How To Calculate External Financing Needed

How to Calculate External Financing Needed (EFN)

Determining the amount of external financing needed (EFN) is crucial for any business planning for growth. Understanding this calculation helps businesses avoid cash flow crunches and secure the necessary funds to support expansion. This comprehensive guide will walk you through the process of calculating EFN, exploring different approaches and offering practical tips to improve accuracy and refine your financial forecasting.

Understanding External Financing Needed (EFN)

External Financing Needed (EFN) represents the additional funding a company requires to support its projected sales growth. This funding gap arises when a company's projected assets increase at a faster rate than its spontaneous liabilities and retained earnings. In essence, it’s the difference between a company's projected total assets and its projected total liabilities and equity.

A positive EFN signifies that the company needs to secure external financing – such as loans, equity investments, or debt issuance – to bridge the funding gap. A negative EFN indicates that the company is projecting more funding than needed, potentially allowing for debt reduction or increased dividend payouts.

The Basic EFN Calculation: A Step-by-Step Approach

The fundamental EFN calculation revolves around understanding the relationship between sales growth, asset requirements, and spontaneous financing. Here's a detailed step-by-step guide:

Step 1: Project Sales Growth:

Begin by forecasting your sales growth for the upcoming period. This projection should be based on market research, historical data, and industry trends. The more accurate your sales forecast, the more reliable your EFN calculation will be. Consider using various forecasting techniques, such as regression analysis or time series modeling, to enhance accuracy.

Step 2: Determine the Asset Requirements:

Identify which assets are directly linked to sales growth. For instance, an increase in sales usually requires a corresponding increase in inventory, accounts receivable, and possibly fixed assets (property, plant, and equipment). Estimate the percentage of sales each asset represents (asset/sales ratio). These ratios are usually found by reviewing past financial statements.

• Example: If your inventory consistently represents 20% of your annual sales, and you project a $1 million increase in sales, your projected inventory increase would be $200,000 ($1,000,000 * 0.20).

Step 3: Project Spontaneous Liabilities:

Some liabilities increase automatically with sales growth. Accounts payable, a common example, tends to rise as a company purchases more inventory on credit. Estimate the percentage of sales each spontaneous liability represents (liability/sales ratio).

• Example: If your accounts payable typically represents 10% of annual sales, and you project a $1 million increase in sales, your projected increase in accounts payable would be $100,000 ($1,000,000 * 0.10).

Step 4: Calculate the Increase in Retained Earnings:

Retained earnings represent the portion of net income that isn't paid out as dividends. To calculate the projected increase in retained earnings, you'll need to estimate your profit margin and dividend payout ratio.

• Profit Margin: Net Income/Sales

• Increase in Retained Earnings: Projected Net Income * (1 – Dividend Payout Ratio)

• Example: If your profit margin is 5% and the dividend payout ratio is 40%, a $1 million sales increase would generate a $50,000 increase in net income ($1,000,000 * 0.05). The increase in retained earnings would be $30,000 ($50,000 * (1 - 0.40)).

Step 5: Calculate External Financing Needed (EFN):

Finally, calculate the EFN by summing the increase in assets and subtracting the increase in spontaneous liabilities and the increase in retained earnings:

EFN = Increase in Assets - Increase in Spontaneous Liabilities - Increase in Retained Earnings

Example:

Let's assume the following projections:

• Projected increase in sales: $1,000,000
• Increase in assets (inventory, receivables, fixed assets): $300,000
• Increase in spontaneous liabilities (accounts payable): $100,000
• Increase in retained earnings: $30,000

Therefore, the EFN would be:

EFN = $300,000 - $100,000 - $30,000 = $170,000

This indicates that the company needs an additional $170,000 in external financing to support the projected sales growth.

Advanced Considerations and Refinements

The basic EFN calculation provides a solid foundation, but several factors can enhance its accuracy and applicability:

1. Adjusting for Capacity Utilization:

The basic calculation assumes that existing assets are fully utilized. If you have excess capacity, you may not need to invest as heavily in new assets. Consider adjusting your asset requirements accordingly, reducing the EFN.

2. Accounting for Sales Growth Variation:

Sales growth rarely follows a perfectly linear path. For more accurate projections, incorporate potential variations and scenarios (best-case, worst-case, and most likely). Sensitivity analysis is crucial here.

3. Considering Non-Spontaneous Liabilities:

While the basic calculation focuses on spontaneous liabilities, you might need to include other forms of liabilities (long-term debt, etc.) into your projections, especially for significant growth plans. These need to be planned and incorporated into the financing strategy.

4. Incorporating Depreciation:

Depreciation reduces the need for new asset purchases. Incorporate depreciation expense in your projections to adjust the required investment in fixed assets.

5. Analyzing the Composition of Financing:

The EFN calculation doesn't dictate the type of financing. Analyze the optimal mix of debt and equity financing based on your company's financial health, risk tolerance, and market conditions. Consider the cost of each financing source and their impact on your capital structure.

6. Regular Review and Adjustment:

The business environment is dynamic. Regularly review and adjust your EFN calculations based on updated market conditions, sales performance, and changes in your business strategy. Regular financial forecasting is vital for accurate planning.

Using EFN in Financial Planning and Forecasting

EFN is a critical component of comprehensive financial planning. Here's how it’s used:

• Capital Budgeting: EFN projections inform your capital budgeting decisions, helping determine which projects are feasible given the availability of funding.

• Debt Management: Understanding your EFN helps in planning the appropriate level of debt financing and managing your overall debt burden.

• Equity Financing: EFN calculations guide your equity financing needs, informing decisions on issuing new shares or seeking equity investments.

• Working Capital Management: EFN is crucial for managing working capital, ensuring you have sufficient cash flow to meet your operating expenses and invest in growth opportunities.

• Financial Risk Assessment: The accuracy of your EFN projection directly impacts your risk assessment. An inaccurate EFN projection can lead to liquidity issues or missed growth opportunities.

Conclusion

Calculating external financing needed is a critical skill for anyone involved in financial management. While the basic calculation provides a solid starting point, incorporating the advanced considerations discussed above will significantly enhance the accuracy and usefulness of your EFN projections. By effectively using EFN, businesses can confidently navigate growth opportunities, optimize their financing strategies, and achieve sustainable financial success. Remember that accuracy and regular review are essential for successful financial planning, and that a comprehensive understanding of your business’s financial dynamics is paramount. Seek professional financial advice when needed, especially for complex situations or large-scale expansion plans.