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I
In this chapter we return to the business example introduced
in Chapter 3 and whose external financial statements are
interpreted in Chapter 4. The business™s financial perform-
ance for the year just ended was satisfactory at best. For
instance, the business™s profit ratio on sales (bottom-line net
income divided by sales revenue) was just 4.0 percent. Its
lackluster profit ratio resulted in a return on equity (ROE) of
only 12.0 percent. Its shareowners have made it clear that the
business should do better than this.


Later chapters explain analysis tools and strategies
for improving profit. This chapter starts with the
profit improvement plan for the coming year that has been
developed by the business. The chapter focuses on the addi-
tional amount of capital that the business will need to carry
out its profit improvement plan. The main theme of the chap-
ter is this: Profit planning also requires capital planning.
Managers cannot simply assume that the needed capital will
become available like manna from heaven. They should deter-
mine how much additional capital would be needed to support
profit growth and they should plan for the sources of the new
capital.


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A S S E T S A N D S O U R C E S O F C A P I TA L


PROFIT GROWTH PLAN
The business has developed an ambitious profit improvement
plan for the coming year. Sales goals have been established for
virtually every product the business sells. Sales pricing will be
more aggressive. (The very important effects of changes in sales
volume and sales price are examined in later chapters.) Adver-
tising and sales promotion programs have been approved. Cost
control will be a top priority in the coming year. To replace its
old machines, equipment, tools, and vehicles the board of
directors has approved a capital expenditures budget for the
coming year. The business is optimistic that it can achieve its
profit and return on equity goals for the coming year.
Figure 7.1 summarizes the company™s profit plan for the
coming year. Actual results for the year just ended are shown
for comparison, as well as the percent increases over the year
just ended. Note that interest expense has a question mark
after it. At this point the exact amount of debt for the coming
year is not known. The business will need to increase its
assets to support the higher sales level next year, which
means it will need more capital to invest in its assets.
Some of the additional capital may come from increasing
its debt”by borrowing more money from its lenders. Clearly,
the amount of the business™s debt will not decrease given the
planned increase in sales revenue. So the interest expense for
the year just ended is carried forward for the coming year




Year Just Coming
Ended Year Change
$45,857,625 +15.6%
Sales revenue $39,661,250
$28,589,255 +14.5%
Cost-of-goods-sold expense $24,960,750
$17,268,370 +17.5%
Gross margin $14,700,500
$12,675,896 +10.6%
Variable and fixed operating expenses $11,466,135
$ 4,592,474 +42.0%
Earnings before interest and income tax $ 3,234,365
$ 795,000 ? + 0.0%
Interest expense $ 795,000
$ 3,797,474 +55.7%
Earnings before income tax $ 2,439,365
$ 1,329,116 +55.7%
Income tax expense $ 853,778
$ 2,468,358 +55.7%
Net income $ 1,585,587
FIGURE 7.1 Profit improvement plan for coming year.



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C A P I TA L N E E D S O F G R O W T H


until more is known about the amount of capital that the com-
pany will raise from external sources during the coming year.
The final numbers below the earnings before interest and
income tax (EBIT) line would be revised if the level of debt
were increased. However, this last-minute adjustment
shouldn™t be very material.

As Figure 7.1 shows, the business has put together an overall
plan for the coming year that would increase its bottom-line
profit 55.7 percent over the year just ended, which is impres-
sive. However, the profit plan, standing alone, does not reveal
the amount of additional capital that will be needed for the
increase in assets at the higher level of sales. Sales growth
requires more assets to support the higher level of sales rev-
enue and expenses. It would be very unusual to achieve sales
growth without increasing assets. Sales growth needs to gen-
erate enough profit growth to cover the cost of the additional
capital needed for the higher level of assets.

PLANNING ASSETS AND CAPITAL GROWTH
At the close of the business™s most recent year, which is the
starting point for the coming year of course, the capital invested
in its assets and the sources of the capital are as follows (data is
from the company™s balance sheet presented in Figure 4.2):


Total assets $26,814,579
Less operating liabilities $ 3,876,096
Capital invested in assets $22,938,483

Short-term and long-term debt $ 9,750,000
Owners™ equity $13,188,483
Total sources of capital $22,938,483




A Please recall accrued expenses payable) are generated
that operating liabilities (mainly accounts
Remember payable and
spontaneously from making purchases on credit and from
unpaid expenses. These short-term liabilities are non-interest-
bearing and are deducted from total assets to determine the

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A S S E T S A N D S O U R C E S O F C A P I TA L


amount of capital invested in assets. This capital has to be
secured from borrowing and from owners™ equity sources.


A Very Quick But Simplistic Method
According to the company™s profit improvement plan for the
coming year (Figure 7.1), sales revenue is scheduled to increase
15.6 percent. The business could simply assume that its total
assets and operating liabilities would increase the same per-
cent. This calculation yields about a $3.5 million increase in
the capital invested in assets (total assets less operating liabili-
ties). Based on this figure the business could anticipate, say, a
$1 million increase in debt and a $2.5 million increase in
owners™ equity. (At an 8.0 percent annual interest rate the
interest expense for the coming year would increase $80,000,
and the interest and income tax expenses would be adjusted
accordingly.)
This expedient but overly simplistic method for forecasting
assets and capital growth has serious shortcomings:
• It assumes that sales revenue drives assets and operating
liabilities when in fact only accounts receivable is driven
directly by sales revenue; expenses drive the other short-
term operating assets and short-term operating liabilities.
• It ignores the actual amount of capital expenditures
planned for the coming year; the total investment in new
long-term operating resources during a particular year
does not move in lockstep with changes in sales revenue
that year.
• It does not identify the amount of cash flow from profit dur-
ing the coming year; in most situations this internal source
of cash flow provides a sizable amount of the capital for
increasing the assets of the business, which alleviates the
need to go to external sources of capital.
The business should match up the increases in sales rev-
enue and expenses with the particular operating assets and
liabilities that are driven by the sales revenue and expenses.
Then the amount of capital expenditures planned for the com-
ing year should be factored into the analysis, as well as the
planned increase or decrease in the company™s working cash
balance (more on this shortly).


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Finally, the business should include the cash flow
from profit (operating activities) during the coming
year in planning the sources of its total capital needs during
the coming year. Cash flow from profit during the coming year
probably would not provide all the capital needed for growth,
but usually provides a good share of it. Managers have to
know the amount of internal capital that will be generated
from profit so they know the additional amount of capital they
will have to raise from external sources in order to fuel the
growth of the business.

A Fairly Quick and Much More
Sophisticated Method
One method for determining changes in assets and liabilities
for the coming year and for planning where to get the addi-
tional capital for the higher level of assets in the coming year
is to use a formal and comprehensive budget system. As you
probably know, budgeting systems are time-consuming and
somewhat costly”although for management planning and
control purposes the time and money may be well spent.
Many businesses, even some fairly large ones, do not use
budgeting systems. But, they still have to plan for the impend-
ing capital needs to support the growth of the business.
This section demonstrates a method for planning assets
and capital growth based on the profit improvement plan of
the business, one that can be done fairly quickly and that
avoids all the trappings of a detailed budgeting system
approach. The first step is to forecast the changes in assets
and operating liabilities during the coming year”see Figure
7.2. The balance sheet format is used, starting with the clos-
ing balances from the year just ended, which are the starting
balances for the coming year.
Increases in sales revenue and expenses planned for the
coming year drive many of the increases in assets and operat-
ing liabilities, as shown in Figure 7.2. The amounts of the
increases in short-term operating assets and liabilities are
computed based on the changes in sales revenue and
expenses for the coming year in the profit improvement plan.
The actual changes in each of these operating assets and lia-
bilities in all likelihood would deviate from these estimates,


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A S S E T S A N D S O U R C E S O F C A P I TA L




Assets
Based on
Profit
Improvement
Beginning Plan and
Balances (from Planning
Figure 4.2) Decisions Change
Cash $ 2,345,675 Note 1 $ 200,000
Accounts receivable $ 3,813,582 15.6% $ 594,919
Inventories $ 5,760,173 14.5% $ 835,225
Prepaid expenses $ 822,899 10.6% $ 87,227
Total current assets $12,742,329
Property, plant, and equipment $20,857,500 Note 2 $3,000,000
Accumulated depreciation ($ 6,785,250) Note 3 ($ 943,450)
Cost less accumulated depreciation $14,072,250
Total assets $26,814,579

Liabilities and Owners™ Equity
Accounts payable $ 2,537,232 Note 4 $ 325,108
Accrued expenses payable $ 1,280,214 10.6% $ 135,703
Income tax payable $ 58,650 Note 5 $ 0
Short-term debt $ 2,250,000
Total current liabilities $ 6,126,096
Long-term debt $ 7,500,000
Total liabilities $13,626,096
Capital stock (422,823
and 420,208 shares) $ 4,587,500
Retained earnings $ 8,600,983 Note 6 $1,868,358
Total owners™ equity $13,188,483
Total liabilities and owners™ equity $26,814,579
FIGURE 7.2 Increases in assets, liabilities, and retained earnings.




but probably not by too much”unless the business were to
change its basic policies regarding credit terms it offers its

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