Financial plans force managers to be consistent in their goals for growth, investments, SEE BOX and financing. The nearby box describes how one company was brought to its knees when it did not plan sufficiently for the cash that would be required to support its ambitions.
Financial models, such as the one that we have developed for Executive Fruit, can help managers trace through the financial consequences of their growth plans and avoid such disasters. But there is a danger that the complexities of a full-blown financial model can obscure the basic issues. Therefore, managers also use some simple rules of thumb to draw out the relationship between a firm's growth objectives and its requirement for external financing.
Recall that in 1999 Executive Fruit started the year with $1,000,000 of fixed assets and net working capital, and it had $2,000,000 of sales. In other words, each dollar of sales required $.50 of net assets. The company forecasts that sales next year will increase by $200,000. Therefore, if the ratio of sales to net assets remains constant, assets will need to rise by .50 x 200,000 = $100,000.2 Part of this increase can be financed by retained earnings, which are forecast to be $36,000. So the amount of external finance needed is
Required external financing = (sales/net assets) x increase in sales - retained earnings
Sometimes it is useful to write this calculation in terms of growth rates. Executive Fruit's forecasted increase in sales is equivalent to a rise of 10 percent. So, if net assets are a constant proportion of sales, the higher sales volume will also require a 10 percent addition to net assets. Thus
New investment = growth rate x initial assets $100,000 = .10 x $1,000,000
Part of the funds to pay for the new assets is provided by retained earnings. The remainder must come from external financing. Therefore,
2 However, remember our earlier warning that the ratio of saIes to net assets may change as the firm grows.
FINANCE IN ACTION
The Bankruptcy of W.T. Grant: A Failure in Planning
W.T. Grant was the largest and one of the most successful department store chains in the United States with 1,200 stores, 83,000 employees, and $1.8 billion of sales. Yet in 1975 the company filed for bankruptcy, in what Business Week termed "the most significant bankruptcy in U.S. history."
The seeds of Grant's difficulties were sown in the mid-1960s when the company foresaw a shift in shopping habits from inner-city areas to out-of-town centers. The company decided to embark on a rapid expansion policy that involved opening up new stores in suburban areas. In addition to making a substantial investment in new buildings, the company needed to ensure that the new stores were stocked with merchandise and it encouraged customers by extending credit more freely. As a result, the company's investment in inventories and receivables more than doubled between 1967 and 1974.
W.T. Grant's expansion plan led to impressive growth. Sales grew from $900 million in 1967 to $1.8 billion in 1974. For a while profits also boomed, growing from $63 million in 1967 to a peak of $90 million in 1970. Shareholders were delighted. By 1971 the share price had reached a high of $71, up from $20 in 1967.
To achieve the growth in sales, W.T. Grant needed to invest a total of $650 million in fixed assets, inventories, and receivables. However, it takes time for new stores to reach full profitability, so while profits initially increased, the return on capital fell. At the same time, the company decided to increase its dividends in line with earnings. This meant that the bulk of the money to finance the new investment had to be raised from the capital market. W.T. Grant was reluctant to sell more shares and chose instead to raise the money by issuing more than $400 million of new debt.
By 1974 Grant's debt-equity ratio had reached 1.8. This figure was high, but not alarmingly so. The problem was that rapid expansion combined with recession had begun to eat into profits. Almost all the operating cash flows in 1974 were used to service the company's debt. Yet the company insisted on maintaining the dividend on its common stock. Effectively, it was borrowing to pay the dividend. By the next year, W.T. Grant could no longer service its mountain of debt and had to seek postponement of payments on a $600 million bank loan.
W.T. Grant's failure was partly a failure of financial planning. It did not recognize and plan for the huge cash drain involved in its expansion strategy.
Required external financing = new investment - retained earnings
= (growth rate x assets) - retained earnings
This simple equation highlights that the amount of external financing depends on the firm's projected growth. The faster the firm grows, the more it needs to invest and therefore the more it needs to raise new capital. In the case of Executive Fruit,
Required external financing = (.10 X $1,000,000) - $36,000
If Executive Fruit's assets remain a constant percentage of sales, then the company needs to raise $64,000 to produce a 10 percent addition to sales.
The sloping line in Figure 1.20 illustrates how required external financing increases with the growth rate. At low growth rates, the firm generates more funds than necessary for expansion. In this sense, its requirement for further external funds is negative. It may
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