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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 !ou thin" the! should #roceed$ %hich a##roaches or models can
the! use$ %hat are the assum#tions necessar! for utili&ing 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. !ased on their asset
utili"ation rate, they would be able to determine the asset re#uirements for growth. $ome of
the funds re#uired 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%

&. 'ro orma )pproach * 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 techni#ues and feedback effects
involving changes in interest costs etc. can be included.
+. N ormula Method * which is simple to use but does not allow the
inclusion of feedback effects.

'. (f Oats’ R’ Us is o#erating its fi)ed assets at full ca#acit! what growth rate can it
su##ort without the need for an! additional e)ternal financing$

-ere are the steps%

&. alculate the percent of sales figure for each balance sheet item, as well as the net
 profit margin, and the retention rate.
+. /sing the xternal unds Needed (N formula (shown below, set N to 0,
 plug in the re#uired data, and solve for the change in sales that could be achieved
without any external financing.

*+, - /o0So23hange in sales 4 5o0So23hange in Sales 6 ,et Margin2So 7 3hange

in sales2Retention Rate

where, $o 1 urrent sales2

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 New $ales 1 $& 1 ($o 3 hange in sales

4etention 4ate 1 & * 'ayout 4atio

(ncome Statement 4Percent of Sales

+or the 8ear *nded 9ec. :1st ';;<

% of % of % of
 Sales  Sales  Sales
  2004 2004 2003 2003 2002 2002
$ales 5 6,700,000 &008 5 9,7:0,000 &008 5 9,000,000 &008
ost of ;oods $old 9,<77,=00 <+.=8 9,06=,:00 <&.08 +,600,000 <0.08
Gross Profit 822,500 &7.=8 714,400 &>.08 600,000 +0.08
$elling and ;?) xpenses +7=,000 =.>8 +=0,000 :.:8 +&=,000 7.+8
ixed xpenses >0,000 &.>8 >0,000 +.68 >0,000 9.08
@epreciation xpense +=,000 0.=8 +=,000 0.78 +=,000 0.<8
 Earnings Before Interest and Taes 432,500 >.+8 34!,400 >.98 270,000 >.08
Anterest xpense ::,000 &.68 ::,000 &.<8 ::,000 +.+8
 Earnings Before Taes 366,500 7.<8 283,400 7.=8 204,000 :.<8
Taxes B 608 &6::00 9.&8 &&99:0 9.08 <&:00 +.78
 "et In#o$e 21!,!00 6.78 170,040 6.=8 122,400 6.&8
4etained arnings &9&,>60 :0.08 &0+,0+6 :0.08 79,660 :0.08
 

=alance Sheet
+or the 8ear *nded 9ec. :1st ';;<
% of % of % of
 Sales  Sales  Sales
 ssets 2004 2004 2003 2003 2002 2002
ash and ash #uivalents :0,000 &.98 >7,97: +.:8 6<,000 &.:8
)ccounts 4eceivable +=0,6&: =.98 &7=,000 6.78 &=0,000 =.08
Anventory =&&,=00 &0.>8 9>0,000 &0.68 99=,000 &&.+8
Total Current Assets 821,916   &7.=8 662,376  &7.:8 533,000 &7.<8
'lant ? #uipment =:0,000 &&.>8 =:0,000 &6.>8 =:0,000 &<.78
)ccumulated @epreciation &7=,000 9.78 &=0,000 6.08 &+=,000 6.+8
 Net Plant & Equipment  9<=,000 <.+8 6&0,000 &0.>8 69=,000 &6.=8
Total ssets 1,206,!16   +=.78 1,072,376  +<.=8 !68,000 9+.98
 &ia'ilities and ()ner*s E+it-  
)ccounts 'ayable &9=,000 +.>8 &=&,9=+ 6.08 &+<,000 6.98
 Notes 'ayable +7=,000 =.>8 +7=,000 7.98 +=0,000 <.98
Cther urrent Diabilities 69,>=+ 0.>8 =0,000 &.98 6:,000 &.=8

Total Current ia!ilities "53,952 >.78 "76,352 &+.78 "2",000 &6.&8

DongEterm @ebt +7=,000 =.>8 +=0,000 :.:8 900,000 &0.08
Total ia!ilities 728,952 &=.=8 726,352 &>.98 72",000 +6.&8
CwnerFs apital &==,=:0 9.98 &==,=:0 6.&8 &==,=:0 =.+8
4etained arnings 9++,606 :.>8 &>0,6:6 =.&8 <<,660 +.>8
Total &ia'ilities and ()ner*s E+it- 1,206,!16  +=.78 1,072,376  +<.=8 !68,000 9+.98
 

)oG$o +=.:7>8

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 Net 'rofit Margin 6.:7<8

4etention 4ate :08
urrent $ales 56,700,000
DoG$o +.<7+8
hange in $ales  5:=>,=>&.60

,ote> Used *)cel’s Sol?er function to calculate 3hange in Sales see s#readsheet.

S#readsheet solution

 N 1 Ancrease in )ssets E Ancrease in internal e#uity

N1 +=.:7>8H(hange in $o * +.<7H(hange in $o E I6.:7<8H0.:H(56.7 3 hange in $o

  01 ++.<078H(hange in $o * 0.0+<0H(hange in $o E 5&9&,>&>.:0

hange in $o 1 5&9&,>&>.:G0.+000 1 5:=>,=>&.60

;rowth rate that can be supported with no external funds 1 :=>,=>&.60G6,700,000 1 &6.0998

Ancrease in
Ancrease in $pontaneous Ancrease in
  N1 )ssets E inances E Anternal e#uity
  0.00 = 169,376.48 18,943.47 $150,433.01

/lternati?e method

ompute the Anternal growth rate.

Anternal growth rate 1 (4C) x 4etention 4ateGI& E (4C) x 4etention 4ate

1 (&<.+8 x 0.:GI&E(&<.+8 x 0.: 1 &+.+:8

:. Oats’ R’ Us has a fle)ible credit line with the Midwa! =an". (f Mason decides to "ee#
the debt6e@uit! ratio constant u# to what rate of growth in re?enues can the firm
su##ort$ %hat assum#tions are necessar! when calculating this rate of growth$ /re
these assum#tions realistic in the case of Oats’ R’ Us$ Please e)#lain.

Af a constant debtEe#uity ratio is maintained the firm would be able to achieve a higher rate of
growth. This growth rate is called the sustainable growth rate and is calculated as follows%

Sustainable Growth Rate = R! " Retention Rate = 38.1#

  1  R! " Retention Rate

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Khere 4C 1 6:8 and 4etention rate 1 :08.

The assumptions necessary when calculating the sustainable growth rate include%

&.
+. The
The firm will maintain
Net 'rofit a constant
margin will debtEe#uity ratio.
be constant.
9. Total asset turnover will be constant
6. The retention rate will be constant.
=.
The last three assumptions are unrealistic because they depend on the future performance of
the firm i.e. sales and cost control. ) constant debtEe#uity ratio is a matter of management
 policy and could be met #uite easily.

<. (nitiall! Jim assumes that the firm is o#erating at full ca#acit!. Aow much additional
financing will it need to su##ort re?enue growth rates ranging from 'BC to <;C #er

!ear$
$ee $preadsheet ($preadsheet solution Note% There is a slight difference in the spreadsheet
solutions because it carries out the calculations to a greater degree of mathematical accuracy.

  ;rowth 4ate N (with excel

+=8 5&09,0=6.00

908 5&=0,0=+.<0

9=8 5&>7,0=&.:0

608 5+66,0=0.60

or example% when the growth rate 1 6082 $o 1 6,700,0002 hange in $ales 1 &,<<0,0002 Net
Margin 1 6.:7>8

*+, - /0So23hange in sales 4 50S;2 3hange in sales 4 ,et Margin2So 7 3hange in

sales2Retention Rate*  0.0+<7+H&,<<0,000 E 0.06:7>H:,=<0,000H0.:

1 0.+=:7>H&,<<0,000
1 6<+,7:=.+ * =9,>>9.:0 E &<6,7+:.>+
1 +66,066.:< (within rounding

B. /fter conducting an inter?iew with the #roduction manager Jim reali&es that Oats’ R’
Us is o#erating its #lant at D;C ca#acit! how much additional financing will it need to
su##ort growth rates ranging from 'BC to <;C$

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apacity /tili"ation 1 >08

urrent $ales 1 5 6,700,000

ixed )ssets1 9<=,000
ixed )ssetsG$ales 4atio1 <.&>8
ull apacity $ales1 5 =,+++,+++ 1
6,700,000G>08
ull apacity ixed )ssetsG$ales ratio 7.978
urrent )ssetG$ales ratio 1 &7.6>8
$ales Devel ;rowth rate $ales ull $ales 
capacity exceeding
sales ull capacity
urrent $ales 08 5 6,700,000 5 E
apacity &&8 5 =,+++,+++ 5 =++,+++ 5 E
E57
$ales growth
+=8 5 =,<7=,000 5 =++,+++ 5 :=+,77< 5=
908 5 :,&&0,000 5 =++,+++ 5 <<7,77< 5&0
9=8 5 :,96=,000 5 =++,+++ 5 &,&++,77< 5&6
608 5 :,=<0,000 5 =++,+++ 5 &,9=7,77< 5&>

)oG$o (full +=.:7>8

 Net Margin 6.:7>8
4etention 4ate :08   No New ixed ixed and urren
)ssets Needed vary proportionately w
Cnly urrent )ssets
Ancrease with sales

E. %hat are some actions that Mason can ta"e in order to alle?iate some of the need for
e)ternal financing$ /nal!&e the feasibilit! and im#lications of each suggested action.

$ome actions that Mason can take to alleviate some of the need for external financing include%

&. Ancrease accounts payables by using more trade credit * this would be possible up
to a point but can be risky and expensive especially if the firm could avail itself of
discounts for paying cash.
+. Ancrease accruals * limited scope, could hurt relations with employees.
9. Ancrease profit margins * easier said than done because of competition.
6. Ancrease retention rate * this is a policy decision and is feasible. The scope is
limited, though, because profits are typically only a small portion of sales.
=. Ancrease sales * once again, easier said than done.

F. Aow critical is the financial condition of Oats’ R’ Us$ (s ic"! Hustified in being
concerned about the need for financial #lanning$ *)#lain wh!.

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!ased on the calculations above, CatsL 4L /s can grow another &&8 or so without new
external financing, provided it maintains its net profit margin and retention rate. $ince the
owners are expecting sales to grow by about +=8 E 608 next year, there is a need for planning
their finances, although it does not seem to be critical. The owners could retain all the profits
if necessary, and at a +=8 growth rate they would need to raise another 5=6,+>+. Af financing
 became
and 4C. a problem they could
Their li#uidity choose
ratios to cut
are not too back on their
bad and growth.
although theirThe firm
@ebt has(:0.68
ratio a healthy 4C)a
seems
 bit high, their interest coverage ratio is pretty good at :.:. Thus they should not have too
much of a problem raising the additional funds. 'lanning is essential for success, however.
AtLs therefore a good move on part of icky and Mason to analy"e their financial condition.

I. O#tional Mason #refers not to de?iate from the firm’s ';;< debt6e@uit! ratio what
will the firm’s #ro6forma income statement and balance sheet loo" li"e under the
scenario of <;C growth in re?enue for ';;B ignore feedbac" effects
 

$ee $preadsheet for detailed solution ase6$heet. 'lease, check the numbers in redOO

  Oats’ R’ Us  
'ro orma Ancome $tatement
  +00= +006
$ales :,=<0,000.00 6,700,000
osts (>+.+8 of sales :,0::,>00.00 6,999,=00
Taxable Ancome =&9,&00.00 9::,=00.00
Taxes (608 +0=,+60.00 &6:,:00.00
 Net Ancome 907,<:0.00 +&>,>00.00
4etained arnings (:08 &<6,7&:.00 &9&,>60.00

Oats’ R’ Us  
'ro orma !alance $heet
 
 ssets 2005E 2004 % of sales
ash and ash #uivalents 5 <6,000 :0,000 &.+<8
)ccounts 4eceivable 5 9=0,=<+ +=0,6&: =.998
Anventory 5 7&:,&00 =&&,=00 &0.<<8
Total Current Assets  5 &,&=0,:<+ 821,916  &7.6>8
'lant ? #uipment 5 7<6,000 =:0,000 &&.>&8
)ccumulated @epreciation  5 +6=,000 &7=,000 9.7+8
 Net Plant & Equipment   5 =9>,000 9<=,000 <.&>8
Total ssets . 1,68!,682 1,206,!16   +=.:<8
 &ia'ilities and ()ner*s E+it-  
)ccounts 'ayable 5 &<>,000 &9=,000 +.<78
 Notes 'ayable 5 9<=,000 +7=,000 =.<=8
Cther urrent Diabilities 5 :&,=99 69,>=+ 0.>68
Total Current ia!ilities  5 :9=,=99 "53,952 >.::8
DongEterm @ebt 5 9<=,000 +7=,000 =.<=8

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Total ia!ilities  5 &,0+0,=99 728,952 &=.=&8

CwnerFs apital  5 &==,=:0 &==,=:0 9.9&8
4etained arnings  5 =07,&+0 +&>,>00 6.:<8
Total &ia'ilities and ()ner*s E+it-  5 &,:<>,:<+ 1,206,!16  +=.:<8
 

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