Question

EFN and Growth Rates. Broslofski Co. maintains a positive retention ratio and keeps its debt–equity ratio constant every year. When sales grow by 20 percent, the firm has a negative projected EFN. What does this tell you about the firm’s sustainable growth rate? Do you know, with certainty, if the internal growth rate is greater than or less than 20 percent? Why? What happens to the projected EFN if the retention ratio is increased? What if the retention ratio is decreased? What if the retention ratio is zero?

Use the following information to answer the next six questions: A small business called The Grandmother Calendar Company began selling personalized photo calendar kits. The kits were a hit, and sales soon sharply exceeded forecasts. The rush of orders created a huge backlog, so the company leased more space and expanded capacity; but it still could not keep up with demand. Equipment failed from overuse and quality suffered. Working capital was drained to expand production, and, at the same time, payments from customers were often delayed until the product was shipped. Unable to deliver on orders, the company became so strapped for cash that employee paychecks began to bounce. Finally, out of cash, the company ceased operations entirely three years later.

Answer 1

1

The sustainable growth rate is greater than 20%, because at a 20% growth rate the negative EFN indicates that there is excess financing still available.

If the firm is 100% equity financed, then the sustainable and internal growth rates are equal and the internal growth rate would be greater than 20%.

However, when the firm has some debt, the internal growth rate is always less than the sustainable growth rate, so it is ambiguous whether the internal growth rate would be greater than or less than 20%.

If the retention ratio is increased, the firm will have more internal funding sources available, and it will have to take on more debt to keep the debt/equity ratio constant, so the EFN will decline.

Conversely, if the retention ratio is decreased, the EFN will rise. If the retention rate is zero, both the internal and sustainable growth rates are zero, and the EFN will rise to the change in total assets.

2

(a)

Do you think the company would have suffered the same fate if its product had been less popular? Why or why not?

Presumably not, but, of course, if the product had been much less popular, then a similar fate would have awaited due to lack of sales

(b)

The Grandmother Calendar Company clearly had a cash flow problem.In the context of the cash fl ow analysis we developed in what was the impact of customers not paying until orders were shipped?

Since customers did not pay until shipment, receivables rose. The firm's NWC, but not its cash, increased. At the same time, costs were rising faster than cash revenues, so operating cash flow declined. The firm's capital spending was also rising. Thus, all three components of cash flow from assets were negatively impacted.

(c)

The firm actually priced its product to be about 20 percent less than that of competitors, even though the Grandmother calendar was more detailed. In retrospect, was this a wise choice?

Apparently not! In hindsight, the firm may have underestimated costs and also underestimated the extra demand from the lower price.

(d)

If the firm was so successful at selling, why wouldn't a bank or some other lender step in and provide it with the cash it needed to continue?

Financing possibly could have been arranged if the company had taken quick enough action. Sometimes it becomes apparent that help is needed only when it is too late, again emphasizing the need for planning.

(e)

Which was the biggest culprit here: too many orders, too little cash, or too little production capacity?

All three were important, but the lack of cash or, more generally, financial resources ultimately spelled doom. An inadequate cash resource is usually cited as the most common cause of small business failure.

(f)

What are some of the actions that a small company like The Grandmother Calendar Company can take if it finds itself in a situation in which growth in sales outstrips production capacity and available financial resources? What other options (besides expansion of capacity) are available to a company when orders exceed capacity?

Demanding cash up front, increasing prices, subcontracting production, and improving financial resources via new owners or new sources of credit are some of the options. When orders exceed capacity, price increases may be especially beneficial

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