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Earnings before income tax

$ 2,439,365

$ 3,797,474

+55.7%

Income tax expense

$

853,778

$ 1,329,116

+55.7%

Net income

$ 1,585,587

$ 2,468,358

+55.7%

FIGURE 7.1
Profit improvement plan for coming year.

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until more is known about the amount of capital that the company will raise from external sources during the coming year.

The final numbers below the earnings before interest and income tax (EBIT) line would be revised if the level of debt were increased. However, this last-minute adjustment shouldn’t be very material.

As Figure 7.1 shows, the business has put together an overall plan for the coming year that would increase its bottom-line profit 55.7 percent over the year just ended, which is impres-sive. However, the profit plan, standing alone, does not reveal the amount of additional capital that will be needed for the increase in assets at the higher level of sales. Sales growth requires more assets to support the higher level of sales revenue and expenses. It would be very unusual to achieve sales growth without increasing assets. Sales growth needs to generate enough profit growth to cover the cost of the additional capital needed for the higher level of assets.

PLANNING ASSETS AND CAPITAL GROWTH

At the close of the business’s most recent year, which is the starting point for the coming year of course, the capital invested in its assets and the sources of the capital are as follows (data is from the company’s balance sheet presented in Figure 4.2): Total assets

$26,814,579

Less operating liabilities

$ 3,876,096

Capital invested in assets

$22,938,483

Short-term and long-term debt

$ 9,750,000

Owners’ equity

$13,188,483

Total sources of capital

$22,938,483

Please recall that operating liabilities (mainly accounts A

Remember
payable and accrued expenses payable) are generated spontaneously from making purchases on credit and from unpaid expenses. These short-term liabilities are non-interest-bearing and are deducted from total assets to determine the
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amount of capital invested in assets. This capital has to be secured from borrowing and from owners’ equity sources.

A Very Quick But Simplistic Method

According to the company’s profit improvement plan for the coming year (Figure 7.1), sales revenue is scheduled to increase 15.6 percent. The business could simply assume that its total assets and operating liabilities would increase the same percent. This calculation yields about a $3.5 million increase in the capital invested in assets (total assets less operating liabilities). Based on this figure the business could anticipate, say, a $1 million increase in debt and a $2.5 million increase in owners’ equity. (At an 8.0 percent annual interest rate the interest expense for the coming year would increase $80,000, and the interest and income tax expenses would be adjusted accordingly.)

This expedient but overly simplistic method for forecasting assets and capital growth has serious shortcomings:

• It assumes that sales revenue drives assets and operating liabilities when in fact only accounts receivable is driven directly by sales revenue; expenses drive the other short-term operating assets and short-term operating liabilities.

• It ignores the actual amount of capital expenditures planned for the coming year; the total investment in new long-term operating resources during a particular year does not move in lockstep with changes in sales revenue that year.

• It does not identify the amount of cash flow from profit during the coming year; in most situations this internal source of cash flow provides a sizable amount of the capital for increasing the assets of the business, which alleviates the need to go to external sources of capital.

The business should match up the increases in sales revenue and expenses with the particular operating assets and liabilities that are driven by the sales revenue and expenses.

Then the amount of capital expenditures planned for the coming year should be factored into the analysis, as well as the planned increase or decrease in the company’s working cash balance (more on this shortly).

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Finally, the business should include the cash flow from profit (operating activities) during the coming year in planning the sources of its total capital needs during the coming year. Cash flow from profit during the coming year probably would not provide all the capital needed for growth, but usually provides a good share of it. Managers have to know the amount of internal capital that will be generated from profit so they know the additional amount of capital they will have to raise from external sources in order to fuel the growth of the business.

A Fairly Quick and Much More

Sophisticated Method

One method for determining changes in assets and liabilities for the coming year and for planning where to get the additional capital for the higher level of assets in the coming year is to use a formal and comprehensive
budget system.
As you probably know, budgeting systems are time-consuming and somewhat costly—although for management planning and control purposes the time and money may be well spent.

Many businesses, even some fairly large ones, do not use budgeting systems. But, they still have to plan for the impending capital needs to support the growth of the business.

This section demonstrates a method for planning assets and capital growth based on the profit improvement plan of the business, one that can be done fairly quickly and that avoids all the trappings of a detailed budgeting system approach. The first step is to forecast the changes in assets and operating liabilities during the coming year—see Figure 7.2. The balance sheet format is used, starting with the closing balances from the year just ended, which are the starting balances for the coming year.

Increases in sales revenue and expenses planned for the coming year drive many of the increases in assets and operating liabilities, as shown in Figure 7.2. The amounts of the increases in short-term operating assets and liabilities are computed based on the changes in sales revenue and expenses for the coming year in the profit improvement plan.

The actual changes in each of these operating assets and liabilities in all likelihood would deviate from these estimates,
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Assets

Based on

Profit

Improvement

Beginning

Plan and

Balances (from Planning

Figure 4.2)

Decisions

Change

Cash

$ 2,345,675

Note 1

$ 200,000

Accounts receivable

$ 3,813,582

15.6%

$ 594,919

Inventories

$ 5,760,173

14.5%

$ 835,225

Prepaid expenses

$

822,899

10.6%

$

87,227

Total current assets

$12,742,329

Property, plant, and equipment

$20,857,500

Note 2

$3,000,000

Accumulated depreciation

($ 6,785,250)

Note 3

($ 943,450)

Cost less accumulated depreciation
$14,072,250

Total assets

$26,814,579

Liabilities and Owners’ Equity

Accounts payable

$ 2,537,232

Note 4

$ 325,108

Accrued expenses payable

$ 1,280,214

10.6%

$ 135,703

Income tax payable

$

58,650

Note 5

$

0

Short-term debt

$ 2,250,000

Total current liabilities

$ 6,126,096

Long-term debt

$ 7,500,000

Total liabilities

$13,626,096

Capital stock (422,823

and 420,208 shares)

$ 4,587,500

Retained earnings

$ 8,600,983

Note 6

$1,868,358

Total owners’ equity

$13,188,483

Total liabilities and owners’ equity

$26,814,579

FIGURE 7.2
Increases in assets, liabilities, and retained earnings.

but probably not by too much—unless the business were to change its basic policies regarding credit terms it offers its customers, its average inventory holding periods, and so on.

To complete the picture the business has to make certain planning decisions for the coming year. These key planning decisions concern capital expenditures, whether to increase its working cash balance, and whether to pay out cash dividends
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to shareowners. Also the amount of depreciation that will be recorded in the coming year needs to be calculated. These key points are summarized as follows:

Planning Decisions for Coming Year

•
Note 1.
The business prefers to increase its working cash balance at least $200,000 to keep pace with the increase in sales growth. At the end of the most recent year its cash balance was about $2.3 million. I discuss in other chapters that there is no standard or generally agreed upon ratio of the working cash balance of a business relative to its annual sales or total assets or any other point of reference.

This business plans to increase its sales revenue in the coming year to about $46 million (Figure 7.1). Whether a $2.3 million working cash balance is sufficient for $46 million annual sales is a matter of opinion. Many businesses would be comfortable with this balance, but many would not. This business believes that it should increase its working cash balance at least $200,000, which is shown in Figure 7.2.

•
Note 2.
Based on a thorough study of the condition, productivity, and capacity of its fixed assets, the business has adopted a $3 million budget for capital expenditures during the coming year. (Usually, the board of directors of a business must approve major capital outlays for investments in new long-term operating assets.) The decision regarding when to replace such items as old machines, equipment, vehicles, tools is seldom clear-cut and obvious. As a rough comparison, these business decisions are similar to deciding when to replace your old high-mileage auto with a new model. Many factors enter into the decisions regarding replacing old fixed assets of a business with newer models that may be more efficient and reliable, or that are needed to expand the capacity of the business.

•
Note 3.
Depreciation expense increases the accumulated depreciation account, which is a
contra,
or negative, account. Its balance is deducted from the fixed assets account in which the original cost of property, plant, and equipment is recorded. An increase in the accumulated depreciation account means that its negative balance
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becomes larger. The amount of depreciation expense for the coming year will be higher than last year because new fixed assets costing $3 million will be purchased during the year. The accounting department calculates the amount of depreciation expense that will be recorded during the com-

ing year.

Recording depreciation expense does not require a cash outlay during the year—just the opposite in fact. The cash inflow from sales revenue includes recovery of part of the original cost of the business’s long-term operating resources (recorded in the property, plant, and equipment account).

Therefore the amount of depreciation expense recorded during a year is added to net income for calculating cash flow from profit for the coming year. (There are other cash flow adjustments to net income as well.)

•
Note 4.
Inventories will increase 14.5 percent, so accounts payable from inventory purchases on credit should increase this percent. Also, the accounts payable liability account includes expenses recorded in the period and that are still unpaid at the end of the period. This component should increase 10.6 percent, which is equal to the percent increase in operating expenses for the coming year. The increase in accounts payable includes both components.

•
Note 5.
Income tax payable may change during the coming year; in any case the increase or decrease is likely to be rel-

TEAMFLY

atively minor, so a zero change is entered for this liability.

•
Note 6.
Net income planned for the coming year equals $2,468,358 according to the profit improvement plan (Fig-

ure 7.1). The board of directors would like to pay $600,000

cash dividends to shareowners during the coming year.

Therefore retained earnings would increase $1,868,358

($2,468,358 net income − $600,000 cash dividends to shareowners).

The forecast changes in operating assets, liabilities, and retained earnings that are presented in Figure 7.2 provide the essential information for determining the
internal
cash flow from profit for the coming year. Cash flow from profit may not be all the capital needed for growth, however. The business probably will have to go to its external sources for additional capital.

Cash flow from profit (operating activities) during the coming
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year is based on the profit improvement plan and the increases in operating assets and liabilities forecast for the coming year. The first section in Figure 7.3 calculates cash flow from profit, which is then compared with the demands for capital during the coming year. In this way the amount of additional capital from external sources is determined.