Solution to Case 01

Financial Analysis and Forecasting

Growing Pains

Questions

1. Since this is the first time Jim and Mason will be conducting a financial forecast for Oats’ R’ Us, how do you think they should proceed? Which approaches or models can they use? What are the assumptions necessary for utilizing each model?

Jim and Mason should begin their planning with a reasonable sales forecast. The sales forecast ought to be based on clearly stated assumptions about future economic conditions. Next, they should prepare pro forma financial statements by either assuming that the key items vary proportionately with sales or remain constant (as the case may be). Based on their asset utilization rate, they would be able to determine the asset requirements for growth. Some of the funds required to finance growth would be raised from spontaneous sources such as accounts payables and accruals and from future retained earnings. The remaining funds necessary for growth could then be raised from external sources such as new debt and stock offering.

Jim and Mason can use one of the following approaches:

1. Pro Forma Approach – where most of the income statement and balance sheet items are assumed to maintain a constant proportion to sales, but individual items can be forecasted using statistical techniques and feedback effects involving changes in interest costs etc. can be included. 2. EFN Formula Method – which is simple to use but does not allow the inclusion of feedback effects.

2. If Oats’ R’ Us is operating its fixed assets at full capacity, what growth rate can it support without the need for any additional external financing?

Here are the steps:

1. Calculate the percent of sales figure for each balance sheet item, as well as the net profit margin, and the retention rate. 2. Using the External Funds Needed (EFN) formula (shown below), set EFN to 0, plug in the required data, and solve for the change in sales that could be achieved without any external financing.

EFN = (Ao/So)*(Change in sales) – (Lo/So)*(Change in Sales) - Net Margin*(So + Change in sales)*Retention Rate

where, So = Current sales;

New Sales = S1 = (So + Change in sales)

Retention Rate = 1 – Payout Ratio

|Income Statement –Percent of Sales | |For the Year Ended Dec. 31st, 2004 | | | |For the Year Ended Dec. 31st, 2004 | |Assets | | |Net Profit Margin |4.678% | |Retention Rate |60% | |Current Sales |$4,700,000 | |Lo/So |2.872% | |Change in Sales | $659,591.40 |

Note: Used Excel’s Solver function to calculate Change in Sales (see spreadsheet). Spreadsheet solution

EFN = Increase in Assets - Increase in internal equity

EFN= 25.679%*(Change in So) – 2.87*(Change in So) - [4.678%*0.6*($4.7 + Change in So)] 0 = 22.807%*(Change in So) – 0.0280*(Change in So) - $131,919.60 Change in So = $131,919.6/0.2000 = $659,591.40

Growth rate that can be supported with no external funds = 659,591.40/4,700,000 = 14.033% | |Increase in | | |...