Sales to Assets Ratio = 2x
Profit after Tax to Sales = 6%
Debt to Equity Ratio = 1.2
Dividend Payout Ratio = 0.5
Sales in Year 0 = $10 million
Growth Rate = 10% pa
Simplified Balance Sheet ($M)
At End of Year 0
Assets 5.00
Financed by:
Shareholders' Equity 3.33
Borrowing 1.67
Simplified P&L Statement ($M)
For Year 1
Sales 11.00
Profit after Tax 0.66
Dividend 0.33
Retained Profit 0.33
Simplified Balance Sheet ($M)
At End of Year 1
# Assets 5.50
Financed by:
@ Shareholders' Equity 3.66
** Borrowing 1.84
Notes on Balance Sheet at Year 1
# Increase at the same rate as sales
@ = 3.33 (at Year 0) + 0.33 (Retained Profit of Year 1)
** By difference = 5.50 - 3.66
- From the above example, by maintaining the D/E ratio at around 1:2 (3.66 = 2 x 1.83), the company has no difficulty in financing a 10 percent increase in sales in one year.
- By having a zero dividend payout, it can in fact grow at 18 percent per year without increasing its D/E ratio.
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Under the normal circumstances, a company should be able to finance its additional purchase of assets from either
- retained earnings or
- new borrowing or
- a combination of the two.
(1) The company is improperly managed such that it is either not very profitable (or even losing a lot of money) such that the incoming cash is not adequate to support the need to purchase more assets. Or owing to poor management of its assets, it now requires a lot more assets to support its operations.
(2) The company is moving into another line of business which is large relative to its current size and it requires a great deal of additional capital to start up the new venture.
In order to be a prudent investor, we must analyse the situation of the company which has announced a rights issue carefully to see which category it falls into in the first place.
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