Financial management revision question and answer

Madawa Chemicals Ltd. is in the process of forecasting its financial needs for the coming year ending 31 October 2003. The company attained a turnover ofSh.300 million for the current year ended 31 October 2002.

The following are the summarized financial statements of the company for the year ended 31 October 2001:
From past experience, it has been disclosed that each additional Sh.1 of sales made the company requires, on average, a total investment in fixed assets, stocks and debtors of Sh.1.50. The Sh.1 additional sales also results in the generation of automatic financing of 40 cents as various creditors spontaneously arise with the increase in sales.

The net profit margin after tax and the dividends payout ratio which apply for the year ended 31 October 2002 will also be relevant into the foreseeable future.

Required:
(a) The amount of external finance that will be needed during the year ending 31 October 2003 if sales are expected to increase 15% in the year.

(b) The maximum expected sales growth that can be achieved in the year ending 31 October 2003 if only internally generated funds are used.

(c) The maximum growth in sales that can be achieved in the year ending 31 October 2003 if the company wishes to maintain its current level of financial gearing.

(d) Briefly comment upon the weaknesses of the method of forecasting used above.
ANSWER


Let g be growth rate: If no eternal funds are used


(c) Financial gearing will gradually fall as the amount of a company‟s retained earnings increases.

(d) Limitation of forecasting method
• The net profit margin may vary from the current 12%
• Companies normally try to maintain a constant or slightly increasing dividend per share rather than the constant dividend payout ratio which is assumed in the question.
• Fixed assets, stocks and debtors are unlikely to increase in direct proportion to sales similarly, creditors.
• Internally generated cash is taken to be retained profits this ignores non-cash items (dep n)

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