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CLASS 3: CHAPTER 3 ACCOUNTING FOR GROWTH

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GROWTH It is nearly impossible for a company to remain completely unchanged for some long stretch of time E.g. Management changes, technology is improved, accidents may happen. One such change is growth. Companies may grow too slowly they may fail to incorporate new ideas into their business and fall behind the competition E.g. Bought for $580 million sold for just $35 Million recently. Companies may grow too fast ill-advised explosive growth can be harmful or indeed detrimental. What are the Effects of Growth and how can we plan for it?

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FINANCIAL FORECASTING Just like successful students are able to forecast ahead and plan their studying schedules accordingly during finals week, successful businesses must be able to anticipate financing needs long before they are required. Two General Financial Forecasting Methods: Rely on Cash flow analysis Rely upon Balance Sheet Analysis Same Goal: Will our business have enough funding sources to cover our costs? The result is typically a Surplus of funding or a shortfall. Extra or not enough

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CASH BUDGETING Cash Budgeting Analysis consists of summing expected revenues and subtracting expected cast costs. A surplus occurs when an more funding comes than goes out. A deficit occurs when more funding goes out than comes in. We routinely use this sort of analysis in our daily life Do I have enough money in my purse or wallet to eat dinner tonight? Do example 1 p. 72 and 73 on your own for practice. Is Cash Budgeting without difficulty? Absolutely not! What happens if our forecasts are faulty? What if I think I will be paid $100 next week when I am actually only going to receive $50? Cash Flow budgeting is excessively detailed at times long range cash budgeting analysis is difficult because detailed cash flow forecasts are difficult to obtain. Do I know how much my income will be in great detail 2 years from now? Hence the use of Balance Sheets!

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BALANCE SHEET FORECASTS Remember the previous accounting identity: Total Assets = Total Liabilities + Shareholders equity Balance sheet forecasting utilizes this identity by predicting future total assets and future total liabilities and shareholders equity and calculating the difference. Whatever difference arises is considered the External Financing Needs (EFN.) Positive EFN suggests insufficient funds to finance the companys expected assets additional financing should be sought out. Negative EFN suggests a surplus of funding they have more than enough to finance expected assets

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BALANCE SHEET FORECASTS Consider the following company and its balance sheet shown below: Sales = $2,500 and COGS = $1,875. The company realizes that if they cut by 30 days the length of time that inventory stays on the shelf before it is sold, and if all else remains the same, the company reduces the amount of inventory required. What effect does this inventory change have upon external financing needs? Solution: Step 1 calculate length of time inventory stays on shelf Step 2 calculate shelf life after policy change and solve for Balance Sheet Inventory Step 3 Calculate EFN

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BALANCE SHEET FORECASTS In the previous example we have a surplus of funding? What must then happen to our hypothetical Balance Sheet? Can our final Balance sheet have an EFN unequal to zero? IT IS IMPOSSIBLE! We must somehow incorporate the surplus or shortfall into our final balance sheet to equalize total assets and total liabilities plus shareholders equity. We can increase/decrease cash holdings, or increase/decrease dividends paid, etc.

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INTERNAL FINANCING Recall the discussion about New Retained Earnings not all of our Net Income must be paid out as Dividends. The company can choose to retain those earnings and plug them back into the company. A company can diminish EFN by using Internal Financing, or relying upon NRE. Forecasting when internal financing is available necessitates the availability of a forecast for expected futures sales. Steps to Calculating EFN: 1.Given expected future sales calculate necessary Total Assets required. 2.Forecast future Total Liabilities and Shareholders equity. SE will increase because expected sales creates NRE. 3.Compute EFN as the difference between TA and TL+SE Example 3 In Class

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NATURAL GROWTH RATES So given you can grow too slow or too fast, what is the appropriate amount of growth? There is no hard and fast answer but be can rely upon two baseline cases to provide some insight. Growth relying solely on Internal Financing Sustainable Growth Rate

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GROWTH RELYING UPON INTERNAL FINANCING We can easily answer how fast a company can grow relying solely upon internal financing by adopting the reasonable assumption that several of the companys most important financial ratios are stable. The above requires the following to be constant: Asset Turnover Ratio Net Profit Margin Dividend Payout Ratio

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SUSTAINABLE GROWTH RATE Businesses typically target a particular Debt-to-equity ratio as desirable. Reliance upon the Internal Growth rate is problematic in that over time the Debt-to-equity ratio declines thus we move further away from our target. A slight modification results in the following: As before all of this information can be found on the balance sheet or the income statement. Work Example 6 In Class

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CASH FLOW A companys accounting earnings on the income statement equals Net Income. This is a flow. Note however, that analysts may want other flow measures (E.g. company cash flow to investors.) Analysts like information regarding the distribution of a companys wealth; various cash flows illustrate this distribution. What is the net amount of wealth the company transfers to shareholders? How does it change? What is the net cash flow to Lenders or Creditors? How does it change? Sum these together and we have the total cash flow to the financial markets. Why might an analyst be interested in knowing the cash flow to capitalists?

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OTHER CASH FLOW MEASURES Modern capitalist theory suggests that in perfect markets principal and assets profits ultimately return to financial markets. Thus: Similar justification for analyzing Cash Flow To Capitalists applies to Cash Flow from Assets: Capitalists must believe a company will yield sufficient Cash Flow from Assets to justify investments. Using information from the income statement we can substitute into the above equation and get:

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OTHER CASH FLOW MEASURES Many times analysts want a measure of cash flow resulting directly from the companys ordinary operations: If an analysts suspects unusually high taxes he or she may simply look at EBITDA. Nevertheless, Cash Flow from Operations is often portrays a better picture than Net Income of financial health and wealth creation. Combine 3.9 and 3.10 yields:

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OTHER CASH FLOW MEASURES Many analysts may also be interested in the companys Cash Surplus the change in cash from one balance sheet to the next.

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HOMEWORK After this Chapter you have all the necessary knowledge to complete exam 1. Please exercise due diligence when deciding when to take the exam! EFN2b, EFN3a, GR1, GR4, BA3a, GR2d, GR3b, BA14, EFn1b, CF2, CF1c, CF3a, Due: Wednesday! Do not leave all for the last minute.