Page 105External financing needed and growth are obviously related. All other things staying the same, the higher the rate of growth in sales or assets, the greater will be the need for external financing. In the previous section, we took a growth rate as given, and then we determined the amount of external financing needed to support that growth. In this section, we turn things around a bit. We will take the firm’s financial policy as given and then examine the relationship between that financial policy and the firm’s ability to finance new investments and thereby grow.
Once again, we emphasize that we are focusing on growth not because growth is an appropriate goal; instead, for our purposes, growth is simply a convenient means of examining the interactions between investment and financing decisions. In effect, we assume that the use of growth as a basis for planning is just a reflection of the very high level of aggregation used in the planning process.
EFN AND GROWTH
The first thing we need to do is establish the relationship between EFN and growth. To do this, we introduce the simplified income statement and balance sheet for the Hoffman Company in Table 4.6. Notice that we have simplified the balance sheet by combining short-term and long-term debt into a single total debt figure. Effectively, we are assuming that none of the current liabilities varies spontaneously with sales. This assumption isn’t as restrictive as it sounds. If any current liabilities (such as accounts payable) vary with sales, we can assume that any such accounts have been netted out in current assets. Also, we continue to combine depreciation, interest, and costs on the income statement.
Suppose the Hoffman Company is forecasting next year’s sales level at $600, a $100 increase. Notice that the percentage increase in sales is $100/500 = 20%. Using the percentage of sales approach and the figures in Table 4.6, we can prepare a pro forma income statement and balance sheet as in Table 4.7. As Table 4.7 illustrates, at a 20 percent growth rate, Hoffman needs $100 in new assets (assuming full capacity). The projected addition to retained earnings is $52.8, so the external financing needed (EFN) is $100 − 52.8 = $47.2.
Page 106TABLE 4.6
Notice that the debt–equity ratio for Hoffman was originally (from Table 4.6) equal to $250/250 = 1.0. We will assume that the Hoffman Company does not wish to sell new equity. In this case, the $47.2 in EFN will have to be borrowed. What will the new debt– equity ratio be? From Table 4.7, we know that total owners’ equity is projected at $302.8. The new total debt will be the original $250 plus $47.2 in new borrowing, or $297.2 total. The debt–equity ratio thus falls slightly from 1.0 to $297.2/302.8 = .98.
Table 4.8 shows EFN for several different growth rates. The projected addition to retained earnings and the projected debt–equity ratio for each scenario are also given (you should probably calculate a few of these for practice). In determining the debt–equity ratios, we assumed that any needed funds were borrowed, and we also assumed any surplus funds were used to pay off debt. Thus, for the zero growth case, debt falls by $44, from $250 to $206. In Table 4.8, notice that the increase in assets required is simply equal to the original assets of $500 multiplied by the growth rate. Similarly, the addition to retained earnings is equal to the original $44 plus $44 times the growth rate.
TABLE 4.8 Growth and Projected EFN for the Hoffman Company
Page 107FIGURE 4.1 Growth and Related Financing Needed for the Hoffman Company
Table 4.8 shows that for relatively low growth rates, Hoffman will run a surplus, and its debt–equity ratio will decline. Once the growth rate increases to about 10 percent, however, the surplus becomes a deficit. Furthermore, as the growth rate exceeds approximately 20 percent, the debt–equity ratio passes its original value of 1.0.
Figure 4.1 illustrates the connection between growth in sales and external financing needed in more detail by plotting asset needs and additions to retained earnings from Table 4.8 against the growth rates. As shown, the need for new assets grows at a much faster rate than the addition to retained earnings, so the internal financing provided by the addition to retained earnings rapidly disappears.
As this discussion shows, whether a firm runs a cash surplus or deficit depends on growth. Microsoft is a good example. Its revenue growth in the 1990s was amazing, averaging well over 30 percent per year for the decade. Growth slowed down noticeably over the 2000–2010 period; nonetheless, Microsoft’s combination of growth and substantial profit margins led to enormous cash surpluses. In part because Microsoft pays a relatively small d