The Body Shop was one of the fastest growing manufacturer- retailers in the late 1990s. However, throughout the years, they failed to maintain its brand image by becoming something of a mass-market line. Anita Roddick, the shops founder and Patrick Gournay, CEO are looking for assistance in short and long-term planning for The Body Shop. The goal is to yield practical insights while being straightforward. To get started, we assumed the growth rate for sales is 13%; the cost of goods sold percent change is 38% changes, and a 50% change for operating expenses.
The amount of external financing, the variables affecting the estimates, what the best way to raise the financing, along with important ratios, the internal growth rate, the sustainable growth rate, and future recommendations will all be discussed. External financing helps companies to be profitable and obtain growth. One way to determine if external financing is needed is to look at the pro forma balance sheet, if the trial assets are less than the trial liabilities, a company will not be in need of external financing.
The opposite is also true. If the trial liabilities are less than the trial assets, than the company will be in need of external financing. While looking at the trial assets and liabilities, The Body Shop will not need external financing in 2002. The trail assets are ?187 million compared to the trial liabilities which are ?248 million. However in 2003 and 2004, external financing will be needed. In 2003, the trial assets are approximately ?12 million greater than trial liabilities and in 2004; it is about ?30 million greater.
It seems The Body Shop is in greater need of external financing every year. Another way to determine if external financing is needed is to analysis the external financing equation. Using this method, the company will need external financing for all three years. In 2002, The Body Shop will need ? 27,912 million in external financing. In 2003 and 2004, the need decreases to around ? 15,000 million. 2. Plugging numbers into a formula is always easy, understanding how each number is calculated and what role it plays in determining the answer is more difficult.
In calculation of external funds needed (EFN) for years 2001, 2002, and 2003 we used several figures like current sales, projected sales, net profit margin (NPM), retention ratio, etc. These figures depend greatest on variables like sales growth ratio, cost of goods sold ratio, and operating expenses ratio. The sales growth ratio has a massive impact on current liabilities and current assets. While all three of the variables have an enormous impact the net income and retained earnings and practically every other item on the income statement and balance sheet.
So it is crucial for us to set appropriate ratios as they essentially determine how much external funding we’ll need or don’t need. 3. Let us begin by focusing on Cost of Goods Sold (CoGS). Cost of Goods Sold, as you may know, is the direct costs attributable to the production of the goods sold by a company. (www. investopedia. com) Examples of Cost of Goods Sold are in this case ingredients that the company is using to make their body, bath, and skin care products, direct labor costs associated with production of the products, and material costs.
Let us now observe how a change of CoGS ratio affects the external funds needed for the next three years. At a current level with CoGS ratio at 38%, operating expense ratio of 50%, and expected growth of 13% for each of the next three years we will need ?28. 84 million in 2001 for 2002, ?15. 83 million in 2002 for 2003, and ?16. 27 million in 2003 for 2004. Let us now see if and how the need for external funds will change if we decrease the CoGS ratio to 33% of sales. We notice that some things change, while other don’t.
The EFN for 2002 remains the same, however, the EFN for 2003 and 2004 decreases significantly. The EFN in 2002 for 2003 goes down to ?0. 22 million, a difference of ?15. 61 million and in 2003 the external funds no longer are necessary. But how much in dollar value will this 5% decrease in CoGS represent. In 2002 a 5% decrease of CoGS represents ?21. 14 million. This means that a company will be expected to spend less on materials, ingredients, and direct labor costs in 2002 than they did in 2001, while expecting to increase sales by 13% or ?48. 63 million.
Such move will put a lot of pressure on the company and may not be best for employees and customers as the wages and quality or quantity of products may be reduced. What about operating expenses? Operating expenses is a category of expenditure that a business incurs as a result of its normal business operations. Some examples of operating expenses are employees’ wages, funds for research and development, advertising, maintenance and repair, and utilities. Perhaps these expenses can be managed better and more efficiently to reduce their cost and in turn the need for external financial aid.
A 5% decrease in operating expense represents the same change in EFN as a 5% change in CoGS ratio as both ratios are a percentage of sales, therefore this 5% change represents the same dollar amount change the only difference is what is being changed. Decreasing operating expenses seems like a better choice. Replacing old light bulbs to new ones that are more energy efficient and cutting costs of advertising doesn’t have that immediate effect on employees and customers, although with expenses like advertising being cut it would be difficult to increase sales. What about expected sales growth?
Sales is the variable that affects more items on balance sheet and income statement than operating expense and cost of goods sold. Could it be that this expectation of sales growth of 13% is too high, that the expenses and external financial aid is necessary because of demand for high growth of sales? Let’s try decreasing our expectations of sales growth and observe the effects of that move on our need for external financing. If we keep cost of goods sold ratio and operating expenses ratio constant, but decrease the expected sales growth rate to 3% we notice the significant change in the need for external financing.
The EFN for 2002 decreases form ?27. 92 million to ?7. 67 million in 2002. Sales growth rate is the only thing that can have an effect on the EFN for 2002 as the multiplier, the change in sales, is the only factor that we can change in calculating the EFN for that year. Since, all other variables like assets, net income, and net profit margin are actual and final figures for 2001 that cannot be changed the only option for us to decrease our need for external financing is to decrease our expectation of sales growth. For the EFN numbers for years 2003 and 2004 please refer to the Appendix.
Now, even though we decreased the expected growth rate down to only 3% we still would have a need for external financing. Mike Gulbing will discuss the options we have and ways we can raise the necessary funds to cover the financial need The Body Shop may encounter if we choose to follow a path with the need for external financial aid. 6. Another forecasting tool is the internal growth rate (IGR). This calculation allows investors and financial planners to see how much growth can be financed from retained earnings. The formula is (ROA*retention ration)/[(1-ROA)*retention ration] .
In 2002 the internal growth rate is -2. 58%. A negative IGR indicates external financing will be needed. It shows that a company has no room for growth without external financing. This number matches are forecasting described above. For 2003 the IGR for The Body Shop is 4. 74% and for 2004 it is 5. 26%. When calculating these values, we used the ROA and retention from the previous year to show what growth can be in the coming year. For 2003 and 2004 we see the company can finance about 5% sales growth with cash flows generated from retained earnings. They will not need external financing in these years. . A similar equation and forecasting tool is the sustainable growth rate (SGR). This calculation allows financial planners to see how much revenues can growth without having to invest in new equity capital. The formula used is (ROE*retention ration)/[(1-ROE)*retention ration] . In 2002, the SGR for The Body shop is -1. 25%. This shows new equity capital is needed to sustain growth of the firm. With this equation we see a company’s growth is a function of the return it makes on its shareholders’ equity and the portion of its earnings that it plows back into that equity.
It also shows for true growth to happen, equity has to grow too. In order for this equation to work, the debt to equity ratio must be held constant for the firm. We need more equity if we want to increase debt. It is very important to investors to know how long earnings growth can last. Rapidly growing companies often look the best to investors, but it is important to take these ratios into consideration so you can see if the company can sustain that growth and for how long. The SGR for 2003 is 9. 42% and for 2004 it is 10. 7%.
This shows no external equity needs to be issued for these years. A lot of factors need to be considered when you think about growth rate of a company: If sales grow too slow, you can’t maintain your assets and if you grow too fast you can’t maintain your assets either. It’s very easy to over-forecast when a company is growing rapidly. The above equations are simple estimates and should not be used as the only calculating tool. For The Body Shop, the calculations basically verified we would need external financing for 2002 and not 2003 or 2004. . To conclude, we want to recommend The Body Shop to slow down their growth, at least in 2002. After building additional 100 stores around the world in 2001, as we saw in our data analysis, it is better for The Body Shop to maintain their 2001 level of sales in 2002 and establish stability in a major expansion that they’ve encountered in 2001. Likewise, The Body Shop should obtain bank loans to cover unmet financial needs in 2002 and continue their growth in 2003 and 2004.
In 2003 and 2004, if all goes by the plan, the company should invest leftover money into research and development, try to develop new products, and further expand their customer base by building more shops in more countries and cities. Work Cited 1. Digital image. Copy Mug – Toughts & Ideas. Sanhita Paradkar, 2 Aug. 2010. Web. 4 Feb. 2011. . 2. “Cost Of Goods Sold (COGS) Definition. ” Investopedia. com – Your Source For Investing Education. Web. 4 Feb. 2011. . 3. “Operating Expense Definition. ” Investopedia. com – Your Source For Investing Education. Web. 4 Feb. 2011. .