaneously? Maybe yes, maybe no. As we dis-
cuss later, financial planning is a way of finding out just what is possible, and, by implication,
what is not possible.
The fact that planning forces management to think about goals and to establish priorities is
probably the most important result of the process. In fact, conventional business wisdom says
that plans can’t work, but planning does. The future is inherently unknown. What we can do is
establish the direction that we want to travel in and take 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.
COMMUNICATION WITH INVESTORS AND LENDERS Our discussion to this

point has tried to convince you that financial planning is essential to good management. Because
good management controls the riskiness of a firm, equity investors and lenders are very interest-
ed in studying a firm’s financial plan. As discussed in Chapter 15, securities regulators require that
firms issuing new shares or debt file a detailed financial plan as part of the prospectus describing
the new issue. Chartered banks and other financial institutions that make loans to businesses
almost always require prospective borrowers to provide a financial plan. In small businesses with
limited resources for planning, pressure from lenders is often the main motivator for engaging in
financial planning.
CONCEPT QUESTIONS
1. What are the two dimensions of the financial planning process?
2. 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 differs from firm to
firm. In this section, we discuss some common elements in financial plans and develop a basic
model to illustrate these elements.
A Financial Planning Model: The Ingredients

Most financial planning models require the user to specify some assumptions about the future.
Based on those assumptions, the model generates predicted values for a large number of variables.
Models can vary quite a bit in their complexity, but almost all would have the following elements:
SALES FORECAST Almost all financial plans require an externally supplied sales forecast.
In the models that follow, for example, the sales forecast is the driver, meaning that the user of
the planning model supplies this value and all other values are calculated based on it. This
arrangement would be common for many types of business; planning focuses on projected future
sales and the assets and financing needed to support those sales.
Frequently, the sales forecast is given as a 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 and on industry conditions.
For example, the September 11, 2001 terrorist attacks caused many firms to scale down their
sales forecasts. Some industries were hit particularly hard, such as airlines and hotels. To help
firms come up with such projections, some economic consulting firms specialize in macro-
economic and industry projections. Economic and industry forecasts are also available free from
the economic research departments of chartered banks.
As we discussed earlier, we are frequently interested in evaluating alternative scenarios, so it
isn’t necessarily crucial that the sales forecast be accurate. 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 has a forecasted balance sheet, an income
statement, and a 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.” This means that the finan-
Spreadsheets to use for pro cial statements are the forms we use to summarize the different events projected for the future.
forma statements can be
obtained at www.jaxworks.com
At a minimum, a financial planning model generates these statements based on projections of
key items such as sales.
In the planning models we describe later, the pro formas are the output from the financial
planning model. The user supplies a sales figure, and the model generates the resulting income
statement and balance sheet.
ASSET REQUIREMENTS The plan describes projected capital spending. At a minimum,

the projected balance sheets 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 includes a section on the financial arrange-

ments that are necessary. This part of the plan should discuss dividend policy and debt policy.
Sometimes firms expect to raise cash by selling new shares of stock or by borrowing. Then, the
plan has to spell out what kinds of securities have to be sold and what methods of issuance are
most appropriate. These are subjects we consider in Part 6 when we discuss long-term financing,
capital structure, and dividend policy.
CASH SURPLUS OR SHORTFALL After the firm has a sales forecast and an estimate
of the required spending on assets, some amount of new financing is often necessary because
projected total assets exceed projected total liabilities and equity. In other words, the balance
sheet no longer balances.
Because new financing may be necessary to cover all the projected capital spending, a finan-
cial “plug” variable must be designated. The cash surplus or shortfall (also called the “plug”) is
the designated source or sources of external financing needed to deal with any shortfall (or sur-
plus) in financing and thereby to 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
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.
ECONOMIC ASSUMPTIONS The plan has to explicitly describe the economic environ-
ment in which the firm expects to reside over the life of the plan. Among the more important
economic assumptions that have to be made are the level of interest rates and the firm’s tax rate,
as well as sales forecasts, as discussed earlier.
A Simple Financial Planning Model

We begin our discussion of long-term planning models with a relatively simple example.3 The
Computerfield Corporation’s financial statements from the most recent year are as follows:
COMPUTERFIELD CORPORATION
Financial Statements
Income Statement Balance Sheet
Sales $1,000 Assets $500 Debt $250
Costs 800 Equity 250
Net income $ 200 Total $500 Total $500
Unless otherwise stated, the financial planners at Computerfield assume that all variables are
tied directly to sales and that current relationships are optimal. This means that all items grow at
exactly the same rate as sales. This is obviously oversimplified; we use this assumption only to
make a point.
Suppose that sales increase by 20 percent, rising from $1,000 to $1,200. Then planners would
also forecast a 20 percent increase in costs, from $800 to $800 × 1.2 = $960. The pro forma
income statement would thus be:
PRO FORMA
Income Statement
Sales $1,200
Costs 960
Net income $ 240
3 Computer spreadsheets are the standard way to execute this and the other examples we present. Appendix 10B
gives an overview of spreadsheets and how they are used in planning with capital budgeting as the application.
The assumption that all variables would grow by 20 percent enables us to easily construct the pro
forma balance sheet as well:
PRO FORMA BALANCE SHEET

Assets $600 (+100) Debt $300 (+50)
Equity 300 (+50)
Total $600 (+100) Total $600 (+100)
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 dif-
ference 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. Here, the addition to retained earnings
is the full $240. Computerfield’s equity thus grows to $250 (the starting amount) + 240 (net
income) = $490, and debt must be retired to keep total assets equal to $600.
With $600 in total assets and $490 in equity, debt has to be $600 – 490 = $110. Since we start-
ed with $250 in debt, Computerfield has to retire $250 – 110 = $140 in debt. The resulting pro
forma balance sheet would look like this:
PRO FORMA BALANCE SHEET

Assets $600 (+100) Debt $110 (–140)
Equity 490 (+240)
Total $600 (+100) Total $600 (+100)
In this case, debt is the plug variable used to balance out 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. Since assets are growing, total liabilities and equity, the
right-hand side of the balance sheet, grow as well.
The thing to notice from our simple example is that the way the liabilities and owners’ equi-
ty 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.
Also, in our example the firm needed no outside funds. As this isn’t usually the case, we explore
a more detailed situation in the next section.
CONCEPT QUESTIONS
1. What are the basic concepts of a financial plan?
2. 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, because the amount of long-term borrowing is some-
thing set by management, and it does not necessarily relate directly to the level of sales.
In this section, we describe an extended version of our simple model. The basic idea is to sep-
arate the income statement and balance sheet accounts into two groups, those that do vary direct-
ly with sales and those that do not. Given a sales forecast, we are able to calculate how much
financing the firm needs to support the predicted sales level.
percentage of sales
approach An Illustration of the Percentage of Sales Approach
Financial planning method in
which accounts are projected
The financial planning model we describe next is based on the percentage of sales approach. Our
depending on a firm’s goal here is to develop a quick and practical way of generating pro forma statements. We defer
predicted sales level. discussion of some bells and whistles to a later section.
THE INCOME STATEMENT We start with the most recent income statement for the
Rosengarten Corporation, as shown in Table 4.1. Notice that we have still simplified things by
including costs, depreciation, and interest in a single cost figure. We separate these out in
Appendix 4A at the end of this chapter.
Rosengarten has projected a 25 percent increase in sales for the coming year, so we are antic-
ipating sales of $1,000 × 1.25 = $1,250. To generate a pro forma income statement, we assume
that total costs continue to run at $800/$1,000 = 80% of sales. With this assumption,
Rosengarten’s pro forma income statement is as 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.
dividend payout ratio
Amount of cash paid out Next, we need to project the dividend payment. This amount is up to Rosengarten’s man-
to shareholders divided by agement. We assume that Rosengarten has a policy of paying out a constant fraction of net
net income. income in the form of a cash dividend. From the most recent year, the dividend payout ratio was:
Dividend payout ratio = Cash dividends/Net income [4.1]
= $44/$132
= 331⁄3%
T A B L E 4.1 ROSENGARTEN CORPORATION

Income Statement
Sales $1,000
Costs 800
Taxable income $ 200
Taxes 68
Net income $ 132
Addition to retained earnings $88
Dividends $44

Pro Forma Income Statement
Sales (projected) $1,250
Costs (80% of sales) 1,000
Taxes 85
Net income $ 165
We can also calculate the ratio of the addition to retained earnings to net income as:
Retained earnings/Net income = $88/$132 = 662⁄3%.
retention ratio or This ratio is called the retention ratio or plowback ratio, and it is equal to 1 minus the dividend
plowback ratio payout ratio because everything not paid out is retained. Assuming that the payout and reten-
Retained earnings divided by tion ratios are constant, the projected dividends and addition to retained earnings would be:
net income.
Projected addition to retained earnings = $165 × 2/3 = $110
Projected dividends paid to shareholders = $165 × 1/3 = 55
Net income $165
THE BALANCE SHEET To generate a pro forma balance sheet, we start with the most
recent statement in Table 4.3. On our balance sheet, we assume that some of the items vary direct-
ly with sales, while others do not. For those items that do 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.”
For example, on the asset side, inventory is equal to 60 percent of sales ($600/$1,000) for the
year just ended. We assume that this percentage applies to the coming year, so for each $1 increase
in sales, inventory rises by $.60. More generally, the ratio of total assets to sales for the year just
ended is $3,000/$1,000 = 3, or 300%.

Balance Sheet
($) (%) ($) (%)
Assets Liabilities and Owners’ Equity
Current assets Current liabilities
Cash $ 160 16% Accounts payable $ 300 30%
Accounts Notes payable 100 n/a
receivable 440 44
Inventory 600 60 Total $ 400 n/a
Total $1,200 120%
Long-term debt $ 800 n/a
Fixed assets Owners’ equity
Net plant and Common stock $ 800 n/a
equipment $1,800 180% Retained earnings 1,000 n/a
Total $1,800 n/a
Total assets $3,000 300% Total liabilities and $3,000 n/a
owners’ equity
capital intensity ratio This ratio of total assets to sales is sometimes called the capital intensity ratio. It tells us the
A firm’s total assets divided assets needed to generate $1 in sales; so the higher the ratio is, the more capital intensive is the firm.
by its sales, or the amount of Notice also that this ratio is just the reciprocal of the total asset turnover ratio we defined in the last
assets needed to generate
$1 in sales. chapter. A decrease in a firm’s need for new assets as sales grow increases the sustainable growth rate.
For Rosengarten, assuming 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 has 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 should change spontaneously with sales. Notes payable, on the other hand, represent
short-term debt such as bank borrowing. These would not vary unless we take specific actions to
change the amount, so we mark them 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. The last item on the right-hand side, retained earnings,
varies with sales, but it won’t be a simple percentage of sales. Instead, we 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 calculated earlier wherever possible to calculate the projected amounts. For
example, fixed assets are 180 percent of sales; so, with a new sales level of $1,250, the fixed asset
amount is 1.80 × $1,250 = $2,250, an increase of $2,250 – 1,800 = $450 in plant and equipment.
Importantly, for those items that don’t vary directly with sales, we initially assume no change and
simply write in the original amounts. The result is the pro forma balance sheet in Table 4.4.
Notice that the change in retained earnings is equal to the $110 addition to retained earnings that
we calculated earlier.
Inspecting our pro forma balance sheet, we notice that assets are projected to increase by
$750. However, without additional financing, liabilities and equity only increase by $185, leaving
external financing needed a shortfall of $750 – 185 = $565. We label this amount external financing needed (EFN).
(EFN)
The amount of financing A PARTICULAR SCENARIO Our financial planning model now reminds us of one of those
required to balance both good news/bad news jokes. The good news is that we’re projecting a 25 percent increase in sales. The
sides of the balance sheet. bad news is that this isn’t going to happen unless we 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, a 25 percent increase in sales is probably not feasible.
When we take the need for $565 in new financing as a given, Rosengarten has three possible
sources: short-term borrowing, long-term borrowing, and new equity. The choice of a combina-
tion among these three is up to management; we illustrate only one of the many possibilities.
Suppose that Rosengarten decides to borrow the needed funds. The firm might choose to borrow
some short-term and some long-term. For example, current assets increased by $300 while current lia-
bilities rose by only $75. Rosengarten could borrow $300 – 75 = $225 in short-term notes payable in

Partial Pro Forma Balance Sheet
Present Change from Present Change from
Year Previous Year Year Previous Year
Cash $ 200 $ 40 Accounts payable $ 375 $ 75
Accounts Notes payable 100 0
receivable 550 110 Total $ 475 $ 75
Inventory 750 150
Total $1,500 $300 Long-term debt $ 800 $ 0
Net plant and Common stock $ 800 $ 0
equipment $2,250 $450 Retained earnings 1,110 110
Total $1,910 $110
Total assets $3,750 $750 Total liabilities
and owners’ equity $3,185 $185
External
financing needed $ 565
the form of a loan from a chartered bank. This would leave total net working capital unchanged. With
$565 needed, the remaining $565 – 225 = $340 would have to come from long-term debt. Two exam-
ples of long-term debt discussed in Chapter 15 are a bond issue and a term loan from a chartered bank
or insurance company. Table 4.5 shows the completed pro forma balance sheet for Rosengarten.
Even though we used a combination of short- and long-term debt as the plug here, we
emphasize that this is just one possible strategy; it is not necessarily the best one by any means.
There are many other scenarios that we could (and should) investigate. The various ratios we dis-
cussed in Chapter 3 come in very handy here. For example, with the scenario we have just exam-
ined, 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 changes in
financial position along the lines discussed in Chapter 3. We leave this as an exercise and instead
investigate an important alternative scenario.
AN ALTERNATIVE SCENARIO The assumption that assets are a fixed percentage of

sales is convenient, but it may not be suitable in many cases. For example, 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 capac-
ity, and production could be increased by, perhaps, running an extra shift.
For example, in early 2004, both Ford and GM announced plans to increase production in
Venezuela. The increased production was to accommodate increased sales in that country. In

Pro Forma Balance Sheet
Present Change from Present Change from
Year Previous Year Year Previous Year
Cash $ 200 $ 40 Accounts payable $ 375 $ 75
Accounts Notes payable 325 225
receivable 550 110 Total $ 700 $300
Inventory 750 150 Long-term debt $1,140 $340
Total $1,500 $300 Owners’ equity
Fixed assets Common stock $ 800 $0
Net plant and Retained earnings 1,110 110
equipment $2,250 $450 Total $1,910 $110
Total assets $3,750 $750 Total liabilities and $3,750 $750
owners’ equity
EXAMPLE 4.1: EFN and Capacity Usage
Suppose Rosengarten were operating at 90 percent capacity. level of $1,250, we need $1,250 × 1.62 = $2,025 in fixed
What would be sales at full capacity? What is the capital inten- assets. Compared to the $2,250 we originally projected, this is
sity ratio at full capacity? What is EFN in this case? $225 less, so EFN is $565 – 225 = $340.
Full capacity sales would be $1,000/.90 = $1,111. From Current assets would still be $1,500, so total assets would
Table 4.3, fixed assets are $1,800. At full capacity, the ratio of be $1,500 + 2,025 = $3,525. The capital intensity ratio would
fixed assets to sales is thus: thus be $3,525/$1,250 = 2.82, less than our original value of
3 because of the excess capacity.
Fixed assets/Full capacity sales = $1,800/$1,111 = 1.62
This tells us that we need $1.62 in fixed assets for every

$1 in sales once we reach full capacity. At the projected sales
Ford’s case, the company planned no additional capital expenditures; in other words, the com-
pany did not plan to increase production facilities. GM’s announcement of increased production
came with an announcement that the company would invest in production facilities. Apparently,
Ford had the capacity to expand production without significantly adding to fixed costs, while GM
did not.
If we assume that Rosengarten is only operating at 70 percent of capacity, the need for exter-
nal funds would be quite different. By 70 percent of capacity, we mean that the current sales level
is 70 percent of the full capacity sales level:
Current sales = $1,000 = .70 × Full capacity sales
Full capacity sales = $1,000/.70 = $1,429
This tells us that sales could increase by almost 43 percent—from $1,000 to $1,429—before any
new fixed assets were 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 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 net new 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 only need $565 – 450 = $115
in external funds. The excess capacity thus makes a considerable difference in our projections.
These alternative scenarios illustrate that it is inappropriate to manipulate financial state-
ment information blindly in the planning process. The output of any model is only as good as
the input assumptions or, as is said in the computer field, GIGO: garbage in, garbage out. Results
depend critically on the assumptions made about the relationships between sales and asset needs.
We return to this point later.
CONCEPT QUESTIONS
1. What is the basic idea behind the percentage of sales approach?
2. Unless it is modified, what does the percentage of sales approach assume about fixed asset
capacity usage?
4.4 EXTERNAL FINANCING AND GROWTH

External financing needed and growth are obviously related. All other things being 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 a given, and then we determined the amount of
external financing needed to support the growth. In this section, we turn things around a bit. We
take the firm’s financial policy as a given and then examine the relationship between that finan-
cial policy and the firm’s ability to finance new investments and thereby grow.
T A B L E 4.6 HOFFMAN COMPANY

Income Statement and Balance Sheet
Income Statement
Sales $500
Costs 400
Taxable income $100
Taxes 34
Net income $ 66
Dividends $22
Balance Sheet
$ % of Sales $ % of Sales
Assets Liabilities
Current assets $200 40% Total debt $250 n/a
Net fixed assets 300 60 Owners’ equity 250 n/a
Total assets $500 100% Total liabilities and $500 n/a
owners’ equity
This approach can be very useful because, as you have already seen, growth in sales requires
financing, so it follows that growth that is too fast can cause a company to grow broke.4
Companies that neglect to plan for financing growth can fail even when production and mar-
keting are on track. From a positive perspective, planning growth that is financially sustainable
can help an excellent company achieve its potential. This is why managers, along with their
bankers and other suppliers of funds, need to look at sustainable growth.
External Financing Needed and Growth

To begin, we must establish the relationship between EFN and growth. To do this, we introduce
Table 4.6, a simplified income statement and balance sheet for the Hoffman Company. Notice
that we have simplified the balance sheet by combining short-term and long-term debt into a sin-
gle total debt figure. Effectively, we are assuming that none of the current liabilities varies spon-
taneously 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 they have been netted out in current
assets.5 Also, we continue to combine depreciation, interest, and costs on the income statement.
The following symbols are useful:
S = Previous year’s sales = $500
A = Total assets = $500
D = Total debt = $250
E = Total equity = $250
In addition, based on our earlier discussions of financial ratios, we can calculate the following:
p = Profit margin = $66/$500 = 13.2%
R = Retention ratio = $44/$66 = 2/3
ROA = Return on assets = $66/$500 = 13.2%
ROE = Return on equity = $66/$250 = 26.4%
D/E = Debt/equity ratio = $250/$250 = 1.0
Suppose the Hoffman Company is forecasting next year’s sales level at $600, a $100 increase.
The capital intensity ratio is $500/$500 = 1, so assets need to rise by 1 × $100 = $100 (assuming
4 This phrase and the following discussion draws heavily on R. C. Higgins, “How Much Growth Can a Firm
Afford?” Financial Management 6, Fall 1977, pp. 7–16.
5 This assumption makes our use of EFN here consistent with how we defined it earlier in the chapter.
full capacity usage). Notice that the percentage increase in sales is $100/$500 = 20%. The percent-
age increase in assets is also 20 percent: 100/$500 = 20%. As this illustrates, assuming a constant
capital intensity ratio, the increase in total assets is simply A × g, where g is growth rate in sales:
Increase in total assets = A × g
= $500 × 20%
= $100
In other words, the growth rate in sales can also be interpreted as the rate of increase in the firm’s
total assets.
Some of the financing necessary to cover the increase in total assets comes from internally
generated funds and shows up in the form of the addition to retained earnings. This amount is
equal to net income multiplied by the plowback or retention ratio, R. Projected net income is
equal to the profit margin, p, multiplied by projected sales, S × (1 + g). The projected addition to
retained earnings for Hoffman can thus be written as:
Addition to retained earnings = p(S)R × (1 + g)
= .132($500)(2/3) × 1.20
= $44 × 1.20
= $52.80
Notice that this is equal to last year’s addition to retained earnings, $44, multiplied by (1 + g).
Putting this information together, we need A × g = $100 in new financing. We generate
p(S)R × (1 + g) = $52.80 internally, so the difference is what we need to raise. In other words, we
find that EFN can be written as:
EFN = Increase in total assets – Addition to retained earnings [4.2]
= A(g) – p(S)R × (1 + g)
For Hoffman, this works out to be
EFN = $500(.20) – .132($500)(2/3) × 1.20
= $100 – $52.80
= $47.20
We can check that this is correct by filling in a pro forma income statement and balance sheet, as
in Table 4.7. As we calculated, Hoffman needs to raise $47.20.
Looking at our equation for EFN, we see that EFN depends directly on g. Rearranging things
to highlight this relationship, we get:

Pro Forma Income Statement and Balance Sheet
Income Statement
Sales $600.0
Costs (80% of sales) 480.0
Taxable income $120.0
Taxes 40.8
Net income $ 79.2
Addition to retained earnings $52.8
Dividends $26.4
Balance Sheet
Assets Liabilities
Current assets $240.0 40% Total debt $250.0 n/a
Net fixed assets 360.0 60 Owners’ equity 302.8 n/a
Total assets $600.0 100% Total liabilities $552.8 n/a
External funds $ 47.2
needed
EFN = – p(S)R + [A – p(S)R] × g [4.3]

Plugging in the numbers for Hoffman, the relationship between EFN and g is:
EFN = –.132($500)(2/3) + [$500 – .132($500)(2/3)] × g
= –44 + 456 × g
Notice that this is the equation of a straight line with a vertical intercept of –$44 and a slope of $456.
The relationship between growth and EFN is illustrated in Figure 4.1. The y-axis intercept of
our line, –$44, is equal to last year’s addition to retained earnings. This makes sense because, if
the growth in sales is zero, then retained earnings are $44, the same as last year. Furthermore, with
no growth, no net investment in assets is needed, so we run a surplus equal to the addition to
retained earnings, which is why we have a negative sign.
The slope of the line in Figure 4.1 tells us that for every .01 (1 percent) in sales growth, we
need an additional $456 × .01 = $4.56 in external financing to support that growth.
Internal Growth Rate

Looking at Figure 4.1, there is one growth rate of obvious interest. What growth rate can we
internal growth rate achieve with no external financing? We call this the internal growth rate because it is the rate the
The growth rate a firm can firm can maintain with only internal financing. This growth rate corresponds to the point where
maintain with only internal
our line crosses the horizontal axis, that is, the point where EFN is zero. At this point, the required
financing.
increase in assets is exactly equal to the addition to retained earnings, and EFN is therefore zero.
Figure 4.1 shows that this rate is just under 10 percent.
We can easily calculate this rate by setting EFN equal to zero:
EFN = –p(S)R + [A –p(S)R] × g [4.4]
g = pS(R)/[A –pS(R)]
= .132($500)(2/3)/[$500 – .132($500)(2/3)]
= 44/[500 – 44]
= 44/456 = 9.65%
FIGURE 4.1
External financing
External
needed and growth in financing
sales for the Hoffman needed ($)
Company EFN
= $456
$0 g
Projected growth
9.65% in sales (%)
–$44
Hoffman can therefore grow at a 9.65 percent rate before any external financing is required. With
a little algebra, we can restate the expression for the internal growth rate (Equation 4.4) as:6
ROA × R
Internal growth rate =
1 – ROA × R
[4.5]
For Hoffman, we can check this by recomputing the 9.65% internal growth rate
.132 × 2/3
=
1 – .132 × 2/3
Financial Policy and Growth

Suppose Hoffman, for whatever reason, does not wish to sell any new equity. As we discuss in
Chapter 15, one possible reason is simply that new equity sales can be very expensive.
Alternatively, the current owners may not wish to bring in new owners or contribute additional
equity themselves. For a small business or a start-up, the reason may be even more compelling:
All sources of new equity have likely already been tapped and the only way to increase equity is
through additions to retained earnings.
In addition, we assume that Hoffman wishes to maintain its current debt/equity ratio. To be
more specific, Hoffman (and its lenders) regard its current debt policy as optimal. We discuss why
a particular mixture of debt and equity might be better than any other in Chapters 14 and 15. For
debt capacity now, we say that Hoffman has a fixed debt capacity relative to total equity. If the debt/equity ratio
The ability to borrow to declines, Hoffman has excess debt capacity and can comfortably borrow additional funds.
increase firm value.
Assuming that Hoffman does borrow to its debt capacity, what growth rate can be achieved?
sustainable growth rate The answer is the sustainable growth rate, the maximum growth rate a firm can achieve with
The growth rate a firm can no external equity financing while it maintains a constant debt/equity ratio. To find the sustain-
maintain given its debt
able growth rate, we go back to Equation 4.2 and add another term for new borrowings (up to
capacity, ROE, and retention
ratio. debt capacity). One way to see where the amount of new borrowings comes from is to relate it to
the addition to retained earnings. Because this addition increases equity, it reduces the debt/
equity ratio. Since sustainable growth is based on a constant debt/equity ratio, we use new bor-
rowings to top up debt. Because we are now allowing new borrowings, EFN refers to outside
equity only. Because no new outside equity is available, EFN = 0.
EFN = Increase in total assets – Addition to retained earnings [4.6]
– New borrowing
= A(g) – p(S)R × (1 + g) – pS(R) × (1 + g)[D/E]
EFN = 0
With some algebra we can solve for the sustainable growth rate.7
g* = ROE × R/[1 – ROE × R] [4.7]
This growth rate is called the firm’s sustainable growth rate (SGR).
For example, for the Hoffman Company, we already know that the ROE is 26.4 percent and
the retention ratio, R, is 2/3. The sustainable growth rate is thus:
g* = (ROE × R)/(1 – ROE × R)
= .176/.824
= 21.3%
This tells us that Hoffman can increase its sales and assets at a rate of 21.3 percent per year with-
out selling any additional equity and without changing its debt ratio or payout ratio. If a growth
rate in excess of this is desired or predicted, something has to give.
To better see that the SGR is 21.3 percent (and to check our answer), we can fill out the pro
forma financial statements assuming that Hoffman’s sales increase at exactly the SGR. We do this
to verify that if Hoffman’s sales do grow at 21.3 percent, all needed financing can be obtained
without the need to sell new equity, and, at the same time, the debt/equity ratio can be main-
tained at its current level of 1.
6 To derive Equation 4.5 from (4.4) divide through by A and recognize that ROA = p(S)/A.
7 The derivation of the sustainable rate is shown in Appendix 4B.

To get started, sales increase from $500 to $500 × (1 + .213) = $606. Assuming, as before, that
costs are proportional to sales, the income statement would be:
HOFFMAN COMPANY
Sales $606
Costs (80% of sales) 485
Taxable income $121
Taxes 41
Net income $ 80
Given that the retention ratio, R, stays at 2/3, the addition to retained earnings is $80 × (2/3) =
$53, and the dividend paid is $80 – 53 = $27.
We fill out the pro forma balance sheet (Table 4.8) just as we did earlier. Note that the own-
ers’ equity rises from $250 to $303 because the addition to retained earnings is $53. As illustrat-
ed, EFN is $53. If Hoffman borrows this amount, its total debt rises to $250 + 53 = $303. The
debt/equity ratio therefore is $303/$303 = 1 as desired, thereby verifying our earlier calculations.
At any other growth rate, something would have to change.

Sales $1,000
Costs (80% of sales) 800
Taxes 68
Net income $ 132
Dividends (1/3) $44
Addition to retained earnings 88

Current assets $ 400 Total debt $250
Fixed assets 600 Owners’ equity 338
Total assets $1,000 Total liabilities $588
External funds needed $412
To maintain the debt/equity ratio at 1, Hoffman can increase debt to $338, an increase of $88.
This leaves $412 – $88 = $324 to be raised by external equity. If this is not available, Hoffman
could try to raise the full $412 in additional debt. This would rocket the debt/equity ratio to
($250 + $412)/$338 = 1.96, basically doubling the target amount.

Current assets $242 40 Total debt $250 n/a
Net fixed assets 364 60 Owners’ equity 303 n/a
Total assets $606 100 Total liabilities $553 n/a
External funds needed $ 53
EXAMPLE 4.2: Growing Bankrupt
Suppose the management of Hoffman Company is not satis- We know that the sustainable growth rate for Hoffman is
fied with a growth rate of 21 percent. Instead, the company 21.3 percent, so doubling sales (100 percent growth) is not
wants to expand rapidly and double its sales to $1,000 next possible unless the company obtains outside equity financing
year. What will happen? To answer this question we go back or allows its debt/equity ratio to balloon beyond 1. We can
to the starting point of our previous example. prove this with simple pro forma statements.
Given that the firm’s bankers and other external lenders likely had considerable say over the
target D/E in the first place, it is highly unlikely that Hoffman could obtain this much addition-
al debt. The most likely outcome is that if Hoffman insists on doubling sales, the firm would grow
bankrupt.
Determinants of Growth
In the last chapter, we saw that the return on equity could be decomposed into its various com-
ponents using the Du Pont identity. Because ROE appears prominently in the determination of
the SGR, the important factors in determining ROE are also important determinants of growth.
To see this, recall that from the Du Pont identity, ROE can be written as:
ROE = Profit margin × Total asset turnover × Equity multiplier
Using our current symbols for these ratios,8
ROE = p(S/A)(1 + D/E)
If we substitute this into our expression for g* (SGR), we see that the sustainable growth rate can
be written in greater detail as:
p(S/A)(1 + D/E) × R
g* =
1 – p(S/A)(1 + D/E) × R [4.8]
Writing the SGR out in this way makes it look a little complicated, but it does highlight the var-
ious important factors determining the ability of a firm to grow.
Examining our expression for the SGR, we see that growth depends on the following four factors:
1. Profit margin. An increase in profit margin, p, increases the firm’s ability to generate
funds internally and thereby increase its sustainable growth.
2. Dividend policy. A decrease in the percentage of net income paid out as dividends increases the
retention ratio, R. This increases internally generated equity and thus increases sustainable growth.
3. Financial policy. An increase in the debt/equity ratio, D/E, increases the firm’s financial leverage.
Since 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, S/A, 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 the 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 p, its asset use efficiency as measured by S/A, its dividend policy as measured by R,
and its financial policy as measured by D/E.
Given values for all four of these, only one growth rate 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, there is only one possible
maximum growth rate.
As we described early in this chapter, one of the primary benefits to financial planning is to
ensure internal consistency among the firm’s various goals. The sustainable growth rate captures
this element nicely. For this reason, sustainable growth is included in the software used by com-
mercial lenders at several Canadian chartered banks in analyzing their accounts.
Also, we now see how to use a financial planning model 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
8 Remember that the equity multiplier is the same as 1 plus the debt/equity ratio. Appendix 4B shows the deriva-
tion in detail.
increase profit margins, increase total asset turnover, increase financial leverage, increase earnings
retention, or sell new shares.
At the other extreme, suppose the firm is losing money (has a negative profit margin) or is
paying out more than 100 percent of earnings in dividends so that R is negative. In each of these
cases, the negative SGR signals the rate at which sales and assets must shrink. Firms can achieve
negative growth by selling assets and closing divisions. The cash generated by selling assets is
often used to pay down excessive debt taken on earlier to fund rapid expansion. Nortel Networks
and CanWest Global Communications Corp. are examples of Canadian companies that under-
went this painful negative growth in 2002. Nortel was losing money on its operations, and was
selling assets to keep the remaining core businesses operating. CanWest Global, on the other
hand, experienced negative growth because it paid out more in dividends than it earned.
CanWest elected to sell some assets to pay down a portion of its debt.
A Note on Sustainable Growth Rate Calculations

Very commonly, the sustainable growth rate is calculated using just the numerator in our expres-
sion, ROE × R. 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 begin-
ning of the period, then the simpler formula is the correct one.
In Their Own Words . . . Robert C. Higgins on Sustainable Growth
MOST FINANCIAL OFFICERS know intuitively that it takes run viability of their busi-
money to make money. Rapid sales growth requires ness, it is necessary to keep
increased assets in the form of accounts receivable, growth and profitability in
inventory, and fixed plant, which, in turn, require money to pay proper balance.
for assets. They also know that if their company does not Finally, comparison of
have the money when needed, it can literally “grow broke.” actual to sustainable growth
The sustainable growth equation states these intuitive truths rates helps a banker
explicitly. understand why a loan
Sustainable growth is often used by bankers and other applicant needs money and
external analysts to assess a company’s creditworthiness. They for how long the need
are aided in this exercise by several sophisticated computer might continue. In one
software packages that provide detailed analyses of the instance, a loan applicant
company’s past financial performance, including its annual requested $100,000 to pay off several insistent suppliers and
sustainable growth rate. promised to repay in a few months when he collected some
Bankers use this information in several ways. Quick accounts receivable that were coming due. A sustainable
comparison of a company’s actual growth rate to its growth analysis revealed that the firm had been growing at
sustainable rate tells the banker what issues will be at the top four to six times its sustainable growth rate and that this
of management’s financial agenda. If actual growth pattern was likely to continue in the foreseeable future. This
consistently exceeds sustainable growth, management’s alerted the banker that impatient suppliers were only a
problem will be where to get the cash to finance growth. The symptom of the much more fundamental disease of overly
banker thus can anticipate interest in loan products. rapid growth, and that a $100,000 loan would likely prove to
Conversely, if sustainable growth consistently exceeds actual, be only the down payment on a much larger, multiyear
the banker had best be prepared to talk about investment commitment.
products, because management’s problem will be what to do
Robert C. Higgins is professor of finance at
with all the cash that keeps piling up in the till.
the University of Washington. He pioneered the
Bankers also find the sustainable growth equation useful use of sustainable growth as a tool for financial
for explaining to financially inexperienced small business analysis. Updates on his research are
owners and overly optimistic entrepreneurs that, for the long- at www.depts.washington.edu/~finance/higgins.html.
EXAMPLE 4.3: Sustainable Growth
The Sandar Company has a debt/equity ratio of .5, a profit To achieve a 10 percent growth rate, the profit margin has to
margin of 3 percent, a dividend payout of 40 percent, and a rise. To see this, assume that g* is equal to 10 percent and
capital intensity ratio of 1. What is its sustainable growth rate? then solve for p:
If Sandar desires a 10 percent SGR and plans to achieve this
.10 = p(1.5)(.6)/[1 – p(1.5)(.6)]
goal by improving profit margins, what would you think?
p = .1/.99 = 10.1%
The sustainable growth rate is:
For the plan to succeed, the necessary increase in profit mar-
g* = .03(1)(1 + .5)(1 – .40)/[1 – .03(1) (1 + .5)(1 – .40)]
gin is substantial, from 3 percent to about 10 percent. This
= 2.77%
may not be feasible.
In principle, you’ll get exactly the same sustainable growth rate regardless of which way you
calculate it (as long 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. Note:
all of our comments here apply to the internal growth rate as well.
One more point that is important to note is that for the sustainable growth calculations to
work, all items involved in the formulas must increase at the same rate. If any items do not change
at the same rate, the formulas will not work properly.
CONCEPT QUESTIONS
1. What are the determinants of growth?
2. How is a firm’s sustainable growth related to its accounting return on equity (ROE)?
3. What does it mean if a firm’s sustainable growth rate is negative?
4.5 SOME CAVEATS ON 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 output that gives the user
many meaningful clues about what strategies would 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
very 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. The final plan is a negotiated result between all the dif-
ferent parties to the process. In practice, long-term financial planning in some corporations relies too
much on a top-down approach. Senior management has a growth target in mind and it is up to the
planning staff to rework and ultimately deliver a plan to meet that target. Such plans are often made fea-
sible (on paper or a computer screen) by unrealistically optimistic assumptions on sales growth and tar-
get debt/equity ratios. The plans collapse when lower sales make it impossible to service debt. This is
what happened to Campeau’s takeover of Federated Department Stores, as we discuss in Chapter 23.
As a negotiated result, the final plan implicitly contains different goals in different areas and
also satisfies many constraints. For this reason, such a plan need not be a dispassionate assess-
ment 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
1. What are some important elements often missing in financial planning models?
2. Why do we say that 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 fea-
tures of the planning process. We describe what financial planning can accomplish and the com-
ponents of a financial model. We go on to develop the relationship between growth and financ-
ing needs. Two growth rates, internal and sustainable, are summarized in Table 4.9. The table
recaps the key difference between the two growth rates. The internal growth rate is the maximum
growth rate that can be achieved with no external financing of any kind. The sustainable growth
rate is the maximum growth rate that can be achieved with no external equity financing while
maintaining a constant debt/equity ratio. For Hoffman, the internal growth rate is 9.65 percent
and the sustainable growth rate is 21.3 percent. The sustainable growth rate is higher because the
calculation allows for debt financing up to a limit set by the target debt/equity ratio. We discuss
how a financial planning model is useful in exploring that relationship.
Corporate financial planning should not become a purely mechanical activity. When it does,
it probably focuses 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 con-
cerned with accounting statements. Nevertheless, the alternative to financial planning is stum-
bling into the future backwards.
T A B L E 4.9 I. INTERNAL GROWTH RATE

Summary of internal and ROA × R .132 × /3
2
Internal growth rate = =
1 – ROA × R 1 – 0.132 × 2/3
= 9.65%
sustainable growth rates
where
from Hoffman Company
ROA = Return on assets = Net income/Total assets = 13.2%
example R = Plowback (retention) ratio = 2/3
= Addition to retained earnings/Net income
The internal growth rate is the maximum growth rate that can be achieved with no external
financing of any kind.
II. SUSTAINABLE GROWTH RATE
ROE × R 0.264 × ( /3)

2
Sustainable growth rate = =
1 – ROE × R 1 – 0.264 × (2/3)
= 21.3%
where
ROE = Return on equity = Net income/Total equity = 26.4%
R = Plowback (retention) ratio = 2/3
= Addition to retained earnings/Net income
The sustainable growth rate is the maximum growth rate that can be achieved with no
external equity financing while maintaining a constant debt/equity ratio.
Key Terms
aggregation (page 88) internal growth rate (page 99)
capital intensity ratio (page 94) percentage of sales approach (page 92)
debt capacity (page 100) planning horizon (page 88)
dividend payout ratio (page 93) retention ratio or plowback ratio (page 93)
external financing needed (EFN) (page 94) sustainable growth rate (page 100)
www.mcgrawhill.ca/olc/ross
Chapter Review Problems and Self-Test

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 cap-
acity. The payout ratio is constant.
SKANDIA MINING COMPANY

Financial Statements
Sales $4,250.0 Assets Liabilities and Owner’s Equity

Costs 3,876.0 Current assets $ 900 Current liabilities $ 500
Taxable income $ 374.0 Net fixed assets 2,200 Long-term debt $1,800
Taxes (34%) 127.2 Total $3,100 Owners’ equity 800
Net income $ 246.8 Total liabilities and
owners’ equity $3,100
Dividends $ 82.4
Addition to retained earnings 164.4
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?
Answers to Self-Test Problems

4.1 We can calculate EFN by preparing the pro forma statements using the percentage of sales approach. Note that sales are
forecasted to be $4,250 × 1.10 = $4,675.
SKANDIA MINING COMPANY
Pro Forma Financial Statements
Income Statement
Sales $4,675.0 Forecast

Costs 4,263.6 91.2% of sales
Taxable income $ 411.4
Taxes (34%) $ 139.9
Net income $ 271.5
Dividends $ 90.6 33.37% of net
Addition to retained earnings 180.9 income
Balance Sheet

Current assets $ 990.0 21.18% Current liabilities $ 550 11.76%
Net fixed assets 2,420.0 51.76% Long-term debt $1,800.0 n/a
Total assets $3,410.0 72.94% Owners’ equity 980.9 n/a
Total liabilities and 3,330.9 n/a
owners’ equity
EFN $ 79.1 n/a
4.2 Full-capacity sales are equal to current sales divided by the capacity utilization. At 60 percent of capacity:
$4,250 = .60 × Full-capacity sales
$7,083 = Full-capacity sales
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 $79.1 – 220 = –$140.9, a surplus. No exter-
nal 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 $79.1 – 121.3 = $42.2,
a surplus. No additional financing is needed.
4.3 Skandia retains R = 1 – .3337 = 66.63% of net income. Return on assets is $246.8/3,100 = 7.96%. The internal growth
rate is:
ROA × R .0796 × .6663
=
1 – ROA × R 1 – .0796 × .6663
= 5.60%
Return on equity for Skandia is $246.8/800 = 30.85%, so we can calculate the sustainable growth rate as:
ROE × R .3085 × .6663
=
1 – ROE × R 1 – .3085 × .6663
R = 25.87%
Concepts Review and Critical Thinking Questions

1. Why do you think most long-term financial planning more space and expanded capacity, but it still could
begins with sales forecasts? Put differently, why are not keep up with demand. Equipment failed from
future sales the key input? overuse and quality suffered. Working capital was
2. Would long-range financial planning be more impor- drained to expand production, and, at the same time,
tant for a capital intensive company, such as a heavy payments from customers were often delayed until the
equipment manufacturer, or an import-export busi- product was shipped. Unable to deliver on orders, the
ness? Why? company became so strapped for cash that employee
3. Testaburger, Ltd., uses no external financing and paycheques began to bounce. Finally, out of cash, the
maintains a positive retention ratio. When sales grow company ceased operations entirely in January 1995.
by 15 percent, the firm has a negative projected EFN. 5. Do you think the company would have suffered the
What does this tell you about the firm’s internal same fate if its product had been less popular? Why or
growth rate? How about the sustainable growth rate? why not?
At this same level of sales growth, what will happen to 6. The Grandmother Calendar Company clearly had a
the projected EFN if the retention ratio is increased? cash flow problem. In the context of the cash flow
What if the retention ratio is decreased? What happens analysis we developed in Chapter 2, what was the
to the projected EFN if the firm pays out all of its impact of customers not paying until orders were
earnings in the form of dividends? shipped?
4. Broslofski Co. maintains a positive retention ratio and 7. The firm actually priced its product to be about
keeps its debt-equity ratio constant every year. When 20 percent less than that of competitors, even though
sales grow by 20 percent, the firm has a negative pro- the Grandmother calendar was more detailed. In ret-
jected EFN. What does this tell you about the firm’s rospect, was this a wise choice?
sustainable growth rate? Do you know, with certainty, 8. If the firm was so successful at selling, why wouldn’t a
if the internal growth rate is greater than or less than bank or some other lender step in and provide it with
20 percent? Why? What happens to the projected EFN the cash it needed to continue?
if the retention ratio is increased? What if the reten- 9. Which is the biggest culprit here: too many orders, too
tion ratio is decreased? What if the retention ratio little cash, or too little production capacity?
is zero? 10. What are some of the actions that a small company
Use the following information to answer the next like The Grandmother Calendar Company can take if
six questions: A small business called The Grand- it finds itself in a situation in which growth in sales
mother Calendar Company began selling personalized outstrips production capacity and available financial
photo calendar kits in 1992. The kits were a hit, and resources? What other options (besides expansion of
sales soon sharply exceeded forecasts. The rush of capacity) are available to a company when orders
orders created a huge backlog, so the company leased exceed capacity?
Questions and Problems

Basic 1. Pro Forma Statements Consider the following simplified financial statements for the Fisk Corporation (assuming no
(Questions income taxes):
1–15)
Sales $16,000 Assets $8,900 Debt $5,100

Costs 12,500 Equity 3,800
Net income $ 3,500 Total $8,900 Total $8,900
Fisk has predicted a sales increase of 10 percent. It has predicted that every item on the balance sheet will increase by
10 percent as well. Create the pro forma statements and reconcile them. What is the plug variable here?
Basic 2. Pro Forma Statements and EFN In the previous question, assume Fisk pays out half of net income in the form of a
(continued) 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.
3. Calculating EFN The most recent financial statements for Bradley’s Bagels, Inc., are shown here (assuming no income
taxes):

Net income $1,715 Total $13,400 Total $13,400
Assets and costs are proportional to sales. Debt and equity are not. No dividends are paid. Next year’s sales are
projected to be $5,192. What is the external financing needed?
4. EFN The most recent financial statements for McGillicudy, Inc., are shown here:

Taxable income $3,650 Total $93,000 Total $93,000
Taxes (34%) 1,241
Net income $ 2,409
Assets and costs are proportional to sales. Debt and equity are not. A dividend of $963.60 was paid, and McGillicudy wishes
to maintain a constant payout ratio. Next year’s sales are projected to be $23,040. What is the external financing needed?
5. EFN The most recent financial statements for 2 Doors Down, Inc., are shown here:
Sales $3,600 Current Assets $4,500 Current Liabilities $ 920

Costs 2,900 Fixed Assets 3,900 Long-term debt 1,840
Taxable income $ 700 Equity $5,640
Taxes (34%) 238 Total $8,400 Total $8,400
Net income $ 462
Assets, costs, and current liabilities are proportional to sales. Long-term debt and equity are not. 2 Doors Down main-
tains a constant 50 percent dividend payout ratio. Like every other firm in its industry, next year’s sales are projected to
increase by exactly 15%. What is the external financing needed?
6. Calculating Internal Growth The most recent financial statements for Panama Co. are shown here:
Sales $10,400 Current Assets $11,000 Debt $22,000

Costs 6,820 Fixed Assets 27,000 Equity 16,000
Taxable income $ 3,580 Total $38,000 Total $38,000
Taxes (34%) 1,217
Net income $ 2,363
Assets and costs are proportional to sales. Debt and equity are not. Panama maintains a constant 20 percent dividend
payout ratio. No external equity financing is possible. What is the internal growth rate?
7. Calculating Sustainable Growth For the company in the previous problem, what is the sustainable growth rate?
8. Sales and Growth The most recent financial statements for Fontenot Co. are shown here:
Sales $54,000 Current Assets $ 26,000 Long-term Debt $ 58,000

Costs 34,800 Fixed Assets 105,000 Equity 73,000
Taxable income $19,200 Total $131,000 Total $131,000
Taxes (34%) 6,528
Net income $12,672
Basic Assets and costs are proportional to sales. The company maintains a constant 30 percent dividend payout ratio and a
(continued) 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 Consider the following income statement for the Armour
Corporation:
ARMOUR CORPORATION
Income Statement
Sales $29,000
Costs 11,200
Taxable income $17,800
Taxes (34%) 6,052
Net income $11,748
Dividends $4,935
Addition to retained earnings 6,813
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 The balance sheet for the Armour 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.
ARMOUR CORPORATION
Balance Sheet
Percentage Percentage
$ of Sales $ of Sales

Cash $ 3,525 Accounts payable $ 3,000
Accounts receivable 7,500 Notes payable 7,500
Inventory 6,000 Total $10,500
Total $17,025 Long-term debt $19,500
Net plant and Common stock and paid-in surplus $15,000
equipment $30,000 Retained earnings 2,025
Total assets $47,025 Total $17,025
Total liabilities and owners’ equity $47,025
11. EFN and Sales 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 If Highfield Hobby Shop has a 10 percent ROA and a 20 percent payout ratio, what is its internal
growth rate?
13. Sustainable Growth If the Layla Corp. has a 19 percent ROE and a 25 percent payout ratio, what is its sustainable
growth rate?
14. Sustainable Growth Based on the following information, calculate the sustainable growth rate for Kaleb’s Kickboxing:
Profit margin = 8.9%
Capital intensity ratio = .55
Debt-equity ratio = .60
Net income = $29,000
Dividends = $15,000
What is the ROE here?
15. Sustainable Growth Assuming the following ratios are constant, what is the sustainable growth rate?
Total asset turnover = 1.40
Equity multiplier = 1.50
Payout ratio = 40%
Intermediate 16. Full-Capacity Sales Thorpe Mfg., Inc., is currently operating at only 85 percent of fixed asset capacity. Current sales
(Questions are $510,000. How fast can sales grow before any new fixed assets are needed?
16–29)
17. Fixed Assets and Capacity Usage For the company in the previous problem, suppose fixed assets are $415,000 and
sales are projected to grow to $680,000. How much in new fixed assets are required to support this growth in sales?
18. Full-Capacity Sales If a company is operating at 70 percent of fixed asset capacity and current sales are $250,000,
how fast can that company grow before any new fixed assets are needed?
19. Full-Capacity Sales Red Brick Manufacturing sold $300,000 of red bricks in the last year. They were operating at
91 percent of fixed asset capacity. How fast can Red Brick grow before they need to purchase new fixed assets?
20. Growth and Profit Margin Top Hat Co. wishes to maintain a growth rate of 8 percent a year, a debt-equity ratio of
.40, and a dividend payout ratio of 50 percent. The ratio of total assets to sales is constant at 1.30. What profit margin
must the firm achieve?
21. Growth and Debt-Equity Ratio A firm wishes to maintain a growth rate of 11 percent and a dividend payout ratio of
60 percent. The ratio of total assets to sales is constant at .9, and profit margin is 9.5 percent. If the firm also wishes to
maintain a constant debt-equity ratio, what must it be?
22. Growth and Assets A firm wishes to maintain an internal growth rate of 9 percent and a dividend payout ratio of
30 percent. The current profit margin is 8 percent and the firm uses no external financing sources. What must total
asset turnover be?
23. Sustainable Growth Based on the following information, calculate the sustainable growth rate for Hendrix Guitars, Inc.:
Total asset turnover = 1.80
Total debt ratio = .60
Payout ratio = 60%
What is the ROA here?
24. Sustainable Growth and Outside Financing You’ve collected the following information about Bad Company, Inc.:
Sales = $140,000
Net income = $21,000
Dividends = $12,000
Total debt = $85,000
Total equity = $49,000
What is the sustainable growth rate for Bad Company, Inc.? 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?
25. Sustainable Growth Rate No Return, Inc., had equity of $165,000 at the beginning of the year. At the end of the year,
the company had total assets of $250,000. During the year the company sold no new equity. Net income for the year
was $80,000 and dividends were $49,000. What is the sustainable growth rate for the company? What is the sustainable
growth rate if you use the formula ROE × R 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?
26. Internal Growth Rates Calculate the internal growth rate for the company in the previous problem. Now calculate the
internal growth rate using ROA × R for both beginning of period and end of period total assets. What do you observe?
27. Calculating EFN The most recent financial statements for Moose Tours, Inc., follow. Sales for 2007 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, and accounts payable increase spontaneously with sales. If the firm is
operating at full capacity and no new debt or equity is issued, what is the external financing needed to support the
20 percent growth rate in sales?
MOOSE TOURS, INC.
2006 Income Statement
Sales $905,000
Costs 710,000
Other expenses 12,000
Earnings before interest and taxes $183,000
Interest paid 19,700
Taxable income $163,300
Taxes (35%) 57,155
Net income $106,145
Dividends $42,458
Addition to retained earnings 63,687
Intermediate MOOSE TOURS, INC.

(continued) Balance Sheet as of December 31, 2006
Accounts receivable 43,000 Notes payable 9,000
Inventory 76,000 Total $ 74,000
Total $144,000 Long-term debt $156,000
Net plant and Common stock and paid-in surplus $ 21,000
equipment $364,000 Retained earnings 257,000
Total $278,000
Total assets $508,000 Total liabilities and owners’ equity $508,000
28. Capacity Usage and Growth In the previous problem, suppose the firm was operating at only 80 percent capacity in
2004. What is EFN now?
29. Calculating EFN In Problem 25, suppose the firm wishes to keep its debt-equity ratio constant. What is EFN now?
30. EFN and Internal Growth Redo Problem 25 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 relation-
ship 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?
Challenge
(Questions 31. EFN and Sustainable Growth Redo Problem 27 using sales growth rates of 30 and 35 percent in addition to 20 per-
30–32) cent. Illustrate graphically the relationship between EFN and the growth rate, and use this graph to determine the rela-
tionship 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?
32. Constraints on Growth Bulla Recording, Inc., wishes to maintain a growth rate of 14 percent per year and a debt-
equity ratio of .30. Profit margin is 6.2 percent, and the ratio of total assets to sales is constant at 1.55. Is this growth
rate possible? To answer, determine what the dividend payout ratio must be. How do you interpret the result?
M I N I C A S E
You are an analyst for a major investment bank, and your Balance Sheet as at December 31, 2006 (in 000s)
manager has asked you to develop pro forma financial Assets
information for Skyline Incorporated. You have contacted Cash $ 795
management at Skyline, who have provided you with the
Accounts receivable 1,550
following financial statements for 2006:
Inventory 963
Income Statement for the Year Ended December 31,
2006 (in 000s) Total current assets $ 3,308
Sales $ 10,430 Fixed assets 14,743
Cost of goods sold 4,339 Total assets $ 18,051
Operating expenses 2,100
Liabilities and Owners’ Equity
Depreciation 765
Accounts payable $ 1,032
EBIT $ 3,226
Short-term debt 550
Interest 315
Total current liabilities $ 1,582
Taxable income $ 2,911
Long-term debt 2,527
Taxes (at 35%) 1,019
Total liabilities $ 4,109
Net income $ 1,892
Common shares 9,725
Retained earnings 4,217
Total liabilities and owners’ equity $ 18,051
M I N I C A S E ( c o n t i n u e d )
You also asked a number of specific questions about the • Taxes are paid each December.
company’s expected performance in the next year, and • A total of $850,000 of the long-term debt will be
were provided with the following: due this June (with no more issued).
• Projected sales for 2007 (in 000s) • The firm has access to a line of credit for any cash
January $ 150 July $1,425 shortfalls.
February 150 August 1,275 a) Prepare quarterly pro forma financial statements for
March 150 September 1,200 2007 (discuss any necessary assumptions).
April 1,275 October 450 b) Your manager is concerned that with present poor
May 2,469 November 150 economic conditions, Skyline’s second quarter sales
could be as much as 25 percent lower. However, an
June 1,950 December 150
economic recovery is predicted by some and would
• While demand for the company’s products is highly result in sales that are 10 percent higher through the
seasonal, the firm’s labour availability and plant last three quarters. Adjust the pro forma statements
capacity mean it must undertake even production to reflect these possibilities.
throughout the year.
c) If there are 1,500,000 common shares in Skyline,
• Skyline is expecting its cost of goods sold to increase how much is each share worth right now (at the start
with the rate of inflation, or about 0.5% each quar- of 2007)? How much will they be worth at the end
ter through 2007. of 2007 if the projections in part (a) are correct?
• Accounts payable are paid two months after the d) Skyline’s bank is considering placing a new limit of
material is used in production. Labour costs must be $2,500,000 on the company’s line of credit. If all the
paid immediately. company’s short-term debt is on this line of credit, is
• Labour is approximately 65% of the cost of goods there a possible cash flow concern for the company
sold. under each of the scenarios?
• Depreciation for 2007 is expected to be $625,000.
• A minimum cash balance of $1,100 is required to
operate the company.
S&P Problems
1. Calculating EFN Find the income statements and balance sheets for Magna International (MGA). Assuming sales
grow by 10 percent, what is the EFN for Magna next year? Assume non-operating income/expense and special items
will be zero next year. Assets, costs, and current liabilities are proportional to sales. Long-term debt and equity are
not. Magna will have the same tax rate next year as it does in the current year.
2. Internal and Sustainable Growth Rates Look up the financial statements for Potash Corporation of Saskatchewan
Inc. (POT) and CanWest Global Communications (CWG). For each company, calculate the internal growth rate and
sustainable growth rate over the past two years. Are the growth rates the same for each company for the two years?
Why or why not?
Internet Application Questions

1. Go to www.globeinvestor.com and enter the ticker symbol “TRP-T” for TransCanada Pipelines. When you get the quote,
follow the “Reports” link. What is projected earnings growth for next year? For the next five years? How do these earnings
growth projections compare to the industry and to the TSX-S&P index?
2. You can find the homepage for Barrick at www. barrick.com. Go to the Annual Report. Using the growth in sales for the most
recent year as the projected sales growth rate for next year, construct a pro forma income statement and balance sheet.
3. Locate the most recent annual financial statements for Canadian Tire at www.canadiantire.ca by clicking on “Investor
Relations” and then on “Annual/Quarterly Reports.” Using the information from the financial statements, what is the internal
growth rate for Canadian Tire? What is the sustainable growth rate?
Suggested Readings
A useful textbook on financial planning is:
Higgins, R. C. Analysis for Financial Management. 8th ed. McGraw-Hill Irwin, 2007.
Sustainable growth is discussed in:
Higgins, R. C. “Sustainable Growth under Inflation.” Financial Management 10, Autumn 1981.
For a critical discussion of sustainable growth, see:
Rappaport, A. Creating Shareholder Value: The New Standard for Business Performance. New York: Free Press, 1986.
APPENDIX 4A A FINANCIAL PLANNING MODEL FOR THE

HOFFMAN COMPANY
In this Appendix, we discuss how to get started with building a financial planning model in some-
what greater detail.9 Our goal is to build a simple model for the Hoffman Company, incorporat-
ing some features commonly found in planning models. This model includes our earlier per-
centage of sales approach as a special case, but it is more flexible and a little more realistic. It is by
no means complete, but it should give you a good idea of how to proceed.
Table 4A.1 shows the financial statements for the Hoffman Company in slightly more detail
than we had before. Primarily, we have separated out depreciation and interest. We have also
included some abbreviations that we use to refer to the various items on these statements.
As we have discussed, it is necessary to designate a plug. We use new borrowing as the plug
in our model, and we assume Hoffman does not issue new equity. This means our model allows
the debt/equity ratio to change if needed. Our model takes a sales forecast as its input and sup-
plies the pro forma financial statements as its output.
To create our model, we take the financial statements and replace the numbers with formu-
las describing their relationships. In addition to the preceding symbols, we use E0 to stand for the
beginning equity.
In Table 4A.2, the symbols a1 through a7 are called the model parameters. These describe the
relationships among the variables. For example, a7 is the relationship between sales and total
assets, and it can be interpreted as the capital intensity ratio:
TA = a7 × S
a7 = TA/S = Capital intensity ratio
T A B L E 4A.1 HOFFMAN COMPANY

Income Statement
Sales (S) $500
Costs (C) 235
Depreciation (DEP) 120
Interest (INT) 45
Taxable income (TI) 100
Taxes (T) 34
Net income (NI) $ 66
Addition to retained earnings (ARE) $22
Dividends (DIV) $44
Balance Sheet
Assets Liabilities
Current assets (CA) $ 400 Total debt (D) $ 450
Net fixed assets (FA) 600 Owners’ equity (E) 550
Total assets (TA) $1,000 Total liabilities (L) $1,000
9 This Appendix draws, in part, from R. A. Brealey and S. C. Myers, Principles of Corporate Finance, 3d ed. (New York: McGraw-
Hill Book Company, 1984), chap. 28.

Long-Term Financial Planning Model
Income Statement
Sales S = Input by user

Costs C = a1 × S
Depreciation DEP = a2 × FA
Interest INT = a3 × D
Taxable income TI = S – C – DEP – INT
Taxes T = a4 × TI
Net income NI = TI – T
Addition to retained earnings ARE = NI – DIV
Dividends DIV = a5 × NI
Balance Sheet
Assets Liabilities
Current assets CA = TA – FA Total debt D = TA – E
Net fixed assets FA = a6 × TA Owners’ equity E = E0 × ARE
Total assets TA = a7 × S Total liabilities L = TA
Similarly, a3 is the relationship between total debt and interest paid, so a3 can be interpreted as an overall
interest rate. The tax rate is given by a4, and a5 is the dividend payout ratio.
This model uses new borrowing as the plug by first setting total liabilities and owners’ equity equal to
total assets. Next, the ending amount for owners’ equity is calculated as the beginning amount, E0, plus the
addition to retained earnings, ARE. The difference between these amounts, TA – E, is the new total debt
needed to balance the balance sheet.
The primary difference between this model and our earlier EFN approach is that we have separated out
depreciation and interest. Notice that a2 expresses depreciation as a fraction of beginning fixed assets. This,
along with the assumption that the interest paid depends on total debt, is a more realistic approach than we
used earlier. However, since interest and depreciation now do not necessarily vary directly with sales, we no
longer have a constant profit margin.
Model parameters a1 to a7 can be based on a simple percentage of sales approach, or they can be deter-
mined by any other means that the model builder wishes. For example, they might be based on average val-
ues for the last several years, industry standards, subjective estimates, or even company targets. Alternatively,
sophisticated statistical techniques can be used to estimate them.
We finish this discussion by estimating the model parameters for Hoffman using simple percentages
and then generating pro forma statements for a $600 predicted sales level. We estimate the parameters as:
a1 = $235/500 = .47 = Cost percentage
a2 = $120/600 = .20 = Depreciation rate
a3 = $45/450 = .10 = Interest rate
a4 = $34/100 = .34 = Tax rate
a5 = $44/66 = 2/3 = Payout ratio
a6 = $600/1,000 = .60 = Fixed assets/Total assets
a7 = $1,000/500 = 2 = Capital intensity ratio
With these parameters and a sales forecast of $600, our pro forma financial statements are shown in
Table 4A.3.10
What our model is now telling us is that a sales increase of $100 requires $200 in net new assets (since the
capital intensity ratio is 2). To finance this, we use $24 in internally generated funds. The balance of $200 – $24
= $176 has to be borrowed. This amount is the increase in total debt on the balance sheet: $626 – $450 = $176.
If we pursue this plan, our profit margin would decline somewhat and the debt/equity ratio would rise.
Appendix Questions and Problems

Consider the following simplified financial statements from the Hoffman Company.
HOFFMAN COMPANY
Income Statement
Sales $5,623
Costs 4,500
Taxable income $ 1,123
Taxes 381
Net income $ 742
Dividends $495
Balance Sheet
Assets Liabilities
Current assets $3,000 Total debt $3,375
Net fixed assets 4,500 Owners’ equity 4,125
Total assets $7,500 Total liabilities $7,500
A.1 Prepare a financial planning model along the lines of our model for the Hoffman Company.
Estimate the values for the model parameters using percentages calculated from these statements.
Prepare the pro forma statements by recalculating the model by hand three or four times.
A.2 Modify the model in the previous question so that borrowing doesn’t change and new equity sales
are the plug.
A.3 This is a challenge question. How would you modify the model for Hoffman Company if you want-
ed to maintain a constant debt/equity ratio?
A.4 This is a challenge question. In our financial planning model for Hoffman, show that it is
possible to solve algebraically for the amount of new borrowing. Can you interpret the resulting expression?

Pro Forma Financial Statements
Income Statement
Sales (S) $600 = Input
Cost of sales (C) 282 = .47 × $600
Depreciation (DEP) 144 = .20 × $720
Interest (INT) 63 = .10 × $626
Taxable income (TI) $111 = $600 – 282 – 144 – 63
Taxes (T) 38 = .34 × $111
Net income (NI) $ 73 = $111 – 38
10 If you put this model in a standard computer spreadsheet (as we did to generate the numbers), the software may “complain”
that a “circular” reference exists, because the amount of new borrowing depends on the addition to retained earnings, the
addition to retained earnings depends on the interest paid, the interest paid depends on the borrowing, and so on. This isn’t
really a problem; we can have the spreadsheet recalculated a few times until the numbers stop changing.
There really is no circular problem with this method because there is only one unknown, the ending total debt, which we
can solve for explicitly. This will usually be the case as long as there is a single plug variable. The algebra can get to be
somewhat tedious, however. See the problems at the end of this Appendix for more information.
APPENDIX 4B DERIVATION OF THE SUSTAINABLE GROWTH

FORMULA
EFN = Increase in total assets – Addition to retained earnings [4B.1]
– New borrowing
= A(g) – p(S)R × (1 + g) – pS(R) × (1 + g)[D/E]
Since
EFN = 0
0 = A(g) – pS(R)(1 + g)[1 + D/E]
= –pS(R)[1 + D/E] + [A – pS(R) × (1 + D/E)]g
Dividing through by A gives:
= – p(S/A)(R)[1 + D/E] + [1 – p(S/A)(R) × (1 + D/E)]g

p(S/A)(R)[1 + D/E]
g* =
1 – p(S/A)(R)[1 + D/E]
In the last chapter, we saw that the return on equity could be decomposed into its various components using
the Du Pont identity. Recall that from the Du Pont identity, ROE can be written as:
ROE = Profit margin × Total asset turnover × Equity multiplier
Using our current symbols for these ratios, ROE is:
ROE = p(S/A)(1 + D/E) [4B.2]
ROE × R
g* =
1 – ROE × R
M I N I C A S E
Ratios and Financial Planning at S&S Air, Inc. plane may take one and a half to two years to manufacture
an airplane once the order is placed.
Chris Guthrie was recently hired by S&S Air, Inc., to assist the
Mark and Todd have provided the following financial
company with its financial planning, and to evaluate the com-
statements. Chris has gathered the industry ratios for the
pany’s performance. Chris graduated from university five years
light airplane manufacturing industry.
ago with a finance degree. He has been employed in the
finance department of a Fortune 500 company since then. S&S Air, Inc.
2006 Income Statement
S&S Air was founded 10 years ago by friends Mark
Sexton and Todd Story. The company has manufactured Sales $12,870,000
and sold light airplanes over this period, and the company’s Cost of goods sold 9,070,000
products have received high reviews for safety and reliabili- Other expenses 1,538,000
ty. The company has a niche market in that it sells primarily Depreciation 420,000
to individuals who own and fly their own airplanes. The
EBIT $ 1,842,000
company has two models, the Birdie, which sells for
Interest 231,500
$53,000, and the Eagle, which sells for $78,000.
While the company manufactures aircraft, its operations Taxable income $ 1,610,500
are different from those of commercial aircraft companies. Taxes (40%) 644,200
S&S Air builds aircraft to order. By using prefabricated parts, Net income $ 966,300
the company is able to complete the manufacture of an air-
Dividends $289,890
plane in only five weeks. The company also receives a
Add. to retained earnings 676,410
deposit on each order, as well as another partial payment
before the order is complete. In contrast, a commercial air-
M I N I C A S E ( c o n t i n u e d )
S&S Air, Inc.

2006 Balance Sheet
Assets Liabilities & Equity
Accounts receivable 421,000 Notes payable 1,006,000
Inventory 472,000 Total current liabilities $1,503,000
Total current assets $1,127,000
Long-term debt $2,595,000
Fixed assets
Net plant and equipment $7,228,000 Shareholder equity
Common stock $ 100,000
Retained earnings 4,157,000
Total equity $4,257,000
Total assets $8,355,000 Total liabilities & equity $8,355,000
Light Airplane Industry Ratios

Lower Upper
Quartile Median Quartile
Current ratio 0.50 1.43 1.89
Quick ratio 0.21 0.38 0.62
Cash ratio 0.08 0.21 0.39
Total asset turnover 0.68 0.85 1.38
Inventory turnover 4.89 6.15 10.89
Receivables turnover 6.27 9.82 14.11
Total debt ratio 0.44 0.52 0.61
Debt-equity ratio 0.79 1.08 1.56
Equity multiplier 1.79 2.08 2.56
Times interest earned 5.18 8.06 9.83
Cash coverage ratio 5.84 8.43 10.27
Profit margin 4.05% 6.98% 9.87%
Return on assets 6.05% 10.53% 13.21%
Return on equity 9.93% 16.54% 26.15%
Questions 4. Calculate the internal growth rate and sustainable

1. Calculate the following ratios for S&S Air: current growth rate for S&S Air. What do these numbers
ratio, quick ratio, cash ratio, total asset turnover, mean?
inventory turnover, receivables turnover, total debt 5. S&S Air is planning for a growth rate of 20 percent
ratio, debt-equity ratio, equity multiplier, times inter- next year. Calculate EFN assuming the company is
est earned, cash coverage, profit margin, return on operating at full capacity.
assets, and return on equity. 6. Most assets can be increased as a percentage of sales.
2. Mark and Todd agree that a ratio analysis can provide For instance, cash can be increased by any amount.
a measure of the company’s performance. They have Fixed assets often must be increased in specific
chosen Bombardier Aerospace as an aspirant compa- amounts since it is usually impossible or impractical to
ny. Would you choose Bombardier Aerospace as an buy part of a new plant or machine. So, assume
aspirant company? Why or why not? S&S Air cannot increase fixed assets as a percentage of
3. Compare the performance of S&S Air to the industry sales. Instead, whenever the company needs to pur-
average. For each ratio, comment on why it might be chase new manufacturing equipment, it must pur-
viewed as positive or negative relative to the industry. chase in the amount of $3,000,000. Calculate the new
Suppose you create an inventory ratio calculated by EFN with this assumption. What does this imply about
inventory divided by current liabilities. How do you capacity utilization for the company next
think S&S Air’s ratio would compare to the industry year?
average?

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CHAPTER 4

4.1 WHAT IS FINANCIAL PLANNING?

Growth as a Financial Management Goal

Dimensions of Financial Planning

What Can Planning Accomplish?

EXAMINING INTERACTIONS As we discuss in greater detail later, the financial plan

ENSURING FEASIBILITY AND INTERNAL CONSISTENCY Beyond a specific goal of

COMMUNICATION WITH INVESTORS AND LENDERS Our discussion to this

2. Why should firms draw up financial plans?

4.2 FINANCIAL PLANNING MODELS: A FIRST LOOK

A Financial Planning Model: The Ingredients

ASSET REQUIREMENTS The plan describes projected capital spending. At a minimum,

FINANCIAL REQUIREMENTS The plan includes a section on the financial arrange-

A Simple Financial Planning Model

PRO FORMA BALANCE SHEET

PRO FORMA BALANCE SHEET

2. Why is it necessary to designate a plug in a financial planning model?

4.3 THE PERCENTAGE OF SALES APPROACH

T A B L E 4.1 ROSENGARTEN CORPORATION

T A B L E 4.2 ROSENGARTEN CORPORATION

T A B L E 4.3 ROSENGARTEN CORPORATION

T A B L E 4.4 ROSENGARTEN CORPORATION

AN ALTERNATIVE SCENARIO The assumption that assets are a fixed percentage of

T A B L E 4.5 ROSENGARTEN CORPORATION

EXAMPLE 4.1: EFN and Capacity Usage

This tells us that we need $1.62 in fixed assets for every

4.4 EXTERNAL FINANCING AND GROWTH

T A B L E 4.6 HOFFMAN COMPANY

External Financing Needed and Growth

T A B L E 4.7 HOFFMAN COMPANY

EFN = – p(S)R + [A – p(S)R] × g [4.3]

Internal Growth Rate

Financial Policy and Growth

7 The derivation of the sustainable rate is shown in Appendix 4B.

Pro Forma Income Statement

Pro Forma Balance Sheet

T A B L E 4.8 HOFFMAN COMPANY

EXAMPLE 4.2: Growing Bankrupt

A Note on Sustainable Growth Rate Calculations

In Their Own Words . . . Robert C. Higgins on Sustainable Growth

EXAMPLE 4.3: Sustainable Growth

3. What does it mean if a firm’s sustainable growth rate is negative?

4.5 SOME CAVEATS ON FINANCIAL PLANNING MODELS

2. Why do we say that planning is an iterative process?

4.6 SUMMARY AND CONCLUSIONS

T A B L E 4.9 I. INTERNAL GROWTH RATE

II. SUSTAINABLE GROWTH RATE

ROE × R 0.264 × ( /3)

Chapter Review Problems and Self-Test

SKANDIA MINING COMPANY

Income Statement Balance Sheet

Sales $4,250.0 Assets Liabilities and Owner’s Equity

Answers to Self-Test Problems

Sales $4,675.0 Forecast

Assets Liabilities and Owners’ Equity

Concepts Review and Critical Thinking Questions

Questions and Problems

Sales $16,000 Assets $8,900 Debt $5,100

Income Statement Balance Sheet