How to Calculate External Financing Needed

External Financing Needed (EFN) is a financial projection tool that helps businesses determine the additional funding they will require to support planned growth. This calculation estimates the capital a company needs from outside sources, such as loans or equity investments, to finance increased sales and operations. Understanding EFN is important for strategic financial planning, allowing businesses to anticipate future funding gaps and secure necessary resources.

Key Financial Concepts for Forecasting

Forecasting future financial needs involves understanding core financial concepts that influence a company’s funding requirements. Sales growth is a primary driver, as increased sales necessitate more assets to produce and sell goods or services. This expansion requires financing.

Certain balance sheet accounts, called “spontaneous accounts,” naturally fluctuate with sales volume. Spontaneous assets like inventory and accounts receivable increase as sales rise to support higher production and credit sales. For instance, a growing company needs more raw materials and finished goods, and may extend more credit to customers.

Spontaneous liabilities, such as accounts payable, also increase with sales. As a business expands and purchases more supplies, its outstanding payments to suppliers grow. These liabilities provide natural financing, as they represent funds a company uses without immediate payment, reducing external financing needed.

A company’s profitability and dividend policy also determine internal funding. The profit margin, net income divided by sales, indicates profit per dollar of sales. A higher profit margin means more cash is retained to fund growth.

The dividend payout ratio is the proportion of net income distributed to shareholders. The retention ratio, or plowback ratio, represents the percentage of net income reinvested into the business. A higher retention ratio means more earnings are kept, reducing reliance on external financing.

The External Financing Needed Calculation

Calculating EFN typically involves the Percent of Sales Method, which projects financial statement items as a percentage of sales. This approach estimates how much additional funding is required for projected sales increases. The calculation compares the increase in assets needed for higher sales with spontaneous liabilities and retained earnings generated internally.

The first component is the increase in assets required due to sales growth. This is found by taking current assets as a percentage of current sales, then multiplying that ratio by the projected change in sales.

Next, the increase in spontaneous liabilities is accounted for, as these liabilities automatically grow with sales and provide funding. This is calculated by taking current spontaneous liabilities as a percentage of current sales, then multiplying that percentage by the projected change in sales. This figure represents financing spontaneously generated through operations as sales expand.

The third component is the increase in retained earnings, representing internally generated funds for reinvestment. This amount is calculated by multiplying projected new sales by the company’s profit margin, then by the retention ratio (1 minus the dividend payout ratio).

The full EFN formula synthesizes these components: EFN = (Assets/Sales) Change in Sales – (Spontaneous Liabilities/Sales) Change in Sales – (Profit Margin New Sales Retention Ratio). Consider an example: a company with current sales of $1,000,000, assets that are 60% of sales ($600,000), and spontaneous liabilities that are 10% of sales ($100,000). Sales are projected to increase to $1,200,000, a change of $200,000.

If the company has a profit margin of 5% and a retention ratio of 70%, we calculate the EFN. The increase in assets needed is (0.60 $200,000) = $120,000. The increase in spontaneous liabilities is (0.10 $200,000) = $20,000. The increase in retained earnings is (0.05 $1,200,000 0.70) = $42,000.

Plugging these values into the EFN formula: EFN = $120,000 (increase in assets) – $20,000 (increase in spontaneous liabilities) – $42,000 (increase in retained earnings). This results in an EFN of $58,000. This $58,000 represents the additional external financing the company needs to support its projected sales growth.

Analyzing Your External Financing Needs

Once the EFN calculation is complete, the resulting figure provides insights for a company’s financial strategy. A positive EFN indicates that projected sales growth requires more funding than the company can generate internally. The business will need to seek additional capital from external sources.

Conversely, a negative EFN suggests the company generates more internal funds than needed for projected sales growth. In this scenario, the business may have surplus cash. This cash could reduce existing debt, repurchase shares, increase dividends, or invest in new projects. A negative EFN can signal strong financial health.

Businesses use the calculated EFN figure to inform strategic financial planning decisions. If a positive EFN is identified, management can determine appropriate external funding mechanisms, such as securing new bank loans, issuing bonds, or raising equity. The EFN amount quantifies the financing gap, allowing for precise negotiations.

Changes in financial variables significantly impact the EFN result. A higher projected sales growth rate leads to a greater need for external financing, as more assets are required. A decrease in profit margin or an increase in dividend payout ratio (reducing retention ratio) lessens internally generated funds, increasing EFN. Understanding these relationships helps businesses assess the financial implications of their policies.