                                                       Financial Forecasting  Concepts  Percentage of Sales Method  External Financing Needed  Financial Forecasting Equations  Tools & Problems  Financial Forecasting Exercise  EFN Calculator  EFN Exercise  Financial Forecasting Quiz     ## External Financing Needed (EFN)

Identifying the funds which must be raised in order to support the forecasted sales level is one of the key outputs of the forecasting process. This amount is known as the External Financing Needed (EFN) or Additional Funds Needed (AFN).

In this section, we shall develop approaches which allow the EFN to be identified quickly through the use of an equation. We shall also extend this approach to consider the case when the firm has excess capacity in its fixed assets. The calculations presented on this page are based on the Balance Sheet and Income Statement below.

 Balance Sheet (\$ in Millions) Assets 1999 Liabilities and Owners' Equity 1999 Current Assets Current Liabilities Cash 200 Accounts Payable 400 Accounts Receivable 400 Notes Payable 400 Inventory 600 Total Current Liabilities 800 Total Current Assets 1200 Long-Term Liabilities Long-Term Debt 500 Fixed Assets Total Long-Term Liabilities 500 Net Fixed Assests 800 Owners' Equity Common Stock (\$1 Par) 300 Retained Earnings 400 Total Owners' Equity 700 Total Assets 2000 Total Liab. and Owners' Equity 2000
 Income Statement (\$ in Millions) 1999 Sales 1200 Cost of Goods Sold 900 Taxable Income 300 Taxes 90 Net Income 210 Dividends 70 Addition to Retained Earnings 140

### Full Capacity

The equation used to calculate EFN when fixed assets are being utilized at full capacity is given below. (Please note that this equation is based on the same assumptions that underly the Percentage of Sales Method. Namely that the Profit Margin and the Retention Ratio are constant.) where

• S0 = Current Sales,
• S1 = Forecasted Sales = S0(1 + g),
• g = the forecasted growth rate is Sales,
• A*0 = Assets (at time 0) which vary directly with Sales,
• L*0 = Liabilities (at time 0) which vary directly with Sales,
• PM = Profit Margin = (Net Income)/(Sales), and
• b = Retention Ratio = (Addition to Retained Earnings)/(Net Income).

When the firm is utilizing its assets at full capcacity, A*0 will equal Total Assets. L*0 typically consists of Accounts Payable (and if present Accruals). The logic of underlying this equation can be explained as follows.

• = the required increase in Assets,
• = the "spontaneous" increase in Liabilities, and
• = the "spontaneous" increase in Retained Earnings.

The incresed in Liabilities and Retained Earnings in the equation are considered "spontaneous" because the occur essentially automatically as a consequence of the firm conducting its business.

 Full Capacity Example Use the Balance Sheet and Income Statement above to determine the EFN given that Fixed Assets are being utilized at full capacity and the forecasted growth rate in Sales is 25%. Solution: First calculate the Forecasted Sales. S1 = 1200(1 + .25) = \$1500 Next, solve using the EFN equation. Note that we are substituting (Net Income)/(Sales) for Profit Margin and (Addition to Retained Earnings)/(Net Income) for the Retention Ratio. ### Excess Capacity

If the firm has excess capacity in its Fixed Assets then the Fixed Assets may not have to increase in order to support the forecasted sales level. Moreover, if the Fixed Assets do need to increase in order to support the forecasted sales level, then they will not have to increase by as much as would be required if they were being used at full capacity.

When a firm has excess capacity in its Fixed Assets the first step is to determine the sales level that the existing Fixed Assets can support. This can be determined by dividing Current Sales by the percentage of capacity at which the Fixed Assets are presently being utilized. This sales level is called Full Capacity Sales, SFC. If Forecasted Sales are less than Full Capacity Sales, then fixed assets do not need to increase to support the forecasted sales level. On the other hand, if Forecasted Sales are greater than Full Capacity Sales, then Fixed Assets will have to increase. We shall consider these two cases below.

#### Case 1: S1 Less Than SFC

When the Forecasted Sales are less than or equal to Full Capacity Sales, EFN can be determined in one step using the above equation. The only adjustment is that A*0 now only consists of Total Current Assets since Fixed Assets do not need to increase to suppor the forecasted sales level.

 Excess Capacity Example: S1 < SFC Use the Balance Sheet and Income Statement above to determine the EFN given that Fixed Assets are currently being utilized at 60% of capacity and the forecasted growth rate in Sales is 25%. Solution: First calculate the Forecasted Sales and Full Capacity Sales. S1 = 1200(1 + .25) = \$1500 SFC = 1200/.60 = \$2000 Since Forecasted Sales are less than Full Capacity Sales the EFN can be found in one step. Here A*0 is equal to Total Current Assets which equals \$1200. #### Case 2: S1 Greater Than SFC

When the Forecasted Sales are greater than Full Capacity Sales, EFN can be determined in two steps. The first step, illustrated by the equation for EFN1 below, finds the EFN needed to get to Full Capacity Sales. The second step, illustrated by the equation for EFN2 below, finds the additional EFN to get from Full Capacity Sales to the Forecasted Sales. The total EFN is simply EFN1 plus EFN2. Excess Capacity Example: S1 > SFC Use the Balance Sheet and Income Statement above to determine the EFN given that Fixed Assets are currently being utilized at 90% of capacity and the forecasted growth rate in Sales is 25%. Solution: First calculate the Forecasted Sales and Full Capacity Sales. S1 = 1200(1 + .25) = \$1500 SFC = 1200/.90 = \$1333.33 Since Forecasted Sales are greater than Full Capacity Sales the EFN has to be found in two steps.  © 2002 - 2010 by Mark A. Lane, Ph.D.