Part Three

Dr. Doaa El-Diftar

Lecture 4
 3.4 Internal and Sustainable Growth
PRUFROCK Dividend Payout and Earnings Retention:
Income Statement - 2023
Sales $ 2,311
COGS $ 1,344 Dividend payout ratio “1-b” = cash dividends / net income
Depreciation $ 276 121 / 363 = 0.333 or 33.3%
EBIT $ 691
Interest $ 141
Taxable Income $ 550 Retention ratio “b” = Addition to retained earnings / net
Taxes $ 187 income OR. 1 – div. payout ratio
Net Income $ 363
$242 / 363 = 0.667 or 66.7% OR 1 – 0.33 = 66.7%
Dividends $ 121
Addition to RE $ 242
Investors are interested in knowing how rapidly a firm grows.
A firm has two broad sources of financing: internal and
external.
Internal growth rate
(ROA x b) / (1 – ROA x b) b  retention

The maximum possible growth rate for a firm that relies only on internal
financing. The maximum possible growth rate a firm can achieve without
external financing of any kind.
ROA  b
Internal Growth Rate 
1 - ROA  b
.1012  .667

1  .1012  .667
 7.23%
Sustainable growth rate
(ROE x b) / (1 – ROE x b)

The maximum possible growth rate a firm can grow by using internally
generated funds and issuing debt to maintain a constant debt ratio.

ROE  b
Sustainabl e Growth Rate 
1 - ROE  b
.14  0.667

1 - 0.14  0.667
 10.29%
Example one:
Mulligan, Inc. has net income of $50,000 and total assets of
$400,000. The dividend payout ratio is 0.6. What is the internal
growth rate?

Example two:
Beaver Industries has a total asset turnover rate of 1.8, an
equity multiplier of 1.2, a profit margin of 7%, a retention ratio
of 0.6, and total assets of $300,000, what is the sustainable
growth rate?
3.5 Using Financial Statement Information
Why evaluate financial statements?
• Internal Uses
• Performance evaluation  Management are frequently evaluated
and compensated on the basis of accounting measures of
performance such as profit margin and return on equity.
• Planning for the future  Guide in estimating future cash flows

• External Uses
• Useful to many outside parties such as short-term and long-term
creditor, potential investors, customers, suppliers, stockholders,
competitors, etc.
Choosing a benchmark:
• Ratios need to be compared to something/benchmark in order for
them to be helpful.
• Two ways of choosing a benchmark
• Time-Trend Analysis  Used to see how the firm's performance is
changing over time
• Peer Group Analysis  Compares the firm to other companies in
the same industry
Revision
Problem one:
If jPhone, Inc., has as equity multiplier of 1.65, total asset turnover of
1.8, and a profit margin of 6 percent, what is its ROE?

Problem two:
The Cavo Company has ROA of 9 percent, a profit margin of 6 percent,
and ROE of 17 percent. What is the company’s total asset turnover?
What is the equity multiplier?

Problem three:
Larson, Inc. has total assets of $248,000 and an equity multiplier of 2.5.
What is the debt-equity (D/E) ratio?
Problem four:
It takes Ted's Trucks 85 days, on average, to sell its inventory. Costs of goods
sold for the year are $1,250,000. What is the average value of the firm's
inventory?

Problem five:
Morgan's Industrial Park has total assets of $541,700, long-term debt of
$201,400, total equity of $306,800, fixed assets of $469,200, and sales of
$600,500. The profit margin is 7 percent. What is the current ratio?

Problem six:
Thayer, Inc. has earnings before interest and taxes of $10,350 and net income
of $2,528.50. The tax rate is 35 percent. What is the times interest earned
(TIE) ratio?
Problem seven:
Benet, Inc. has total sales of $128,000 and a profit margin of 12.89
percent. Currently, the firm has 15,000 shares outstanding. What are the
earnings per share?

Problem eight:
Decorative Paintings has total debt of $69,000, total equity of $345,000,
and a return on equity of 10 percent. What is the return on assets?