Case Study 2 : Growing Pains

Submitted to:
Mr. Felix D. Cena

Submitted by:
Demetillo, Angel Marie
Emnace, Cheveem Grace C.
Juen, Danica P.
C07

October 28, 2020

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?
We all know how important and beneficial financial forecasting is. Financial forecasting
helps a company estimate and predict how their business will perform in the future. The first and
the most important step that Jim and Mason must do is to forecast their sales. Sales forecasting is
estimating future sales. It is not just a mere prediction of sales because it also enables a company
predict their short-term and long-term performance. Jim and Mason could use the Pro Forma
method which is a method of calculating financial results using certain projections and
presumptions. For them to forecast their sales, they could make a pro forma income statement
and balance sheet by assuming that items from these statements vary in direct proportion with
sales. These assumptions include all expenses grow with the same rate as sales and as for the
balance sheet, current assets, fixed assets, and current liabilities such as accounts payable and
accruals also grow with the same rate as sales. Their assumptions and projections regarding the
sales will depend on the historical data or the financial statements for the past years. Another
method Jim and Mason could use in conducting a financial forecast is the use of AFN equation.
This equation will help the company in calculating how much new funding is required to achieve
the projected sales. Through this equation, they would know how much asset they would need to
generate each amount of sales and whether they should increase that asset and if it is efficient
enough for them to perform in the long run. As what is mentioned above, increase in assets is
dependent on the growth rate in sales. In using this equation, the company should also assume
that increase in assets, spontaneous increase in liabilities and changes in retained earnings is
connected with sales. If there is an increase in asset, there would also be a corresponding increase
in liabilities and equity for it to be balanced. Another assumption is that fixed assets were used at
full capacity because if not, the excess capacity should be adjusted and may be used in raising
dividends, repurchasing stocks, or retiring debt. If this is the case, the AFN would have a
negative balance. Overall, these methods would help the company achieve their higher projected
sales and be able to support its growth thus, enabling them to perform in the long-run.

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?

Oats ‘R’ Us
Income Statement
For the Year Ended December 31, 2004

2004 % of 2003 % of 2002 % of

Sales Sales Sales
Sales $4,700,000 100% $3,760,000 100% $3,000,000 100%
Cost of Goods Sold 3,877,500 82.50% 3,045,600 81% 2,400,000 80%
Gross Profit 822,500 17.50% 714,400 18.99% 600,000 20%
Selling and G&A 275,000 5.85% 250,000 6.65% 215,000 7.17%
Expenses
Fixed Expenses 90,000 1.91% 90,000 2.39% 90,000 3%
Depreciation 25,000 0.53% 25,000 0.66% 25,000 0.83%
Expense
EBIT 432,500 9.20% 349,400 9.29% 270,000 9%
Interest Expense 66,000 1.40% 66,000 1.76% 66,000 2.20%
EBT 366,500 7.80% 283,400 7.54% 204,000 6.80%
Taxes (40%) 146,600 3.12% 113,360 3.01% 81,600 2.72%
Net Income $219,900 4.68% $170,040 4.52% $122,400 4.08%
Retained Earnings $131,940 60% $102,024 60% $73,440 60%

Oats ‘R’ Us
BalanceSheet
For the Year Ended December 31, 2004

2004 % of 2003 % of 2002 % of

Sales Sales Sales
Assets
Cash and Cash $60,000 1.28% $97,376 2.59% $48,000 1.60%
Equivalents
Accounts 250,416 5.33% 175,000 4.65% 150,000 5%
Receivable
Inventory 511,500 10.88% 390,000 10.37% 335,000 11.17%
Total Current 821,916 17.49% 662,376 17.62% 533,000 17.77%
Assets
Plant and 560,000 11.91% 560,000 14.89% 560,000 18.67%
Equipment
Accumulated 175,000 3.72% 150,000 3.99% 125,000 4.17%
Depreciation
Net Plant and 385,000 8.19% 410,000 10.90% 435,000 14.50%
Equipment
Total Assets $1,206,916 25.68% $1,072,376 28.52% $968,000 32.27%

Liabilities and
Owner’s Equity
 Accounts Payable $135,000 2.87% $151,352 4.03% $128,000 4.27%
Notes Payable 275,000 5.85% 275,000 7.31% 250,000 8.33%
Other Current 43,952 0.94% 50,000 1.33% 46,000 1.53%
Liabilities
Total Current 453,952 9.66% 476,352 12.67% 424,000 14.13%
Liabilities
Long-term Debt 275,000 5.85% 250,0000 6.65% 300,000 10%
Total Liabilities 728,952 15.51% 726,352 19.32% 724,000 24.13%
Owner’s Capital 155,560 3.31% 155,560 4.14% 155,560 5.19%
Retained 322,404 6.86% 190,464 5.07% 88,440 2.95%
Earnings
Total Liabilities $1,206,916 25.68% $1,072,376 28.52% $968,000 32.27%
and Owner’s
Equity

A0/S0 = $1,206,916/$4,700,000 A0/S0

= 25.68%

L0/S0 = $135,000/$4,700
L0/S0 = 2.87%

Profit Margin on Sales = Net Income/Sales

Profit Margin on Sales = 4.68%

Retention Ratio = 60%

AFN = (A0/S0)(∆S) – (L0/S0)(∆S) – (M)(S1)(1 – Payout)

$0 = (25.68%)(∆S) – (2.87%)(∆S) – (4.68%)($4,700,000 + ∆S) (60%)
$0 = .2568∆S - .0287∆S – (2.81%)($4,700,000 + ∆S)
$0 = .2568∆S - .0287∆S – $132,070 - .0281∆S
$0 = .20∆S - $132,070
$132,070 = .20∆S
∆S = $132,070/.20
∆S = $660,350

Growth Rate = Change in Sales/Current Sales

Growth Rate = $660,350/$4,700,000
Growth Rate = 14.05%

In calculating the growth rate the company could support without the need for any additional
external financing, we first calculated each balance sheet and income statement items
corresponding percentage out of sales. As what we have mentioned above, increase in sales
may also mean increase in corresponding financial statement items. We then identify the data
needed for calculating the change in sales using the AFN equation. We used the AFN equation
assuming that the additional funds needed is equal to 0 since we’re calculating the growth rate
it could support without the need for additional funds. After calculating the change in sales
which amounted to $660,350, we solved for the growth rate using the formula: Growth Rate =
Change in Sales/Current Sales. The current sales was given in the problem which amounted to
$4,700,000. Lastly, we arrived at 14.05% which is the growth rate the company could support
without the need for any additional external financing. In other words, 14.05% is the
sustainable growth rate of the company or its maximum achievable growth rate with it having
to raise external funds.

3. Oats ‘R’ Us has a flexible credit line with the Midway Bank. If Mason decides to keep the
debt-equity ratio constant, up to what rate of growth in revenue can the firm support?
What assumptions are necessary when calculating this rate of growth? Are these
assumptions realistic in the case of Oats ‘R’ Us? Please explain.
If Mason decided to keep the debt-equity ratio constant, the firm would be able to have a
higher rate of growth rate that can sustain the company without having additional equity or debt,
which is called sustainable growth rate.
In order to solve for the sustainable growth rate, we need to know how profitable the firm
is by getting the Return on Equity first, we divide net income by the total common equity of the
entity (Owner’s Capital + Retained Earnings).
ROE = Net Income
Total Common Equity
= $ 219,900
$ 477,964
ROE = 0.46 or 46%

We can now solve for the sustainable Growth rate by multiplying the ROE by the
retention ratio, Retention Ratio is the proportion of earnings kept back in the business as retained
earnings (Retained Earning/Net Income). Since we calculated ROE by dividing net income by
current year equity instead of using the opening retained earnings, an alternative formula needs
to be used, and that is:

Sustainable Growth Rate = (ROE) (Retention Ratio)

1 – (ROE * Retention Ratio)
= (0.46)(.60)
1 – (0.46)(.60)
Sustainable Growth Rate = 38.12%

The firm can support up to 38.12% if decides to keep the debt-equity ratio constant.
The assumptions needed in calculating sustainable growth are: continue to have a
maximum achievable growth rate without issuing new equity, Sustainable growth rate is the
maximum rate of growth that the company can sustain without additional equity, having this, the
firm can highly maintain its ideal dividend payment ratio and constant debt-equity ratio, which
are also necessary in calculating SGR, because it allows the company to operate without the
additional external funds. The next assumption needed is heighten the sales as market condition
allow which is also realistic to the firm because the firm can generate profits by only using
their internal funds or their spontaneous generated funds. However, the assumption needed
like the Net profit margin, total asset turnover, and retention rate will be constant are unrealistic
for the firm since these depend on the firm’s future performance, and there are a lot of instances
that might affect sales like the new trend, advancement of technology, etc. , and these might
result to an unsteady cost of sales resulting for the profit margin not to be constant. Not all
assumptions are realistic for the firm, it is better to double check it so it will not affect the
financial performance of it.

4. Initially, Jim assumes that the firm is operating at full capacity. How much
additional financing will it need to support revenue growth rates ranging from 25% -
40%?
Growth (A0/S0) (∆S) (L0/S0) (∆S) (M)(S1) Additional
Rate (Retention Ratio) Funds Needed
25% $ 301,740.00 $ 33,722.50 $ 164,970.00 $ 103,047.50
26% $ 313,809.60 $ 35,071.40 $ 166,289.76 $ 112,448.44
27% $ 325,879.20 $ 36,420.30 $ 167,609.52 $ 121,849.38
28% $ 337,948.80 $ 37,769.20 $ 168,929.28 $ 131,250.32
29% $ 350,018.40 $ 39,118.10 $ 170,249.04 $ 140,651.26
30% $ 362,088.00 $ 40,467.00 $ 171,568.80 $ 150,052.20
31% $ 374,157.60 $ 41,815.90 $ 172,888.56 $ 159,453.14
32% $ 386,227.20 $ 43,164.80 $ 174,208.32 $ 168,854.08
33% $ 398,296.80 $ 44,513.70 $ 175,528.08 $ 178,255.02
34% $ 410,366.40 $ 45,862.60 $ 176,847.84 $ 187,655.96
35% $ 422,436.00 $ 47,211.50 $ 178,167.60 $ 197,056.90
36% $ 434,505.60 $ 48,560.40 $ 179,487.36 $ 206,457.84
37% $ 446,575.20 $ 49,909.30 $ 180,807.12 $ 215,858.78
38% $ 458,644.80 $ 51,258.20 $ 182,126.88 $ 225,259.72
39% $ 470,714.40 $ 52,607.10 $ 183,446.64 $ 234,660.66
40% $ 482,784.00 $ 53,956.00 $ 184,766.40 $ 244,061.60

The table above is provided for the purpose of conveying how much additional funds the
company need to support its revenue growth rate ranging from 25% to 40%. The first column is
consist of the growth rates from 25% up to 40%. The second column represents the projected
increase in assets. We calculated that using the formula: Projected increase in assets = (A0/S0)
(∆S) from 25% to 40%. The third column represents the spontaneous increase in liabilities using
the formula: (L0/S0) (∆S) also from 25% to 40%. The fourth column represents the increase in
retained earnings using the formula: (M)(S1)(Retention Ratio). The last column is the additional
funds the company need to support its revenue growth rate ranging from 25% to 40%.We
calculated this by using the AFN equation which is: AFN = Projected increase in sales –
Spontaneous increase in liabilities – Increase in retained earnings or in other words by
subtracting the third and the fourth columns from the second column.

5. After conducting an interview with the production manager, Jim realizes that Oats
‘R’ Us is operating its plant at 90% capacity, how much additional financing will it need to
support growth rates ranging from 25% to 40%?
AFN = Projected Increase in Assets –Spontaneous Increase in Liabilities –Increase in Retained
Earnings

AFN = ( A*/ S0) (ΔS) –(L* / S0) (ΔS) –MS1 (1-d) Sample
computation:
Growth rate : 25%
AFN = Assets/Sales[Sales(25%)] –Liabilities/Sales[Sales(25%)] –(PM)(Retention Ratio)
[Sales(1+0.25)]
AFN = 1 206 916/ 4 700 000[4 700 000(.25)] –135 000/4 700 000[4 700 000(.25)] – (0.04679)
(.60)[4 700 000(1.25)]
AFN = 0.256790638(1175000) –0.028723404(1175000) –(0.028074)(5875000)
AFN = 301 729 –33 750 –164 925
AFN (Growth rate 25%) = 103 054
Note: The same process for each growth rate.
Range Projected Spontaneous Increase in AFN (Full
Increase in Sales Increase in Retained Capacity)
Liabilities Earnings
25% 301,729 33,750 164,925 103,054
26% 313,789.16 35,100 166,244.40 112,453.76
27% 325,867.32 36,450 167,563.80 121,853.52
28% 337,936.48 37,800 168,883.20 131,253.28
29% 350,000.64 39,150 170,202.60 140,653.04
30% 362,074.80 40,500 171,522 150,052.80
31% 374,143.96 41,850 172,841.40 159,452.56
32% 386,213.12 43,200 174,160.80 168,852.32
33% 398,282.28 44,550 175,480.20 178,252.08
34% 410,351.44 45,900 176,799.60 187,651.84
35% 422,420.60 47,250 178,119 197,051.60
36% 434,489.76 48,600 179,438.40 206,451.36
37% 446,558.92 49,950 180,757.80 215,851.12
38% 458,628.08 51,300 182,077.20 225,250.88
39% 470,697.24 52,650 183,396.60 234,650.64
40% 482,766.40 54,000 184,716 244,050.40
Sample Computation
Growth Rate = 25% Difference in Fixed Asset Needed = (Target fixed assets /Sales)(Projected
Sales) – Estimated Fixed Asset [Fixed assets(1.25)]
=(385 000/5 222 222.22)(5 875 000) – (385 000)(481 250)
Difference in Fixed Asset Needed = (48,125)

EFN amounts in bold letters is the additional financing Oats’ R Us will need in order to
support growth rates from 25% - 40%

Full capacity Difference in fixed EFN

asset needed
103,054.00 - 48,125 54,929.00
112,453.76 -48510 63,943.76
121,853.52 -48895 72,958.52
131,253.28 -49280 81,973.28
140,653.04 -49665 90,988.04
150,052.80 -50050 100,002.80
159,452.56 -50435 109,017.56
168,852.32 -50820 118,032.32
178,252.08 -51205 127,047.08
187,651.84 -51590 136,061.84
197,051.60 -51975 145,076.60
206,451.36 -52360 154,091.36
215,851.12 -52745 163,106.12
225,250.88 -53130 172,120.88
234,650.64 -53515 181,135.64
244,050.40 -53900 190,150.40

6. What are some actions that Mason can take in order to alleviate some of the need
for external financing? Analyze the feasibility and implications of each suggested action.
External financing is a kind of funding for the business acquired from sources outside the
company. Bank loans, investments from private individuals or investment firms, grants and
selling company shares are all examples of external financing. There are a disadvantages in
external financing like it require you to give up a portion of the ownership in your company in
exchange for the funding, it require a return on their investment, etc. So we have suggested
actions that Mason can take in order to alleviate some of the need for external financing. The
actions can be, improving the retained earning percentage, improving the profitability margin
to reduce the needs of external financing, and can be increase accounts payables by using
more trade credit.
 Improving the retained earning percentage is feasible. Retained earnings is a portion of
the company’s profit that is retained for future use. It can be used for future expansions paying
dividends to shareholders at a later date. Because of this, the company does not need to acquire
external financing. Meanwhile, improving the profitability margin is important because the
higher profit margin leads to a higher internal funds, therefore, the need for external financing
would be reduce and the company does not have to loan money to fund the business. In order to
achieve this they first need to improve the operational efficiency of the company since profit
margin depends on the company’s performance, and because of this, this action is also feasible.
For the increase in accounts payable by using more trade credit, this means that the company will
pay their suppliers in a long period of time so they will have higher accounts payable. This action
is possible but it is also risky and expensive and this may not be the best since suppliers may not
like that the company is taking a while to pay and the company may lose some discounts,
however, this means that they have a longer payable turnover ratio, that results to more cash in
hand, and more cash in hand alleviate the need of external financing.
These actions we’ve suggested have advantages and disadvantages, we already gave the
possibilities and the company must weigh every detail we talked about so that they will have
better decisions for the company.

7. How critical is the financial condition of Oats ‘R’ Us? Is Vicky justified in being
concerned about the need for financial planning? Explain why.
 
Net Income
Return on assets (ROA) =
Total Asset

307,860
Return on assets (ROA) =
1,689,682.40

Return on assets (ROA) = 0.18

Current Ratio Current Asset 821,916 1.81

Current Liabilitites 453,952
Quick Ratio Current Asset−Inventories 821,916−511,500 0.68
Current Liabilitites 453,952
Debt Ratio Total Liabilities 728 952 60.40%
Total Assets 1206 916
Times Interest EBIT 432 500/349 400 6.55
Earned Ratio Interest Expense
Internal Growth Rate = Retention Ratio x Return on Assets
Internal Growth Rate = 0.6 x 0.18
Internal Growth Rate = 0.1080
Internal Growth Rate = 10.80%
Internal Growth Rate = 11%
The calculations shows that Oats’ R’ Us has an internal growth rate of 11%. This rate is the
maximum Oats’ R’ Us business operations can continue to fund and grow the company, without
issuing new equity or debt. It can achieve growth up to this level without the need of any
external financing, provided it maintains profit margin and retention rate. Noticeably, the growth
rate of 14%, is 3% higher than the internal growth rate of 11%, thus, the firm will need external
sources of capital if internal growth rate is maintained. Furthermore, since the revenues is
expected to grow by about 25% to 40% next year, it is crucial to set out financial and strategic
plans to accommodate and achieve this expected growth. With 25% growth rate, $54,292 still
has to be raised even if the owners were to retain all its profit. There are a lot of factors that may
affect the future operations, and one of the major concerns is its finances. Without proper plan,
Oats’ R’ Us could miss great opportunities, and managing finances may become a problem. If
then, owners may be forced to postpone their expected growth. Hence, Vicky is reasonable for
being concerned about the need for financial planning, since developing and using a financial
plan may enable her to visualise how much resources are needed for the business to grow- which
is crucial for future growth and success. Furthermore, previous calculations shows that the firm
has a healthy Return on Equity, and its liquidity ratios are not too bad either. The interest
coverage ratio of 6.55 may be good enough to allow Oats’ R’ Us have the capacity to raise, or
obtain additional funds, although the firm’s debt ratio is a bit high at 60.40%. On the other hand,
Vicky made a commendable act by initiating a move to plan for the future, by starting from how
much additional funding the firm is going to need for the next year. It allows her to know what
she may need, and how to attain it.