Reference no: EM1356008

Take the company's most recent financial statements and project a 10% increase in sales.
Determine whether, and how much, external financing would be needed to support the projected increase in sales
Please use finance.google.com for current stock information for JCP which is the company to apply this question to.

Stock symbol (JCP) company JC Penny

Here is the instructor's way to figure out the equation:
When projecting future financial statements, one simple and common technique is to assume that assets will be proportional to sales revenue. In other words, if sales is expected to increase by 10%, then the basic assumption is that assets will have to increase by 10% in order to support that higher level of activity. So the question for the financial manager is: how will those assets be paid for? If the asset side of the balance sheet grows by 10%, then the liability and equity side must grow by 10% (otherwise it would not be a balance sheet, would it?).
The next major concept to understand is Spontaneous Financing. This is a process by which the right side of the balance sheet increases automatically when the asset side increases, just as a result of doing business. As sales increases, you are probably building more inventory, which means current assets is increasing. If sales is increasing, then accounts receivable is probably also increasing, which again is a current asset.

On the other side, if you are building more inventory, that probably means you are ordering more materials from your suppliers, so accounts payable, a current liability, is probably increasing. If you are running more production, wages payable may be increasing. If you use short-term debt, like a line-of-credit, to pay for operating expenses, then with an increased level of sales your short-term debt, a current liability, may be increasing.
Notice how no one makes any major decisions about these increased current liabilities. This all tends to happen automatically, as a result of the increased operating activities. That's why it is called Spontaneous Financing.
The other change on the right side of the balance sheet that happens naturally is retained earnings. Let's assume the company is profitable, meaning it has positive net income. Remember from accounting that net income goes to either one or two places: IF the company pays dividends, then that comes out of net income; whatever is left after paying dividends is added to the retained earnings account on the balance sheet.
Now back to the overall question: is the spontaneous financing enough to pay for the increased assets needed to support the projected increased sales? The External Financing Needed process is a simple model to answer this question.

We start with the current balance sheet, which is of course, balanced (Assets = Liabilities + Equity).
Then we create a proforma balance sheet. If sales are projected to increase by 10%, then we assume that assets will also have to increase by 10%. Then we look at the other side of the balance sheet. We assume that current liabilities will increase by 10% through spontaneous financing. But we do not make any change to long-term liabilities.
We also determine how much retained earnings will increase. If sales increased by 10%, we will assume that net income will also increase by 10%. Then you need to determine how much the company pays out in dividends (if any). You can find this out by looking at the Cash Flow Statement ... the Cash flow from Financing Activities section will identify "cash dividends paid". Determine what percentage those dividends were of that year's net income ... that is the payout ratio. Assume that in the projected year, with net income increased by 10%, the dividend payout ratio will be the same. After those dividends are paid out, whatever is left is then added to the retained earnings account on the balance sheet. This causes Total Equity to increase.

The reason we don't change long-term liabilities is that long-term debt does not happen spontaneously. A financial manager must make a conscious decision to go to the bank to request a loan, or to issue bonds, to raise long-term debt. That is called Discretionary Financing, because it will only occur by a decision, not automatically. The point of this process is to see whether the spontaneous sources of financing are enough to pay for the increased assets needed. If not, then we need additional external financing, which will be either long-term debt, or possibly equity capital raised by selling additional shares of stock.
So now we have a proforma balance sheet in which:
total assets has increased by 10%;
current liabilities has increased by 10%;
long-term liabilities has not changed;
total equity has increased by the amount of retained earnings.

The final question now is: Does the Balance Sheet Balance?
If Total Liabilities + Shareholders' Equity is greater than or equal to Total Assets, that tells us that spontaneous financing (in the form of current liabilities and retained earnings) provides enough capital to pay for the increased assets required to support the increased sales. That means no external financing is necessary.
However, if Total Liabilities + Shareholders' Equity is less than Total Assets, that means spontaneous financing is not sufficient to finance the required increase in assets. This tells us that in order to achieve the projected increase in sales, we need to raise enough external capital to balance the balance sheet. This would either be new long-term debt, or equity capital from the sale of stock.