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Chapter 17 - Web Appendix 17A

# Chapter 17 - Web Appendix 17A - WEB APPENDIX 17A...

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WEB APPENDIX 17A Forecasting Financial Requirements When Financial Ratios Change The AFN formula as we initially used it assumes that the ratios of assets and liabilities to sales (A 0 */S 0 and L 0 */S 0 ) remain constant over time. This, in turn, requires the assumption that each spontaneous asset and liability item increases at the same rate as sales. In graph form, this implies the type of relationship shown in Panel a of Figure 17A-1, a relationship (1) that is linear and (2) that passes through the origin. Under those conditions, if the company s sales increase from \$200 million to \$400 million, or by 100%, inventory also will increase by 100%, from \$100 million to \$200 million. Four Possible Ratio Relationships (Millions of Dollars) FIGURE 17A-1 Capacity 300 225 150 75 0 100 200 300 Sales (\$) Excess Capacity (Temporary) FA/S 50 Fixed Assets (\$) A B d. Lumpy Assets Sales (\$) 400 200 0 100 200 Inventory (\$) a. Constant Ratios I/S I/S 100/200 = 0.50 = 50% 200/400 = 0.50 = 50% Base Stock 300/200 = 1.50 = 150% 200 0 0 4 0 Sales (\$) 400/400 = 1.00 = 100% Inventory (\$) b. Economies of Scale; Declining Ratios I/S 300 400 200 0 0 4 0 Sales (\$) Inventory (\$) c. Curvilinear Relationship 300 424 17A-1

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The assumption of constant ratios and identical growth rates is appropriate at times, but there are times when it is incorrect. Three such conditions are described in the following sections. Economies of Scale There are economies of scale in the use of many kinds of assets; and when economies occur, the ratios are likely to change over time as the size of the firm increases. For example, retailers often need to maintain base stocks of different inventory items even if current sales are quite low. As sales expand, inventories
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Chapter 17 - Web Appendix 17A - WEB APPENDIX 17A...

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