Ross, Westerfield, Jaffe, and Jordan's Excel Master

Corporate Finance, 11th edition

by Brad Jordan and Joe Smolira
Version 11.0

Chapter 3
In these spreadsheets, you will learn how to use the following Excel fu

Absolute references
IF
SUMIF
Conditional formatting
Text boxes
Shapes and lines
Data tables
Graphing
Iterative calculations
The following conventions are used in these spreadsheets:

1) Given data in blue

2) Calculations in red

NOTE: Some functions used in these spreadsheets may require that

the "Analysis ToolPak" or "Solver Add-In" be installed in Excel.
To install these, click on the File tab
then "Excel Options," "Add-Ins" and select
"Go." Check "Analysis ToolPak" and
"Solver Add-In," then click "OK."
 the following Excel functions:

eadsheets:

equire that
 Chapter 3 - Section 1
Financial Statements Analysis

Below, we have the balance sheets for Prufrock Corporation. Each account also has a calculation column to show th

Prufrock Corporation
2014 and 2015 Balance Sheets
($ millions)
2014 2015 Change
Current assets
Cash $ 84 $ 98 $ 14
Accounts receivable 165 188 $ 23
Inventory 393 422 $ 29
Total $ 642 $ 708 $ 66

Fixed assets
Net plant and equipment $ 2,731 $ 2,880 $ 149

Total assets $ 3,373 $ 3,588 $ 215

To construct a common-size balance sheet in Excel we need to divide all the asset accounts by Total Assets and all li
Equity. A time saving shortcut in Excel is to use an absolute reference.

Prufrock
2014 and 2015 Corporation
Common-Size Balance Sh

2014 2015 Change

Current assets
Cash 2.5% 2.7% 0.2%
Accounts receivable 4.9% 5.2% 0.3%
Inventory 11.7% 11.8% 0.1%
Total 19.0% 19.7% 0.7%

Fixed assets
Net plant and equipment 81.0% 80.3% -0.7%

Total assets 100.0% 100.0% 0.0%

RWJ Excel Tip

Use an absolute reference whenever you want to reference the same cell, column, or row. In this case, we wanted t
accomplish this more efficiently, we entered the equation in cell D30 as D11/D21, then put $ signs in front of the D a
quick way to do this is when the cursor is on the cell you want to make an absolute reference, hit the F4 key.) Once
can copy and paste the equation to other cells and it will always divide by the value in cell D21. If you want to refere
and not the column letter (D$21). To use an absolute column reference, put the dollar sign in front of the cell letter

We would like to construct a sources and uses statement to show which accounts created cash and which accounts
is problematic. Each account can be a source or use, so we would end up with a lot of empty rows in both the sourc
sources and uses in one table below. An increase in an asset is a use of cash, a decrease in an asset is a source of cas
decrease in a liability is a use of cash. We will use negative signs to denote a use of cash and positive numbers to de
show the account name and whether there was an increase or decrease in that account.

RWJ Excel Tip

IF statements are used for a logical test. The IF function is located under Logical. The basic format of an IF statement
IF statement, we determine the possible conditions first, then determine what value we want if the test is true, or e
case, our possible conditions are that each account will be a source of funds or a use of funds (we will ignore the po
neither a source or use of funds in this example.) If an asset account increases in value, it is a use of funds and if an a
So, for each account we will test if each account increased in value or not. If it did increase in value, we will label it a
it as a source of funds. To have an IF statement return text, put the text in quotes. The format for the inventory acco

Account
Increase in accounts receivable is a use of cash:
 Increase in inventory is a use of cash:
Increase in fixed assets receivable is a use of cash:
Increase in accounts payable is a source of cash:
Decrease in notes payable is a use of cash:
Decrease in long-term debt is a use of cash:
Increase in common stock is a source of cash:
Increase in retained earnings is a source of cash:

We would also like a total of the sources and uses of cash. A simple sum will not work, but SUMIF will accomplish th

RWJ Excel Tip

To sum only the positive numbers and sum only the negative numbers, we used the SUMIF function. The SUMIF fun
input box we used for the sources of cash we used looks like this:

Sources of cash:
Uses of cash:
Net additions to cash:

The income statement and common-size income statement for Prufrock are:

Tax rate 34%

Prufrock Corporation
2015 Income Statement
Sales $ 2,311
Cost of goods sold 1,344
Depreciation 276
Earnings before interest and taxes $ 691
Interest paid 141
Taxable income $ 550
Taxes (34%) 187
Net income $ 363

Dividends $ 121
Addition to retained earnings 242

Prufrock Corporation
2015 Common-Size Income Statement
Sales 100.0%
Cost of goods sold 58.2%
Depreciation 11.9%
Earnings before interest and taxes 29.9%
Interest paid 6.1%
Taxable income 23.8%
Taxes (34%) 8.1%
Net income 15.7%

Dividends 5.2%
Addition to retained earnings 10.5%
o has a calculation column to show the change in that account.

Prufrock Corporation
2014 and 2015 Balance Sheets
($ millions)
2014 2015 Change
Current liabilities
Accounts payable $ 312 $ 344 $ 32
Notes payable 231 196 $ (35)
Total $ 543 $ 540 $ (3)
Long-term debt $ 531 $ 457 $ (74)
Owners' equity
Common stock and
paid-in surplus $ 500 $ 550 $ 50
Retained earnings 1,799 2,041 $ 242
Total $ 2,299 $ 2,591 $ 292
$ -
Total liabilities and equity $ 3,373 $ 3,588 $ 215

set accounts by Total Assets and all liabilities and equity accounts by Total Liabilities and

Prufrock
14 and 2015 Corporation
Common-Size Balance Sheets
($ millions)
2014 2015 Change
Current liabilities
Accounts payable 9.2% 9.6% 0.3%
Notes payable 6.8% 5.5% -1.4%
Total 16.1% 15.1% -1.0%
Long-term debt
Owners' equity
Common stock and
paid-in surplus 14.8% 15.3% 0.5%
Retained earnings 53.3% 56.9% 3.5%
Total 68.2% 72.2% 4.1%

Total liabilities and equity 100.0% 100.0% 0.0%

 mn, or row. In this case, we wanted to divide every asset account in 2014 by cell D21. To
21, then put $ signs in front of the D and the 21 in the denominator like this: $D$21. (Note, a
lute reference, hit the F4 key.) Once we entered this equation with an absolute reference, we
value in cell D21. If you want to reference an absolute row, put a $ in front of the cell number
e dollar sign in front of the cell letter and not the number of the cell ($D21).

nts created cash and which accounts used cash; however, a strict sources and uses statement
a lot of empty rows in both the sources and uses sections. Instead, we will calculate the
decrease in an asset is a source of cash, an increase in a liability is a source of cash, and a
e of cash and positive numbers to denote sources of cash. The column labeled "Account" will
t account.

l. The basic format of an IF statement is =IF(logical_test,[value_if_true],[value_if_false]). In an

value we want if the test is true, or else the value in the cell will be false. For example, in this
a use of funds (we will ignore the possibility that the accounts are unchanged, and therefore
in value, it is a use of funds and if an asset account decreases in value it is a source of funds.
did increase in value, we will label it as a use of funds and if it decreased in value we will label
tes. The format for the inventory account is:

Cash flow
$ (23)
 $ (29)
$ (149)
$ 32
$ (35)
$ (74)
$ 50
$ 242

ot work, but SUMIF will accomplish this.

d the SUMIF function. The SUMIF function is located under the Math & Trig functions. The

$ 324
(310)
$ 14
 Chapter 3 - Section 2
Ratio Analysis

To compare the performance of companies, rather than compare the financial statements, financial ratios are often
each ratio measures. Below, we calculate some basic financial ratios for Prufrock for 2015:

Short-Term Solvency, or Liquidity, Measures

Current ratio: 1.31 times
Quick ratio: 0.53 times
Cash ratio: 0.18 times
NWC ratio: 4.68%
Interval measure: 192.28 days

Long-Term Solvency Measures

Total debt ratio: 0.28 times
Debt-equity ratio: 0.38 times
Equity multiplier: 1.38 times
Long-term debt ratio: 0.85 times
Times interest earned: 4.90 times
Cash coverage: 6.86 times

Asset Management, or Turnover, Measures

Inventory turnover: 3.18 times
Days' sales in inventory: 114.61 days
Receivables turnover: 12.29 times
Days' sales in receivables: 29.69 days
NWC turnover: 13.76 times
Fixed asset turnover: 0.80 times
Total asset turnover: 0.64 times

Profitability Measures
Profit margin: 15.71%
Return on assets (ROA): 10.12%
Return on equity (ROE): 14.01%

Since ROA and ROE are intended to measure performance over a prior period, often the average assets and av
The ROA and ROE using the averages in the denominator are:

ROA with average assets: 10.43%

ROE with average equity: 14.85%
 Market Value Measures
Market value ratios use other numbers such as shares outstanding and share price that are not found on the b

Shares outstanding: 33.00 (in millions)

Price per share: $ 88.00

Earnings per share (EPS): $ 11.00

Price-earnings ratio (PE): 8.00 times
Price-sales ratio: 1.26 times
Market-to-book ratio: 1.12 times

RWJ Excel Tip

We used a "trick" in the calculation of ROA, ROE, and the price-earnings ratio. You can always mathematically calcul
denominator is negative? While this is very unlikely to happen with ratios such as the current ratio, it does happen i
if the equity is negative. In this case, these ratios are often reported as "NMF" for "No meaningful figure." Excel will
negative, Excel will report "#DIV/0" to let you know you have tried to divide by zero. We prefer to see "NMF," so we
ratios are negative. Do you see any of these other ratios which could be negative?

Financial ratio analysis is very much a management by exception tool. When you are analyzing ratios, a number by i
above or below some level, it tells us that something is different. It is up to us to determine if that difference is good
industry average, or some ratio target, but looking through columns of numbers can be difficult. Excel has a conditio
the display for numbers within a specified range or outside a specified range. In this case, we have a range in mind,
number, as well as the cell color if the company's ratio is outside a specified range. Additionally, we used a basic IF s
too high, too low, or within the acceptable range.

While we used factors of 0.75 and 1.25, these factors could be higher or lower depending on the industry. If you cha
automatically change the graphics to match the new calculations.

RWJ Excel Tip

In our conditional formatting, on the Home tab, we selected Conditional Formatting, and New Rule. This allows us to
selected "Format only cells that contain" and then used the pulldown menu to choose "not between." The next two
formula to multiply the industry ratio by the lower bound and the industry ratio by the upper bound. Next, we selec
took us to another window that allows you to specify the font color, cell color fill, and more. We made the font colo
outside the range specified in the 3rd and 4th inputs. Below, you will see our inputs for the current ratio cell.
Lower range: 0.75
Upper range: 1.25

Short-Term Solvency, or Liquidity, Measures

Current ratio: 1.31
Quick ratio: 0.53
Cash ratio: 0.18

Long-Term Solvency Measures

Total debt ratio: 0.28
Debt-equity ratio: 0.38
Equity multiplier: 1.38
Times interest earned: 4.90
Cash coverage: 6.86

Asset Management, or Turnover, Measures

Inventory turnover: 3.18
Days' sales in inventory: 114.61
Receivables turnover: 12.29
Days' sales in receivables: 29.69
Fixed asset turnover: 0.80
Total asset turnover: 0.64

Profitability Measures
Profit margin: 15.71%
Return on assets (ROA): 10.12%
Return on equity (ROE): 14.01%
A quick glance indicates that Prufrock's liquidity ratios and long-term solvency ratios are generally outside the range
ratios appear to be similar to the industry average for all of the ratios in these two categories. This means we should
ratios and long-term solvency ratios.
statements, financial ratios are often used. Ratios are divided into categories based on what
ck for 2015:

riod, often the average assets and average equity, respectively, are used in the calculation.
hare price that are not found on the balance sheet. The other numbers we need are:

You can always mathematically calculate a ratio, however what happens when the
as the current ratio, it does happen in these three ratios when the net income is negative, or
for "No meaningful figure." Excel will try to calculate the ratio, as since the denominator is
zero. We prefer to see "NMF," so we used a simple IF statement to display "NMF" if these
ve?

ou are analyzing ratios, a number by itself tells you very little. However, whenever a ratio is
o determine if that difference is good or bad. We can always compare each ratio to the
rs can be difficult. Excel has a conditional formatting function which will allow you to change
n this case, we have a range in mind, so we want to change the font color of the calculated
nge. Additionally, we used a basic IF statement to tell us specifically if the ratio appears to be

depending on the industry. If you change these factors in the spreadsheet, Excel will

atting, and New Rule. This allows us to create a rule for the conditional formatting. We
choose "not between." The next two cells allow us to enter the calculations, so we entered a
o by the upper bound. Next, we selected "Format.." on this window. The "Format.." option
fill, and more. We made the font color white and the cell fill red if the company's ratio is
nputs for the current ratio cell.
Average
1.39 Looks OK.
0.85 Too Low?
0.35 Too Low?

0.19 Too High?

0.29 Too High?
1.29 Looks OK.
3.80 Too High?
4.15 Too High?

2.95 Looks OK.

123.73 Looks OK.
14.15 Looks OK.
25.80 Looks OK.
0.93 Looks OK.
0.71 Looks OK.

17.83% Looks OK.

12.18% Looks OK.
15.83% Looks OK.
ratios are generally outside the ranges we set, while the asset management and profitability
two categories. This means we should investigate the causes of the differences in the liquidity
 Chapter 3 - Section 3
The DuPont Identity

The three-factor DuPont equation separates the ROE into 3 components. For Prufrock, the three-factor DuPont equ

ROE = Profit margin ´ Total asset turnover ´ Equity multiplier

ROE = 15.71% ´ 0.64 ´ 1.38
ROE = 14.01%

This is exactly the same as the ROE we previously calculated, but it breaks ROE into its constant parts. Of course, RO
next. The abbreviated financial statements for EI DuPont de Nemours & Co. for the most recent year were:

DuPont Income Statement DuPont Balance Sheet

12 months ending Dec 31, 2014 12 months ending Dec 31, 2014
($ in millions) ($ in millions)
Sales $ 35,553 Assets
CoGS 21,703 Current assets
Gross profit $ 13,850 Cash $ 7,034
SG&A expenses 6,411 Accounts receivable 6,594
Depreciation 2,067 Inventory 8,120
EBIT $ 5,372 Total $ 21,748
Interest 377
EBT $ 4,995
Taxes 1,370
Net income $ 3,625 Fixed assets $ 28,128

Total assets $ 49,876

Now we can show an expanded DuPont analysis, which is:

Return
on equity
27.21%

Equity
ROA Multiplied multiplier
by
7.27% 3.74
 Profit Total asset
margin Multiplied turnover
10.20% by 0.71

Net Divided Divided

income by Sales Sales by
$ 3,625 $ 35,553 $ 35,553

Total Subtract- Fixed

costs ted from Sales assets
$31,928 $ 35,553 $ 28,128

Cost
of goods
sold Dep.
$21,703 $2,067

Selling,
general,
& admin.
expense Interest
$6,411 $377

Taxes
1,370

RWJ Excel Tip

To insert the mathematical instructions, we used text boxes. To insert a text box, simple go to "Insert" and select "T
is "linked" to the position in which you put the box. Although we could have entered the text in a cell, text boxes in
rows and/or columns, which can often look more professional. Text boxes are also very useful in graphing, which we
boxes, we went to "Insert" and selected "Shapes." We chose the straight line, although many other choices are avai
hree-factor DuPont equation is:

ant parts. Of course, ROE can be further subdivided, which we will do

ent year were:

t Balance Sheet
ending Dec 31, 2014
in millions)
Liabilities and Owner's Equity
Current liabilities
Accounts payable $ 11,217
Notes payable 1,423

Total $ 12,640

Long-term debt $ 23,916

Total equity $ 13,320

Total liabilities and

owner's equity $ 49,876
 Total
assets
$ 49,876

Plus Current
assets
$21,748

Cash
$ 7,034

Accounts
receivable Inventory
$6,594 $8,120

o "Insert" and select "Text Box." Text boxes allow you to enter text that
in a cell, text boxes in this case allow the text to go across multiple
ul in graphing, which we will show later. To draw the lines between the
y other choices are available.
 Chapter 3 - Section 4
Financial Models

A Simple Financial Planning Model

A financial plan begins with the current financial statements. The income statement and balance sheet for Compute

COMPUTERFIELD CORPORATION COMPUTERFIELD

Income Statement Balance
Sales $ 1,000 Assets
Costs 800
Net income $ 200 Total

To find the funds the company will need to raise next year to funds its sales growth, we begin with the forecasted sa
growth for the next year will be:

Sales growth: 20%

If sales grow by this amount, we can construct the pro forma, or projected financial statements. Under the assumpti
rate, the pro forma statements will be:

COMPUTERFIELD CORPORATION COMPUTERFIELD

Pro forma Pro fo
Income Statement Balance
Sales $ 1,200 Assets
Costs $ 960
Net income $ 240 Total

The advantage of financial planning is that it allows us to see what could happen in the future and the options availa
occurred:

Debt increased by: $ 50

Net income was: $ 40
So, dividends paid must have been: $ 190

Of course, that is not the only option available to Computerfield. The company could also keep all of the net income
need to repurchase debt in order to keep the balance sheet in balance. The pro forma balance sheet under this scen

COMPUTERFIELD
Pro fo
Balance
 Pro fo
Balance
Assets

Total

Remember, the purpose of financial planning is not to tell us what to do, but rather allow us to see what might happ

The Percentage of Sales Approach

Below, we have the financial statements for Rosengarten Corporation. Notice, we have an input cell for the tax rate
time.

Tax rate: 34%

ROSENGARTEN CORPORATION ROSENG

Income Statement
Sales $ 1,000 Current assets
Costs 800 Cash
Taxable income $ 200 Accounts receivable
Taxes (34%) 68 Inventory
Net income $ 132 Total

Dividends $ 44 Fixed assets

Addition to $ 88 Net plant and equipment
retained earnings

Total assets

In its financial planning, Rosengarten has projected that sales for the next year will be:

Next years' sales: $ 1,250

The percentage increase in sales and the costs as a percentage of sales for Rosengarten are:

Percentage sales increase: 25%

Costs as a percentage of sales: 80%

The pro forma income statement will be:

ROSENGARTEN CORPORATION
 Pro forma
Income Statement
Sales $ 1,250
Costs 1,000
Taxable income $ 250
Taxes 85
Net income $ 165

Next, we need to calculate the pro forma dividend. Of course, this amount is up to company management, but we w
net income. We can calculate the dividend payout ratio by dividing the dividend payment by net income.

Dividend payout ratio: 33.33%

The retention ratio is the ratio of additions to retained earnings divided by net income or one minus the dividend pa

Retention ratio: 66.67%

For the next year, the pro forma dividends and additions to retained earnings will be:

Dividends: $ 55.00
Addition to retained earnings: $ 110.00

One characteristic of the percentage of sales approach is that most accounts are assumed to be a constant percenta
ratio of total assets to sales. In Rosengarten's case, the capital intensity ratio is:

Capital intensity ratio: 3 or 300%

In the percentage of sales approach, several accounts on the liabilities side of the balance sheet are assumed to not
we use n/a to indicate they do not vary directly with sales.

ROSENGARTEN
PercentageCORPORATION
of sales
Balance Sheet
Current assets Current liabilities
Cash 16% Accounts payable
Accounts receivable 44% Notes payable
Inventory 60% Total
Total 120% Long-term debt
Owners' equity
Fixed assets Common stock and
Net plant and equipment 180% paid-in surplus
Retained earnings
Total
 Total assets 300% Total liabilities and equity

Now we can construct a pro forma balance sheet for Rosengarten. Each of the items on the pro forma balance shee
the pro forma sales. The balance sheet items that do not vary directly with sales are held constant, except for the re
to retained earnings from the pro forma income statement.

ROSENGARTEN CORPORATION
Pro forma
Balance Sheet
Current assets Current liabilities
Cash $ 200 Accounts payable
Accounts receivable $ 550 Notes payable
Inventory $ 750 Total
Total $ 1,500 Long-term debt
Owners' equity
Fixed assets Common stock and
Net plant and equipment $ 2,250 paid-in surplus
Retained earnings
Total

Total assets $ 3,750 Total liabilities and equity

Notice that the balance sheet does not balance. Since the total assets are higher than the total liabilities and equity,
in order to support its growth. These funds are called external financing needed, and in this case will be:

External financing needed: $ 565

Now Rosengarten must fund the necessary EFN in order to grow its sales at the projected amount. How the compan
would be to increase debt. We will assume that the company increases current liabilities by the same amount as the
assets and current liabilities will increase by:

Current asset increase: $ 300

Accounts payable increase: $ 75

Rosengarten will also be able to raise funds from notes payable and long-term debt. The amount raised from these

Increase in notes payable: $ 225

Increase in long-term debt: $ 340

With these assumptions, the new pro forma balance sheet will be:
 ROSENGARTEN CORPORATION
Pro forma
Balance Sheet
Current assets Current liabilities
Cash $ 200 Accounts payable
Accounts receivable $ 550 Notes payable
Inventory $ 750 Total
Total $ 1,500 Long-term debt
Owners' equity
Fixed assets Common stock and
Net plant and equipment $ 2,250 paid-in surplus
Retained earnings
Total

Total assets $ 3,750 Total liabilities and equity

Of course, other possibilities exist in financial planning. Suppose for example that Rosengarten is not operating at fu

Operating capacity: 90%

In this case, we can calculate the full-capacity sales for the company as:

Current sales = Capacity utilization ´ Full-capacity sales

Full-capacity sales = $ 1,111.11

Next, we need to calculate the maximum increase in sales which could occur without the addition of new fixed asse

Maximum sales increase with current fixed assets:

In this case, the pro forma balance sheet will be:

ROSENGARTEN CORPORATION
Pro forma
Balance Sheet
Current assets Current liabilities
Cash $ 200 Accounts payable
Accounts receivable $ 550 Notes payable
Inventory $ 750 Total
Total $ 1,500 Long-term debt
Owners' equity
Fixed assets Common stock and
Net plant and equipment $ 1,800 paid-in surplus
Retained earnings
 Total

Total assets $ 3,300 Total liabilities and equity

Since the company is not at full capacity, the EFN is only:

EFN: $ 115

Of course, in Excel we could set up one spreadsheet that would calculate the EFN whether or not the firm is operati
intensity ratio at full-capacity sales.

Fixed assets/Sales at full capacity: 1.620

At the projected level of sales, the fixed asset requirement for the company is:

If the company will not operate at full capacity, we need to include current level of fixed assets in the balance sheet
capacity, the fixed assets will be the number we calculated. Using an IF statement to test these parameters, we get

ROSENGARTEN CORPORATION
Pro forma
Balance Sheet
Current assets Current liabilities
Cash $ 200 Accounts payable
Accounts receivable $ 550 Notes payable
Inventory $ 750 Total
Total $ 1,500 Long-term debt
Owners' equity
Fixed assets Common stock and
Net plant and equipment $ 2,025 paid-in surplus
Retained earnings
Total

Total assets $ 3,525 Total liabilities and equity

The EFN is: $ 340

ment and balance sheet for Computerfield Corporation are:

COMPUTERFIELD CORPORATION
Balance Sheet
$ 500 Debt $ 250
Equity 250
$ 500 Total $ 500

owth, we begin with the forecasted sales growth. In this case, we will assume that the sales

ncial statements. Under the assumption that all of the variables will grow by the sales growth

COMPUTERFIELD CORPORATION
Pro forma
Balance Sheet
$ 600 Debt $ 300
Equity $ 300
$ 600 Total $ 600

en in the future and the options available. For example, in this case the following must have

could also keep all of the net income as retained earnings. If this happens, the company will
o forma balance sheet under this scenario will be:

COMPUTERFIELD CORPORATION
Pro forma
Balance Sheet

$ 600
$ 600
ather allow us to see what might happen and plan for any contingencies.
we have an input cell for the tax rate since it is possible that the tax rate will change over
unts receivable
plant and equipment
will be:
engarten are:
Pro forma
Balance Sheet
Debt $ 110
Equity 490
Total $ 600
ROSENGARTEN CORPORATION
Balance Sheet
Current liabilities
$ 160 Accounts payable $ 300
440 Notes payable 100
600 Total $ 400
$ 1,200 Long-term debt $ 800
Owners' equity
Common stock and
$ 1,800 paid-in surplus $ 800
Retained earnings 1,000
Total $ 1,800
$ 3,000 Total liabilities and equity $ 3,000
p to company management, but we will assume that dividends are a constant percentage of
d payment by net income.

income or one minus the dividend payout ratio.

will be:

re assumed to be a constant percentage of sales. For example, the capital intensity ratio is the
:

he balance sheet are assumed to not be a constant percentage of sales. For these accounts,

nt liabilities
unts payable 30%
N/A
N/A
N/A

mon stock and

d-in surplus N/A
ned earnings N/A
N/A
 iabilities and equity N/A

items on the pro forma balance sheet that varies with sales is calculated as the percentage of
s are held constant, except for the retained earnings account, which increases by the addition

nt liabilities
unts payable $ 375
100
$ 475
$ 800

mon stock and

d-in surplus $ 800
ned earnings 1,110
$ 1,910

iabilities and equity $ 3,185

er than the total liabilities and equity, we know that Rosengarten must raise additional funds
d, and in this case will be:

e projected amount. How the company does this is a management decision, but one possibility
t liabilities by the same amount as the current assets. Under this assumption, the current

debt. The amount raised from these sources will be:

N

nt liabilities
unts payable $ 375
325
$ 700
$ 1,140

mon stock and

d-in surplus $ 800
ned earnings 1,110
$ 1,910

iabilities and equity $ 3,750

hat Rosengarten is not operating at full capacity, but rather is operating at a capacity of:

ithout the addition of new fixed assets, which is:

nt liabilities
unts payable $ 375
100
$ 475
$ 800

mon stock and

d-in surplus $ 800
ned earnings 1,110
 $ 1,910

iabilities and equity $ 3,185

FN whether or not the firm is operating at full capacity. First, we need to calculate the capital

$ 2,025

el of fixed assets in the balance sheet. However, if the company will end up operating at full
ent to test these parameters, we get the following pro forma balance sheet.

nt liabilities
unts payable $ 375
100
$ 475
$ 800

mon stock and

d-in surplus $ 800
ned earnings 1,110
$ 1,910

iabilities and equity $ 3,185

 Chapter 3 - Section 5
External Financing and Growth

External financing needed and growth are related, but we would like to examine that relationship. Below we have th

Tax rate: 34%

HOFFMAN COMPANY HOF

Income Statement
Sales $ 500 Current assets
Costs 400 Net fixed assets
Taxable income $ 100 Total assets
Taxes 34
Net income $ 66

Dividends $ 22
Addition to
retained earnings $ 44

So what is the EFN? Using the input cell below for the projected sales increase, we can construct the pro forma finan

Projected sales increase: 20%

Dividend payout ratio: 33%
Retention ratio: 67%

HOFFMAN COMPANY HOF

Pro forma
Income Statement
Sales $ 600.0 Current assets
Costs $ 480.0 Net fixed assets
Taxable income $ 120.0 Total assets
Taxes 40.8
Net income $ 79.2

Dividends $ 26.4
Addition to
retained earnings $ 52.8
 So the EFN is: $ 47.20
The increase in assets is: $ 100.0
Assuming Hoffman wishes to issue no new equity, the new total debt is:
And the new debt-equity ratio will be:

RWJ Excel Tip

Suppose we want to examine what will happen to Hoffman for different growth rates? One way to accomplish this i
way data table in Excel. The first column, which shows the growth rates we would like to examine, are all inputs. In
equal to the cells containing the output we would like, namely the increase in assets, addition to retained earnings,
recalculates all of the numbers based on the values in the projected growth rate column and puts them in the table
you go to the cells, the values in the cell will be displayed. From an aesthetic point of view, we didn't like this row sh
and under the "Custom" option, we entered a semicolon ( ; ). This formatting hides what is in the cells from the disp
allows you to see what is entered in the cell only when you select that cell.

Addition
to
Increase retained
in assets earnings

0%
5%
10%
15%
20%
25%

Suppose we wanted to graph the projected retained earnings and increased fixed assets for different growth rates.
which replicates Figure 3.1 in the textbook:

Internal growth rate

gs

$12
 A s s e t s n e e d e d a n d r e t a in e d e a r n in g s
$12

$10

$8

$6

$4

$2

$-
0%

RWJ Excel Tip

To create this graph, we selected the three columns of data we wanted to graph (growth rate, increase in assets, an
and went to "Insert" and then selected the "Line" option for a line graph. Excel automatically uses the headers as th
decided to make the graph more presentable using some of the various options available. For example, to get the co
selected "Format Plot Area," and then selected "Gradient fill." We then used one of the preset colors to put the bac
under the "Insert" menu we used "Text Box" and inserted a text box. Right-clicking on the text box itself brings up a
color of the text box. Finally, the lines pointing to the internal growth rate on the graph were created under the "Ins
available to make graphs look better. Try some out for yourself and remember that if you try something that you do
arrow on the ribbon.

We decided to create a graph of the company's EFN as well. Below is the graph showing the EFN for different sales g
text boxes.

External financing needed (EFN)

$80

$60

$40 Internal growth rate

$20

$-
0% 5% 10% 15%

$(20)

$(40)

$(60)
RWJ Excel Tip
Creating this graph is a little more difficult since the data we want to graph is not in side-by-side columns. To select
click and hold "Ctrl." This will allow you to select another column to graph. Also, notice that the edges of the graph
itself, selected "Format plot area," and then select "3-D Format."

In long-range financial planning, two growth rates that are of particular interest are the internal growth rate and the
maximum growth rate that can be achieved without external financing of any type. For the Hoffman Company, the i

ROA: 13.20%
Internal growth rate: 9.65%

The sustainable growth rate is the maximum growth rate a company can achieve while maintaining a constant debt
growth rate is:

ROE: 26.40%
Sustainable growth rate: 21.36%
ne that relationship. Below we have the financial statements for the Hoffman Company:

HOFFMAN COMPANY
Balance Sheet
$ 200 Total debt $ 250
300 Owners' equity 250
$ 500 Total liabilities and equity $ 500

we can construct the pro forma financial statements as well as the EFN.

HOFFMAN COMPANY
Pro forma
Balance Sheet
$ 240.0 Total debt $ 250.0
$ 360.0 Owners' equity 302.8
$ 600.0 Total liabilities and equity $ 552.8
 $ 297.20
0.98

h rates? One way to accomplish this is to use a data table. Below we have constructed a one-
uld like to examine, are all inputs. In the row above the first growth rate, we made the cells
assets, addition to retained earnings, EFN, and projected debt-equity ratio. Excel automatically
e column and puts them in the table. Notice that the row below the headers is blank. But, if
oint of view, we didn't like this row showing in the data table, so we went to "Format Cells"
ides what is in the cells from the display, but leaves any formulas or values in the cell and

External
financing Projected
needed debt-equity
(EFN) ratio

$ (44.00) 0.70
(21.20) 0.77
1.60 0.84
24.40 0.91
47.20 0.98
70.00 1.05

ed assets for different growth rates. Using the graphing function, we get the following graph,

th rate
gs

$12
 A s s e t s n e e d e d a n d r e t a in e d e a r n in g s
$12
Growth and Related Financing Needed
$10

$8

EFN > 0 Increase

in assets
(deficit)
$6
Addition
to
retained
earnings
$4

EFN < 0
(surplus)
$2

$-
0% 5% 10% 15% 20% 25%
Projected growth rate in sales

h (growth rate, increase in assets, and addition to retained earnings), including the headers,
automatically uses the headers as the legend on the right hand side of the graph. We then
s available. For example, to get the colored background, we right clicked on the chart itself,
ne of the preset colors to put the background color in the chart. To create the text boxes,
king on the text box itself brings up a menu which gives you choices such as the background
he graph were created under the "Insert" menu by choosing "Shapes." Excel has options
that if you try something that you don't like, you can always undo it by clicking the undo

showing the EFN for different sales growth rates. Again, we applied background color and

ancing needed (EFN)

External
financing
needed
(EFN)

10% 15% 20% 25%

ot in side-by-side columns. To select the columns we wanted, highlight the growth rates, then
o, notice that the edges of the graph are beveled. For this option, right clicked on the chart

t are the internal growth rate and the sustainable growth rate. The internal growth rate is the
ype. For the Hoffman Company, the internal growth rate is:

ve while maintaining a constant debt-equity ratio. For the Hoffman Company, the sustainable
Chapter 3 - Master it!

Financial planning can be more complex than the percentage of sales approach. Often, the assumptions behind
example, if the amount of fixed assets increases, then depreciation will increase. A more sophisticated model a
strict percentage of sales.

This model uses new borrowing as the plug variable by setting total liabilities and owners’ equity equal to tota
calculated as the beginning amount plus the additions to retained earnings. The difference between these amo
sheet.

The main difference between this model and the percentage of sales approach is that we have separated out d
percentage of beginning fixed assets, and the amount of interest depends on the amount of debt. However, si
directly with sales, the profit margin is no longer constant.

The model parameters can be based on a percentage of sales model, or they can be determined by other mea
might be based on average values for the last several years, industry standards, subjective estimates, or even c
techniques can be used to estimate them.

The parameter estimates used in this calculation of pro forma financial statements are:

Cost percentage = Costs/Sales

Depreciation rate = Depreciation / Beginning fixed assets
Interest rate = Interest paid / Total debt
Tax rate = Taxes / Net income
Payout ratio = Dividends / Net income
Capital intensity ratio = Fixed assets / Sales

The Loftis Company is preparing its pro forma financial statements for the next year using this model. The abbr

Sales growth 20%

Tax rate 34%

Income Statement
Sales $ 780,000.00
Costs 415,000.00
Depreciation 135,000.00
Interest 68,000.00
Taxable income $ 162,000.00
Taxes 55,080.00
Net income $ 106,920.00
 Dividends $ 30,000.00
Additions to
retained earnings $ 76,920.00

Balance Sheet
Assets Liabilities and Equity
Current assets $ 240,000.00 Total debt
Net fixed assets 1,350,000.00 Owners' equity
Total assets $ 1,590,000.00 Total debt and equity

a. Calculate each of the parameters necessary to construct the pro forma balance sheet.

b. Construct the pro forma balance sheet. What is the total debt necessary to balance the pro forma balance she

c. In this financial planning model, show that it is possible to solve algebraically for the amount of new borrowing

RWJ Excel Tip

Notice that the solution to this problem requires the use of circular logic. The addition to retained earnings depends
which depends on the level of debt, which depends on the addition to retained earnings. When you enter the formu
error. However, Excel can often solve problems that contain circular references. Click on the Office button then "Exc
should see a box that says "Enable iterative calculations." Clicking this box will cause Excel to recalculate the formul
or the change in the value of the final answer is less than the "Maximum Change" you set. Note that the preset in Ex
calculations: First, when you save the spreadsheet, it will save this option with the spreadsheet, so you should not h
spreadsheet. Second, Excel can only do calculations iteratively or one time simultaneously. What this means is that
then open a spreadsheet with iterative calculations, the dominant spreadsheet is the one opened without iterative
opened first tells Excel to handle calculations.
oach. Often, the assumptions behind the percentage of sales approach may be incorrect. For
rease. A more sophisticated model allows these input variables to vary rather than being a

es and owners’ equity equal to total assets. Next, the ending amount of owners’ equity is
s. The difference between these amounts is the total debt necessary to balance the balance

oach is that we have separated out depreciation and interest. Depreciation is calculated as a
on the amount of debt. However, since depreciation and interest now do not necessarily vary

ey can be determined by other means the company deems appropriate. For example, they
ards, subjective estimates, or even company targets. Alternatively, sophisticated statistical

tements are:

next year using this model. The abbreviated financial statements are presented below.
 Liabilities and Equity
$ 880,000.00
710,000.00
debt and equity $ 1,590,000.00

ance sheet.

o balance the pro forma balance sheet?

lly for the amount of new borrowing.

ddition to retained earnings depends on the net income, which depends on the interest rate,
earnings. When you enter the formulas in the spreadsheet, you will get a "Circular Reference"
Click on the Office button then "Excel Options," then "Formulas." On the right hand side, you
ause Excel to recalculate the formulas until the number of iterations set by you are completed,
e" you set. Note that the preset in Excel is 0.001, which is 0.1%. Two notes about iterative
he spreadsheet, so you should not have to reset this option later when you reopen the
ltaneously. What this means is that if you open a spreadsheet without iterative calculations,
is the one opened without iterative calculations. In other words, whichever spreadsheet is
 Master It! Solution

a. Calculate the following ratios for financial planning:

Cost percentage 53%

Depreciation percentage 10%
Interest rate 0.08
Tax rate 0.52
Payout ratio 0.28
Fixed assets/Total assets 0.85
Capital intensity ratio 1.73

b. Construct the pro forma financial statements using the parameters you calculated. Your pro forma balance she

Loftis Company
Pro forma
Income Statement
Sales $ 936,000.00
Costs 498,000.00
Depreciation 162,000.00
Interest 81,600.00
Taxable income $ 194,400.00
Taxes 66,096.00
Net income $ 128,304.00

Dividends $ 36,000.00
Additions to
retained earnings $ 92,304.00

Loftis Company
Pro forma
Balance Sheet
Assets Liabilities and Equity
Current assets $ 288,000.00 Total debt
Net fixed assets $ 1,620,000.00 Owners' equity
Total assets $ 1,908,000.00 Total debt and equity
ed. Your pro forma balance sheet should balance.

ities and Equity

$ 1,056,000.00
$ 852,000.00
$ 1,908,000.00