How To Calculate External Funds Needed

How to Calculate External Funds Needed (EFN)

Understanding how to calculate External Funds Needed (EFN) is crucial for any business planning for growth. EFN represents the additional financing a company needs to support its projected sales increase. Accurately forecasting EFN helps avoid cash flow shortages and ensures the company can fund its expansion plans effectively. This comprehensive guide will walk you through the process step-by-step, explaining the concepts, providing formulas, and offering practical examples.

Understanding External Funds Needed (EFN)

External Funds Needed (EFN), also known as Additional Funds Needed (AFN), is the difference between a company's projected total assets and its projected total liabilities and equity. Essentially, it shows how much extra money the company needs to raise from external sources (like loans or equity financing) to support its projected growth. If the projected total assets exceed the projected total liabilities and equity, the company needs external funding. Conversely, if projected total liabilities and equity surpass projected total assets, the company will have surplus funds.

Why is calculating EFN important?

• Financial Planning: EFN calculations are a cornerstone of financial planning. They help businesses anticipate funding requirements, allowing for proactive fundraising strategies.
• Growth Management: Accurate EFN forecasts enable companies to manage their growth effectively, avoiding overextension or under-capitalization.
• Investment Decisions: Knowing the EFN allows businesses to make informed decisions about investments, ensuring they have the necessary resources to pursue opportunities.
• Avoiding Financial Distress: By accurately predicting EFN, companies can minimize the risk of financial distress caused by unexpected funding gaps.

The Basic Formula for Calculating EFN

The most common formula for calculating EFN is:

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

Let's break down each component:

1. Projected Increase in Assets

This represents the additional assets the company will need to acquire to support the projected sales increase. The amount of increase in assets is usually directly proportional to the projected increase in sales. For example, an increase in sales might necessitate more inventory, accounts receivable, and fixed assets (like equipment or property). The percentage increase in assets is often estimated based on historical data or industry benchmarks.

• Example: If a company's assets are currently $1 million, and its sales are projected to increase by 20%, and the assets-to-sales ratio is 0.8, then the projected increase in assets would be: ($1 million * 0.8) * 20% = $160,000.

2. Spontaneous Increase in Liabilities

These are liabilities that increase automatically with an increase in sales. The most common spontaneous liabilities are accounts payable, which increase as the company purchases more goods to meet higher sales demands. Similar to the assets increase, the percentage of spontaneous liability increase is also often estimated based on historical data.

• Example: If a company's current accounts payable are $200,000, and the increase in sales is expected to lead to a 15% increase in accounts payable, the spontaneous increase in liabilities would be: $200,000 * 15% = $30,000.

3. Increase in Retained Earnings

This represents the portion of the company's profits that are reinvested back into the business rather than distributed as dividends. The increase in retained earnings is calculated as:

Increase in Retained Earnings = Projected Net Income * (1 - Dividend Payout Ratio)

Where:

• Projected Net Income: This is the company's estimated profit after all expenses are deducted. This is often calculated using the profit margin and projected sales.

• Dividend Payout Ratio: This is the percentage of net income that the company intends to pay out as dividends to shareholders.

• Example: If the projected net income is $100,000 and the dividend payout ratio is 40%, the increase in retained earnings would be: $100,000 * (1 - 0.40) = $60,000.

Putting it All Together: A Comprehensive Example

Let's consider a company with the following financial data:

The company projects a 20% increase in sales next year. Based on historical data, they estimate that assets will increase proportionally with sales at a ratio of 0.8 (assets-to-sales ratio), and accounts payable will increase by 15%.

Calculations:

1. Projected Sales: $1,000,000 * 1.20 = $1,200,000
2. Projected Increase in Assets: ($1,000,000 * 0.8) * 0.20 = $160,000
3. Projected Increase in Accounts Payable (Spontaneous Liabilities): $200,000 * 0.15 = $30,000
4. Projected Net Income: Assume the profit margin remains constant at 10% (Net Income/Sales = $100,000/$1,000,000 = 10%). Projected Net Income = $1,200,000 * 0.10 = $120,000
5. Increase in Retained Earnings: $120,000 * (1 - 0.40) = $72,000
6. EFN: $160,000 - $30,000 - $72,000 = $58,000

Therefore, the company needs an additional $58,000 in external funding to support its projected 20% sales growth.

Advanced Considerations and Refinements

While the basic formula provides a good starting point, several refinements can enhance the accuracy of EFN calculations:

• More Detailed Asset and Liability Projections: Instead of using simple percentages, consider projecting each asset and liability item individually. This requires a deeper understanding of the company's operations and future plans.
• Non-Spontaneous Liabilities: Include other liabilities, such as long-term debt, that may not automatically increase with sales. The change in these items will affect the EFN calculation.
• Working Capital Management: Consider how changes in working capital (current assets - current liabilities) will impact the EFN. Efficient working capital management can significantly reduce EFN requirements.
• Tax Effects: Remember to incorporate the impact of taxes on net income when calculating the increase in retained earnings. Taxes reduce the amount available for reinvestment.
• Sensitivity Analysis: Perform sensitivity analysis by varying key assumptions (like sales growth rate, profit margin, and asset-to-sales ratio) to understand the potential range of EFN requirements. This provides a more robust financial forecast.

Utilizing EFN for Strategic Decision Making

The calculated EFN is not just a number; it’s a critical piece of information for strategic decision-making. Here's how companies can use EFN to their advantage:

• Funding Strategy: The EFN value helps determine the type and amount of external financing required. Options include bank loans, equity financing, issuing bonds, or a combination of these.
• Growth Rate Adjustments: If the EFN is unacceptably high, the company might need to reassess its growth projections or find ways to improve efficiency and reduce asset requirements.
• Investment Prioritization: The EFN analysis can help prioritize investment projects, ensuring that the most promising initiatives are funded first.
• Negotiating with Investors: Understanding the EFN provides a strong foundation for negotiating with potential investors or lenders.

Conclusion

Calculating External Funds Needed is a fundamental process for any business planning for growth. While the basic formula provides a useful starting point, incorporating advanced considerations and performing sensitivity analysis can significantly improve the accuracy and usefulness of the calculation. By understanding and effectively utilizing EFN, companies can make informed decisions about funding, growth, and investment, ultimately enhancing their financial stability and long-term success. Remember to always use historical data and industry benchmarks to refine your estimations for greater accuracy.