Introduction to Corporate Finance

16: Financial Planning

The bottom line for Walk-A-Bout Shoes is that its pro forma outlook is quite good. If the company

achieves its sales growth target and keeps expenses and current asset and current liability accounts in line

with historical norms, then it can invest $20 million in new fixed assets while reducing its outstanding

interest-bearing debt.

In one sense, this conclusion is hardly surprising. If we take the 2016 data for Walk-A-Bout Shoes

and plug it into Equation 16.1, we find that the company’s sustainable growth rate is 31.8%. Therefore,

the company’s target growth rate of 30% should leave it with some financial ‘slack’. Going through the

added steps to build pro forma statements provides the company with much more information than

does the sustainable growth rate alone. With the figures in Tables 16.1 and 16.2 programmed into a

spreadsheet, analysts could easily study the effects of changes in any of the assumptions – such as Walk-

A-Bout Shoes’ ability to pay down debt – or identify a need to increase the credit line balance.

A Shorthand Approach for Estimating External Funds Required

We can use the notation defined earlier to present another shorthand approach for estimating the amount

of external funds required (EFR) – the external financing that a company will require. Equation 16.2

states that the EFR is a function of three factors. The first term in the equation, (A/S)ΔS, indicates the

additional investment in assets required for a company if it plans to maintain its total asset turnover ratio

and increase the dollar volume of sales by ΔS. The second term measures the inflow of funds available to

finance this growth. The inflow represented by the second term assumes that the relationship between

a company’s sales and its spontaneous liabilities (in this case, accounts payable (AP)) remains constant.

The third term captures the additional financing inflows that the company creates internally through

retained earnings. Thus, we have:

Eq. 16.2 EFR=∆−∆

A

S

S

AP

S

Sm−+Sg() 11 ()––d

If we apply this shorthand calculation to Walk-A-Bout Shoes, we can determine its external funds

requirement (in thousands of dollars):

=×−×

−











××+×−=

EFR
,

() ()

 ()( ),

$116, 250

$250 000

$75, 000

$19,500

$250, 000

$75, 000

$32, 175

$250, 000

$250, 000 10 .3010.50 $8 111

Under the assumptions of this model, Walk-A-Bout Shoes will require additional external funding of

$8.1 million. In the pro forma projections in Table 16.2, Walk-A-Bout Shoes’ total external financing

actually declines by $6.7 million.^4 Why the discrepancy? Closer examination of the pro forma statements

reveals that several of the assumptions in Equation 16.2 do not hold in a more complete analysis. For

instance, from 2016 to 2017, Walk-A-Bout Shoes’ ratio of assets to sales is not constant, as the equation

assumes; instead, the ratio declines from 0.465 to 0.419. Walk-A-Bout Shoes is increasing sales more

rapidly than assets, so its funding needs are actually less than Equation 16.2 assumes. When we

4 Comparing Table 16.1 and Table 16.2 produces a $5 million reduction in long-term debt and a $1.7 million ($5.0 million – $3.3 million)
reduction in the line of credit. The figures are imprecise because the interest expense and outstanding debt figures in Table 16.2 are not
fully reconciled.

external funds required

(EFR)

The expected shortage or

surplus of financial resources,

given the company’s growth

objectives

With what frequency do

companies construct pro

forma financial statements for

planning purposes?

thinking cap

question

Daniel Carter, Vice

President of Finance,

BevMo!

‘We use information

on our expectations to

manage expectations of

investors.’

See the entire interview on

the CourseMate website.

COURSEMATE

SMART VIDEO

Source: Cengage Learning