Chapter 3, Problem 3MC

Summary Introduction

To determine: The sustainable growth rate of the given company, external funds needed for the given company, pro forma income statement, pro forma balance sheet at sustainable growth rate and the financial ratios.

Sustainable Growth Rate:

It refers to the maximum growth that a company can have without using external funds or increasing the financial leverage of the company.

External Funds:

It refers to the funds that have been provided to the business or company from outside. These funds could be for short term, that is, for a period of less than 1 year or long term, that is, for the period of more than 1 year, which is decided on the basis of need of the funds.

Financial Ratios:

It refers to the measure of comparing and investing the relationships between different aspects of financial information.

Explanation of Solution

Solution:

Given,

Company ECY has recently employed Person DE to provide assistance in the short-term financial planning and the financial performance of the company. Person LW, the founder of Company ECY has provided the below information to Person DE in order to start his analyses:

Inventory of the company is $6,627,300.

Current assets of the company are $15,823,700.

Current liabilities of the company care $21,320,300.

Sales of the company are $210,900,000.

Total assets of the company are $117,304,900.

Cost of goods sold is $148,600,000.

Accounts receivables of the company are $5,910,800.

Total debt of the company is $\left(\$21,320,300+\$36,400,000\right)=\$57,720,300$.

EBIT of the company is $30,229,000.

Interest of the company is $3,791,000.

Net income of the company is $15,862,800.

Total equity of the company is $59,584,600.

The formula to calculate sustainable growth rate is,

$\text{Sustainable Growth Rate}=\frac{\text{ROE}\times \left(1-\text{d}\right)}{1-\text{ROE}\times \left(1-\text{d}\right)}$

ROE refers to return on equity and “d” is the dividend payout percentage.

Where d is the dividend payout ratio.

Substitute 26.62% for ROE and 30% for d in the above formula.

$\begin{array}{c}\text{Sustainable Growth Rate}=\frac{26.62\%\times \left(1-30\%\right)}{1-26.62\%\times \left(1-30\%\right)}\\ =22.90\%\end{array}$

The sustainable growth of the company is 22.90 or 23%.

Pro forma income statement when growth rate is 23% is,

E.C Company Pro forma Income Statement
Particulars	Amount
Sales $\left(210,900,000\times 123\%\right)$	259,407,000
Cost of goods sold $\left(148,600,000\times 123\%\right)$	(182,778,000)
Other expenses $\left(25,192,000\times 123\%\right)$	(30,986,160)
Depreciation	(6,879,000)
Earnings before interest and taxes (EBIT)	38,763,840
Interest	(3,791,000)
Taxable income	34,972,840
Taxes (40%)	(13,989,136)
Net Income	20,983,704
Dividends $\left(19,511,244\times 30\%\right)$	(6,295,111)
Addition to retained earnings	14,688,593

Table (1)

Pro forma balance sheet is,

E.C Company Pro forma Balance Sheet ($ in millions)
Assets	Amount
Current Assets
Cash $\left(3,285,600\times 123\%\right)$	4,041,288
Accounts Receivable $\left(5,910,800\times 123\%\right)$	7,270,284
Inventory $\left(6,627,300\times 123\%\right)$	8,151,579
Total Current Assets	19,463,151
Fixed Assets
Net plant and equipment $\left(101,481,200\times 123\%\right)$	124,821,876
Total Assets	144,285,027
Liabilities and Owners’ Equity
Current Liabilities
Accounts payable $\left(6,977,700\times 123\%\right)$	8,582,571
Notes payable $\left(14,342,600\times 123\%\right)$	17,641,398
Total Current Liabilities	26,223,969
Long Term Debts	36,400,000
Owner’s Equity
Common Stock	5,580,000
Retained Earnings $\left(54,004,600\times 123\%\right)$	66,427,872
Total liabilities and owners’ equity	134,631,841

Table (2)

The formula to calculate additional funds needed is,

$\text{External Funds Needed}=\text{Total Assets}-\text{Total Liabilities and Equity}$

Substitute $144,285,027 for total assets and $134,631,841for total liabilities and equity in the above formula.

$\begin{array}{c}\text{External Funds Needed}=\$144,285,027-\$134,631,841\\ =\$9,653,186\end{array}$

External funds needed are $9,653,186 million.

The formula to calculate current ratio is,

$\text{Current Ratio}=\frac{\text{Current Assets}}{\text{Current Liabilities}}$

Substitute $19,463,151 for current assets and $22,925,171 for current liabilities in the above formula.

$\begin{array}{c}\text{Current Ratio}=\frac{\$19,463,151}{\$22,925,171}\\ =0.85\end{array}$

Current ratio of the company is 0.85.

The formula to calculate quick ratio is,

$\text{Quick Ratio}=\frac{\text{Current Assets}-\text{Inventory}}{\text{Current Liabilities}}$

Substitute $19,463,151 for current assets, $8,151,579 for inventory and $22,925,171 for current liabilities.

$\begin{array}{c}\text{Quick Ratio}=\frac{\$19,463,151-\$8,151,579}{\$22,925,171}\\ =0.49\end{array}$

Quick ratio of the company is 0.49.

The formula to calculate asset turnover ratio is,

$\text{Assets Turnover}=\frac{\text{Sales}}{\text{Total Assets}}$

Substitute $259,407,000 for sales and $120,944,351 for total assets in the above formula.

$\begin{array}{c}\text{Assets Turnover}=\frac{\$259,407,000}{\$120,944,351}\\ =2.14\end{array}$

Asset turnover ratio is 2.14.

The formula to calculate inventory turnover ratio is,

$\text{Inventory Turnover}=\frac{\text{Cost of Goods Sold}}{\text{Inventory}}$

Substitute $182,778,000 for cost of goods sold and $8,151,579 in the above formula.

$\begin{array}{c}\text{Inventory Turnover}=\frac{\$182,778,000}{\$8,151,579}\\ =22.42\end{array}$

Inventory turnover ratio is 22.42.

The formula to calculate receivable turnover ratio is,

$\text{Receivable Turnover}=\frac{\text{Sales}}{\text{Accounts Recievable}}$

Substitute $259,407,000 for sales and $7,270,284 for accounts receivable in the above formula.

$\begin{array}{c}\text{Receivable Turnover}=\frac{\$259,407,000}{\$7,270,284}\\ =35.68\end{array}$

Receivable turnover ratio is 35.68.

The formula to calculate debt ratio is,

$\text{Debt Ratio}=\frac{\text{Total Debt}}{\text{Total Assets}}$

Substitute $\left(\$22,925,171+\$36,400,000\right)=\$59,325,171$ for total debt and $120,944,351 for total assets in the above formula.

$\begin{array}{c}\text{Debt Ratio}=\frac{\$59,325,171}{\$120,944,351}\\ =0.49\end{array}$

Debt ratio of the company is 0.49.

The formula to calculate debt equity ratio is,

$\text{Debt Equity Ratio}=\frac{\text{Total Debt}}{\text{Total Equity}}$

Substitute $59,325,171 for total debt and $73,239,784.48 $\left(\$5,580,000+\$67,659,784.48\right)$ for total equity in the above formula.

$\begin{array}{c}\text{Debt Equity Ratio}=\frac{\$59,325,171}{\$73,239,748.48}\\ =0.81\end{array}$

Debt equity ratio of the company is 0.81.

The formula to calculate equity multiplier is,

$\text{Equity Multiplier}=\frac{\text{Total Asset}}{\text{Total Equity}}$

Substitute $120,944,351 for total asset and $73,239,748.48 for total equity in the above formula.

$\begin{array}{c}\text{Equity Multiplier}=\frac{\$120,944,351}{\$73,239,748.48}\\ =1.65\end{array}$

Equity multiplier is 1.65.

The formula to calculate interest coverage ratio is,

$\text{Interest Coverage}=\frac{\text{EBIT}}{\text{Interest}}$

Substitute $37,181,670 for EBIT and $4,662,930 for interest in the above formula.

$\begin{array}{c}\text{Interest Coverage}=\frac{\$37,181,670}{\$4,662,930}\\ =7.97\end{array}$

Interest coverage ratio of the company is 7.97.

The formula to calculate profit margin is,

$\text{Profit Margin}=\frac{\text{Net Income}}{\text{Sales}}\times 100$

Substitute $19,511,244 for net income and $259,407,000 in the above formula.

$\begin{array}{c}\text{Profit Margin}=\frac{\$19,511,244}{\$259,407,000}\times 100\\ =7.52\%\end{array}$

The formula to calculate return on asset is,

$\text{Return on Asset}=\frac{\text{Net Income}}{\text{Total Assets}}\times 100$

Substitute $19,511,244 for net income and $120,944,351 for total asset.

$\begin{array}{c}\text{Return on Asset}=\frac{\$19,511,244}{\$120,944,351}\times 100\\ =16.13\end{array}$

Return on asset is 16.13%.

The formula to calculate return on equity is,

$\text{Return on Equity}=\frac{\text{Net Income}}{\text{Total Equity}}\times 100$

Substitute $19,511,244 for net income and $73,239,748.48 for total equity in the above formula.

$\begin{array}{c}\text{Return on Equity}=\frac{\$19,511,244}{\$73,239,748.48}\times 100\\ =26.64\%\end{array}$

Return on equity of the company is 26.64%.

The formula to calculate dividend payout percentage is,

$\text{Dividend payout ratio}=\frac{\text{Dividend}}{\text{Net income}}\times 100$

Substitute $4,759,301 for dividend and $15,862,800 for net income in the above formula.

$\begin{array}{c}\text{Dividend payout ratio}==\frac{4,759,301}{15,862,800}\times 100\\ =30\%\end{array}$

Dividend payout ratio of the company is 30%.

The formula to calculate retention payout percentage is,

$\text{Retention payout ratio}=\frac{\text{Net income}-\text{Dividend}}{\text{Net income}}\times 100$

Substitute $4,759,301 for dividend and $15,862,800 for net income in the above formula.

$\begin{array}{c}\text{Retention payout ratio}=\frac{15,862,800-4,759,301}{15,862,800}\times 100\\ =\frac{11,103,499}{15,862,800}\times 100\\ =70\%\end{array}$

Retention payout ratio of the company is 70%.

Thus, the ratios those are dependent on the fixed asset, long term liabilities or common stock are changed due to the growth level of the company and rest ratios are same.