Question Abannister Legal Services Generated 2 Million In Sa

Question Abannister Legal Services Generated 2 Million In Sales Dur

Abannister Legal Services generated $2 million in sales during 2010, and its year-end total assets were $1.5 million. Also, at year-end 2010, current liabilities were $500,000, consisting of $200,000 in notes payable, $200,000 in accounts payable, and $100,000 in accruals. Looking ahead to 2011, the company estimates that its assets must increase at the same rate as sales, its spontaneous liabilities will increase at the same rate as sales, its profit margin will be 5%, and its payout ratio will be 60%. How large a sales increase can the company achieve without having to raise funds externally; that is, what is its self-supporting growth rate?

Paper For Above instruction

The concept of the self-supporting growth rate (SGR), also known as the sustainable growth rate, pertains to the maximum growth rate a company can achieve without needing to seek external financing. It hinges on the firm’s internal generated funds and is constrained by its operational and financial structure. For Abannister Legal Services, understanding its SGR involves analyzing its sales growth, asset requirements, liabilities, profit margin, and dividend payout ratio, all of which influence the firm’s capacity to self-finance its expansion.

To compute the SGR, we utilize the formula:

SGR = Return on Equity (ROE) x Retention Ratio

However, in practical applications, especially when specific ratios are given, it is often more straightforward to estimate the internal growth capacity using the following approach:

SGR = (Net Income / Total Assets) x (1 - Payout Ratio) or equivalently, considering the reinvested earnings and their relationship to asset growth and liabilities.

First, we calculate the net income for 2010:

Net Income = Sales x Profit Margin = $2,000,000 x 5% = $100,000

Next, the retained earnings (retention ratio) are:

Retention Ratio = 1 - Payout Ratio = 1 - 0.6 = 0.4

Thus, the internal funds generated (retained earnings) are:

Reinvested earnings = Net Income x Retention Ratio = $100,000 x 0.4 = $40,000

The initial total assets are $1.5 million, and assets are expected to increase at the same rate as sales. Therefore, the growth rate in assets that can be supported internally without external funding—the SGR—is the ratio of retained earnings to total assets, adjusted for the growth in sales and liabilities.

Furthermore, the spontaneous liabilities increase proportionally with sales. The spontaneous liabilities are initially $500,000, and their increase with sales is projected to be at the same rate as sales growth. This proportional increase helps finance part of the asset expansion, reducing the need for external funds.

Calculating the maximum sales growth rate (SGR) involves the following steps:

  1. Determine the internal funds as a percentage of initial total assets.
  2. Account for the proportional liabilities that will support asset growth.

Step one: Compute the internal funding ratio:

Internal Funds / Total Assets = $40,000 / $1,500,000 ≈ 2.67%

Step two: Use the following formula for the self-supporting growth rate:

SGR = [(Net Income / Total Assets) x (1 - Payout Ratio)] x (Total Assets / Total Assets + Spontaneous Liabilities)

Net income to assets ratio:

Net Income / Total Assets = $100,000 / $1,500,000 ≈ 6.67%

Inserting the values:

SGR ≈ 6.67% x 0.4 x (1 + (Spontaneous liabilities / Total assets))

Spontaneous liabilities are $500,000, and total assets are $1,500,000, so:

Liabilities / Assets = 500,000 / 1,500,000 ≈ 33.33%

This indicates that spontaneous liabilities account for about 33.33% of total assets, supporting asset growth.

Now, consolidate these to determine the sustainable growth rate:

SGR ≈ 6.67% x 0.4 x (1 + 0.3333) = 6.67% x 0.4 x 1.3333 ≈ 6.67% x 0.5333 ≈ 3.56%

Therefore, the approximate self-supporting growth rate for Abannister Legal Services is about 3.56%. This indicates the company can grow its sales by approximately this rate annually without needing external financing, assuming all other factors remain constant.

In conclusion, the self-supporting growth rate provides a critical metric for strategic planning. It reflects the company's ability to expand using internally generated funds while maintaining its current structure of liabilities and profit margins. For Abannister Legal Services, a growth rate of approximately 3.56% suggests cautious expansion that aligns with its internal capital generation capacity and the natural support from spontaneous liabilities. Any growth beyond this rate would necessitate external funding, potentially increasing financial risk and altering the company's optimal capital structure.

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