If sales increase, more assets are required, which increases the AFN. 2. If the payout ratio were reduced, then more earnings would be retained, and this would reduce the need for external financing, or AFN. Note that if the firm is profitable and has any payout ratio less than 100 percent, it will have some retained earnings, so if the growth rate were zero, AFN would be negative, i.e., the firm would have surplus funds. As the growth rate rose above zero, these surplus funds would be used to finance growth. At some point, i.e., at some growth rate, the surplus AFN would be exactly used up. This growth rate where AFN = $0 is called the “sustainable growth rate,” and it is the maximum growth rate which can be financed without outside funds, holding the debt ratio and other ratios constant. 3. If the profit margin goes up, then both total and retained earnings will increase, and this will reduce the amount of AFN. 4. The capital intensity ratio is defined as the ratio of required assets to total sales, or a * /s 0 . Put another way, it represents the dollars of assets required per dollar of sales. The higher the capital intensity ratio, the more new money will be required to support an additional dollar of sales. Thus, the higher the capital intensity ratio, the greater the AFN, other things held constant. 5. If SEC begins paying sooner, this reduces spontaneous liabilities, leading to a higher AFN. Mini Case: 1 2 4 - 13
e. Briefly explain how to forecast financial statements using the percent of sales approach. Be sure to explain how to forecast interest expenses. Answer: Project sales based on forecasted growth rate in sales. Forecast some items as a percent of the forecasted sales, such as costs, cash, accounts receivable, inventories, net fixed assets, accounts payable, and accruals. Choose other items according to the company’s financial policy: debt, dividend policy (which determines retained earnings), common stock. Given the previous assumptions and choices, we can estimate the required assets to support sales and the specified sources of financing. The additional funds needed (AFN) is: required assets minus specified sources of financing. If AFN is positive, then you must secure additional financing. If AFN is negative, then you have more financing than is needed and you can pay off debt, buy back stock, or buy short-term investments. Interest expense is actually based on the daily balance of debt during the year. There are three ways to approximate interest expense. You can base it on: (1) debt at end of year, (2) debt at beginning of year, or (3) average of beginning and ending debt. Basing interest expense on debt at end of year will over-estimate interest expense if debt is added throughout the year instead of all on January 1. It also causes circularity called financial feedback: more debt causes more interest, which reduces net income, which reduces retained earnings, which causes more debt, etc.
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- Balance Sheet, Generally Accepted Accounting Principles, AFN