FIN300 - Financial Planning: Pro Forma, EFN, IGR, SGR - YouTube

In the two previous videos we learned to interpret and compare financial statements. In this

video, we’ll learn how to use financial statements to project a plan. We’ll begin

by using the percentage of sales method to create pro forma (or projected) financial

statements. Then we’ll look at the relationship between something called External Financing

Needed (EFN) and growth, as well as how to determine internal growth rate and sustainable

growth rate.

The percentage of sales method dictates that accounts are projected depending on a firm’s

predicted sales.

DEMO 1 - Beginning with our basic statement of comprehensive income once again, let’s

suppose we predict increased sales of 25% in the coming year: we would make 1612 x 1.25,

2015 in sales. One of our underlying assumptions is that costs run in proportion to sales,

meaning they too would rise 25% from 752 to 940. We then proceed to fill out the rest

of the statement as usual, subtracting interest, then taxes, and paying out dividends which

is calculated here assuming a 10% payout.

However, with a statement of financial position, not everything varies with sales. The accounts

that will vary depends on the particular firm.

DEMO 2 – In our example, let’s assume that on the asset side, the accounts do vary

in proportion to sales and on the liability side, only accounts payable varies because

we can reasonably expect that we will need to place more orders with suppliers with increasing

sales. Let’s calculate how much they change by.

Our first step is to restate these accounts as percentages of sales, so we divide each

by the current sales figure, 1612. Our second step is to multiply each of these percentage

amounts by the projected sales figure, 2015, to get the new amount each of these accounts

will increase to in proportion with the increase in sales. As for the accounts that do not

vary directly with sales, namely notes payable, long-term debt and common stock, we leave

them unchanged for now. Retained earnings does vary with sales, but we can’t follow

the two-step process with this. We have to calculate it explicitly, like we did when

creating a pro forma statement of comprehensive income. On that, we had 630 as additions to

retained earnings. You’ll notice that the balance sheet doesn’t balance. The assets

are 5205 but the liabilities and equities add up to 4939.5. Recalling the financial

position identity, assets = liabilities + equity, we know we must be missing some amount

of money on the right-hand side. This missing amount is called External Financing Needed

(EFN), which is money that we will need to raise in order to be able to sustain the projected

growth in sales. We can obtain it by subtracting the pro forma total assets by the pro forma

total liabilities and equity. When we do this we get 265.5 million dollars. Restating it

in a different way, this means that in order to be able to support the increased sales,

we will need to raise 265.5 million dollars through debt and/or equity financing. This

is a decision for management to make based on their preferences and goals. For example,

if management wants to maintain the same net working capital, they might be inclined to

take on only an amount of short-term debt which corresponds with the increase in short-term

assets.

DEMO 3 - It’s important to point out that what we’ve done here is assume that our

firm is producing at 100% capacity but more often than not businesses operate at below

capacity. In other words, they are not fully using their fixed assets. For example, a factory

is only 90% staffed and can accommodate more workers and a higher rate of production. How

would this scenario affect our EFN? Suppose our current sales figure, 1612, is the figure

when our company was operating at 90% capacity. That means we could potentially handle up

to 1612/0.90 = 1791.11 in sales before we need to acquire additional fixed assets to

raise our production levels. If our projected increase in sales is less than 1791.11, we

needn’t go any further – EFN is zero. If projected sales exceed full capacity sales,

we need to find out the exact amount we will have to spend on increasing fixed assets.

Our first step to do this is dividing our fixed assets of 3200 by full capacity sales,

1791.11 to get the rate at which fixed assets increases for every dollar increase in sales

beyond full capacity. Our second step is to multiply that rate by the projected sales

amount, 2015. We should get the pro forma fixed asset amount of 3040, which is less

than the earlier 3200. This reduces our total assets by 160 to 5045, but our liabilities

side is still 4939.5. Subtracting them again, we obtain the new EFN of 105.5. In sum, we

have to raise less money externally in order to finance our growth in sales as a result

of having some excess capacity.

Up until now we’ve been talking about growth in sales as if it’s just something that

happens to firms, but we all know that many businesses actively find ways to drive sales

themselves. So now let’s switch gears from talking about growth as if it’s just something

that happens to a business and talk about it as if the business was consciously driving

that growth, how a business might affect growth, and how it can affect EFN.

As we established earlier, a projected increase in sales can require us to pour some money

into increasing assets so we can actually fulfill the production requirements. Not all

of this is money that we will need from outside sources. Businesses tend to generate their

own money through operations. That’s the whole point of a business, after all. We can

use that money to finance our asset acquisition. This idea, as a formula, looks like this:

EFN = increase in total assets – additions to retained earnings

= A(g) – p(S)R x (1 + g) Where A represents total assets, g is the

growth rate of sales, p is the Profit Margin, S is the previous year’s sales, and R is

the retention ratio.

If you’re more of a visual-learner and like to establish relationships by graphing them

out, then we can restate the equation like this:

EFN = [A - p(S)R] × g – p(S)R

…which makes it look a lot like the equation for a line, y = m(x) + b. If we were to actually

plot the relationship with projected growth in sales (g) on the x-axis and EFN on the

y-axis, we would get a line with the slope [A – p(S)R], and a y-intercept of negative

p(S)R which might look something like this.

On this graph, there’s actually one point of major interest: the x-intercept. Looking

at it, what are its implications? It’s situated at EFN = 0, and some growth rate, g. This

tells us that that growth rate is the maximum growth rate we can achieve without needing

any external financing. The rate at that point is known as the Internal Growth Rate, IGR.

But we don’t always want to draw out a graph. The way to find this mathematically is by

setting EFN to 0, isolating for g [p(S)R/(A - p(S)R)], and then solving by plugging in

our known amounts. The expression for internal growth rate can be restated as:

IGR = (ROA x R) / (1 – ROA x R)

If a growth rate higher than this is needed or predicted, our next best bet is to take

on debt because equity financing can be tricky. That’s why another relevant figure for growth

is the Sustainable Growth Rate (SGR) which gives us the growth rate that a firm can achieve

without any external equity financing and without changing its debt or payout ratios.

This concept, as a formula, makes a small modification to the previous EFN formula in

that it also subtracts new borrowing: EFN* = increase in total assets – additions

to retained earnings – new borrowing = A(g) – p(S)R x (1 + g) – p(S)R x (1

+ g)(D/E) Given this modified formula, which can also

be used to plot a linear relationship, we can follow the same process as before where

we set EFN to 0, re-arrange to isolate for g, do some algebra magic and we have:

SGR = [ROE x R] / [1 – ROE x R] To get to the root of what determines growth,

we can make use of the Du Pont Identity which we spoke about in the previous video. Recall

that: ROE = p(S/A)(1+D/E)

Plugging that into our formula for SGR, we get:

SGR = [p(TAT)(1+D/E) x R] / [1 - p(TAT)(1+D/E) x R]

TAT = S/A

This makes the formula look atrocious, but it helps highlight the various factors that

affect growth.

That brings us to the end of the video! Still confused?

Recap what you’re unsure about by clicking on the sections listed to the left!

For more, be sure to take a look at the tip sheets uploaded to the Academic Success Centre

website by following the link in the description. Need a more face-to-face approach? Check out

tutoring hours at the Ryerson University Academic Success Centre website!