Introduction to Corporate Finance

16: Financial Planning

Given sales this period of S, a net profit margin (in this case, defined as net income divided by sales)

equal to m, and a dividend payout ratio of d, we can determine the company’s retained earnings next

period:

Retained earnings = S(m)(1 + g)(1 – d)

The product of S and m yields net profits in the current year. Multiplying this product by (1 + g)

results in next year’s profits, and multiplying this result by (1 – d) gives next year’s retained earnings. This

is the amount by which the book equity component of the balance sheet will grow. Next, observe that the

ratio of assets to equity (total assets to ordinary share equity) equals 1 plus the ratio of total liabilities, L,

to shareholders’ equity:

A EL

A

E

EL

E

L

E

=+

=

+

=+ 1

Assuming that the company maintains a constant assets-to-equity ratio is equivalent to assuming that

the ratio of liabilities to equity remains constant. Hence, for each dollar of earnings that the company

retains, it can borrow an additional L/E dollars to keep the mix of debt and equity constant. For example,

if a company finances half of its assets with debt and half with equity, then the ratio L/E equals 1.0. If

the company retains $1 million in earnings in a given year, then it can afford to borrow an additional

$1 million and so maintain the desired mix of debt and equity.

The increase in liabilities next year simply equals the product of next year’s retained earnings and the

ratio of liabilities to equity:

Increasein liabilities=+−



[(Sm)( gd)( )]

L

E

11

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



FIGURE 16.1 SUSTAINABLE GROWTH EQUALITY

As a company grows, it must invest in new assets to support increased sales volume. The investments in new assets must
be financed with some combination of increased liabilities and increased equity.

Increase in assets

Cash

Receivables

Inventories

Fixed assets

Increase in liabilities

Accounts payable

Short-term debt

Long-term debt

Increase in equity

Ordinary shares

Retained earnings

= +