The change in retain earnings is added to the beginning RE EFN is the plug

# The change in retain earnings is added to the

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Compute the change in retain earnings using the formula ∆RE = NI – Div. The change in retain earnings is added to the beginning RE. EFN is the plug figure to make the balance sheet balance 5 AFN Equation Method AFN (or EFN) Key Assumptions Each type of asset grows proportionately with sales Payables and accruals grow proportionately with sales Operating at full capacity Constant profit margin Constant dividend payout ratio If the fixed asset is operating at less than full capacity, we need to check what is the capacity sales (i.e., what is the sales figure when fixed asset is operating at full capacity If the capacity sales are greater than the forecasted sales, no new fixed assets are needed. capacity of % sales Actual Sales Capacity = 6 Cont’d EFN or AFN = required increase in asset – increase in spontaneous liability – change in retained earnings = (A*/S) S – (L*/S) S – MS 1 ( 1 – d) A* = assets that vary directly with sales L* = liabilities that increase spontaneously with sales S = original sales S 1 = total sales projected for next year (based on projection) S =change in sales (based on projection) M =profit margin ; d = dividend payout ratio Where : 7 Cont’d EFN or AFN = required increase in asset – increase in spontaneous liability – change in retained earnings What if EFN is negative? Excess funds 8 Internal Growth Rate The max growth rate that can be achieved with no external financing of any kind. In other words, retained earnings as the only source of financing. In general, Required increase in assets = spontaneous increase in current liabilities + addition to retained earnings Since no externally financing EFN = 0, and here we assume that all liabilities are non-spontaneous: Required increase in assets = addition to retained earnings If EFN = -ve, addition to earnings > required increase in assets to support the current sales. The current sales growth rate is less than the internal growth rate Internal Growth Rate 9 Cont’d The internal growth rate can be calculated as follows: b ROA x - 1 b ROA x Rate Growth Internal = Where ROA = return on asset ; b = retention ratio 10 Sustainable Growth Rate The max growth rate a firm can be achieved with no external equity financing (i.e., only using retained earnings) while maintain a constant debt-to-equity ratio. Here we assume that the debt-to- equity ratio is optimal.  #### You've reached the end of your free preview.

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• Winter '14
• Balance Sheet, Generally Accepted Accounting Principles
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