If the payout ratio increases, fewer earnings would be retained as the equity to finance the company’s expansions. This would increase the need for external financing, i. e. AFN.
With a payout ratio less than 100%, a typical firm will have some retained earnings. These additional funds in equity would be used to finance the growth of the company. A sustainable growth rate means the company is having a growth rate where AFN is zero. It is the maximum growth rate which can be financed without external funds.If the profit margin goes up, the higher the profit margin, the larger the net income available and retained earnings to support increases in assets, hence the lower the need for external financing.
This will reduce the amount of AFN needed. The capital intensity ratio is defined as the ratio of required assets to total sales, which is the amount of assets required per dollar of sales. It has a major effect on capital requirements. Companies with higher assets-to-sales ratios require more assets for a given increase in sales. The higher the capital intensity ratio, the more money will be required to support an additional dollar of sales.Therefore, holding other ratios constant, the higher the capital intensity ratio, the greater is the AFN.
If SEC begins paying its suppliers sooner, the account payable amount will be reduced, which decreases the current and total liabilities of the company. With a lower current liability amount as the working capital to support the company’s sales, this would increase the need for external financing. Notes and long-term debt would be increased together to pay for short-term creditors.
The amount of AFN needed, thus, increases.Percent of sales is a method that begins with the sales forecast, expressed as an annual growth rate in dollar sales revenues. Many items on the income statement and balance sheets are assumed to increase proportionally with sales, with their values estimated as percentages of the forecasted sales for the year. The remaining items that are not tied directly to sales depend on the company’s dividend policy and its relative use of debt and equity financing.
There are four steps by using the percent of sales method: 1) Analyses the historical ratios – The objective of this step is to forecast the future, or pro forma, financial statements.The percent of sales method assumes that costs in a given year will be some specified percentage of that year’s sales. The analysis started by calculating the ratio of costs of sales for several past years. And a thorough analysis should have at least five years of historical data. 2) Forecast income statement – To forecast the income statement, we should use the actual data times the forecast basis that the company had determined. Firstly, we should forecast the sales (Actual sales Growth rate).
After that, we can use the forecast sales times other basis to forecast other expense such as the administrative expense.Secondly, we forecast the earnings before interest and taxes (EBIT), assuming that the cost structure will remain unchanged. Thirdly, we should forecast the interest expense; however, two assumptions are needed.
Assumption 1: Specifying the balance of debt for computing interest expense – Interest on loans and debts is calculated base on the amount of debt at the beginning of the year. If the debt remained constant during the year, the balance used for forecasting interest expense would be the amount of debt at the beginning.Besides, we can also us the amount of debts at the end or use the average amount of debts at the beginning and at the ending of the year. Assumption 2: Specify interest rates – As different debts have different interest rate, for forecasting, a single interest rate is applied.
The forecasted interest expense is the net interest expense paid on short-term financing plus the interest on long-term bonds. We estimate the net interest on short-term financing by first finding the interest expense on notes payable and subtracting any interest income from short-term investments.At last, after we forecast the earning before taxes (EBT), we forecast the dividend paid and calculate the addition to retained earning to see how much the company should transfer its income from income statement (addition to retained earnings) to balance sheet (retained earnings). 3) Forecast the balance sheet – For the assets side, these consist of operating current assets plus operating long-term assets. Assuming that each class of assets is proportional to sales, we can determine the amount of new assets needed to support the forecasted sales.For the liability, the percent of sales method assumes that accounts payable and accruals are both proportional to sales, so given the sales forecast we can forecast operating current liabilities.
Most mature companies rarely issue new common stock, so the forecast for common stock is usually the previous year’s common stock. Assuming that there is no preferred stock, by adding the addition to retained earnings, we can arrive at the total of common equity. The remaining difference between the assets and liabilities and equity side would be the long-term bonds and short-term banks loans to finance the company’s operations.
The exact amount would depend on the individual company’s financing policy. 4) Raising the additional Funds Needed – By subtracting the amount of specified sources of financing from the required assets, the AFN required amount is calculated. If the AFN is positive, it means that the company needs to have additional financing and they need to consider how the additional fund should be raised 5) Analysis of the Forecast – This is the last step which is used to examine the projected statement and determine whether the forecast meets the financial targets as was set in the previous years’ financial plan.