An alternative scenario the assumption that assets

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Unformatted text preview: ratio and the total debt ratio to see if we were comfortable with the new projected debt levels. AN ALTERNATIVE SCENARIO The assumption that assets are a fixed percentage of sales is convenient, but it may not be suitable in many cases. In particular, note that we effectively assumed that Rosengarten was using its fixed assets at 100 percent of capacity because any increase in sales led to an increase in fixed assets. For most businesses, there would be some slack or excess capacity, and production could be increased by perhaps running an extra shift. According to the Federal Reserve, the overall capacity utilization for U.S. industrial companies in July 2007 was 81.9 percent, up from a recent low of 73.9 percent in 2001. If we assume that Rosengarten is operating at only 70 percent of capacity, then the need for external funds will be quite different. When we say “70 percent of capacity,” we mean that the current sales level is 70 percent of the full-capacity sales level: Current sales $1,000 .70 Full-capacity sales Full-capacity sales $1,000/.70 $1,429 This tells us that sales could increase by almost 43 percent—from $1,000 to $1,429—before any new fixed assets would be needed. In our previous scenario, we assumed it would be necessary to add $450 in net fixed assets. In the current scenario, no spending on net fixed assets is needed because sales are projected to rise only to $1,250, which is substantially less than the $1,429 fullcapacity level. CHAPTER 3 Financial Statements Analysis and Long-Term Planning 71 ros82361_ch03.indd 71 7/7/08 3:59:07 PM Confirming Pages As a result, our original estimate of $565 in external funds needed is too high. We estimated that $450 in net new fixed assets would be needed. Instead, no spending on new net fixed assets is necessary. Thus, if we are currently operating at 70 percent capacity, we need only $565 − 450 $115 in external funds. The excess capacity thus makes a considerable difference in our projections. EXAMPLE 3.5 EFN and Capacity Usage Suppose Rosengarten is operating at 90 percent capacity. What would sales be at full capacity? What is the capital intensity ratio at full capacity? What is EFN in this case? Full-capacity sales would be $1,000/.90 $1,111. From Table 3.12, we know that fixed assets are $1,800. At full capacity, the ratio of fixed assets to sales is this: Fixed assets/Full-capacity sales $1,800/1,111 1.62 So, Rosengarten needs $1.62 in fixed assets for every $1 in sales once it reaches full capacity. At the projected sales level of $1,250, then, it needs $1,250 1.62 $2,025 in fixed assets. Compared to the $2,250 we originally projected, this is $225 less, so EFN is $565 225 $340. Current assets would still be $1,500, so total assets would be $1,500 2,025 $3,525. The capital intensity ratio would thus be $3,525/1,250 2.82, which is less than our original value of 3 because of the excess capacity. 3.6 EXTERNAL FINANCING AND GROWTH External financing needed and growth are obviously related. All other things staying the same,...
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