How do I find external financing need (EFN) using this equation with the pro forma statements provided: EFN = (asset/sales * change in sales – spontaneous liabilities/sales * change in sales – PM * projected sales * (1-d) 2019 Income Statement 2020 Pro Forma Income Statement Sales:
790.9 Dividends: -498.6 Addition to retained earnings:
174.9 Accounts receivable: 741.8 Inventory: 1,366.4 Other current assets: 174.1 Total current assets: 2,457.2 Net plant and equipment: 1,266.4 Other long-term assets: 76.3 Total assets:
192.8 Accrued expenses: 348.9 Short-term debt: 3.0 Total current liabilities: 544.7 Long-term debt: 342.0 Other long-term liabilities: 209.2 Total liabilities: 1,095.9 Common stock and paid-in surplus: 70.1 Retained earnings: 2,633.9 Total equity: 2,704.0 Total liabilities and owners’ equity: $3,799.9 External financing needs (EFN): 121.21
The Correct Answer and Explanation is:
To find the External Financing Needed (EFN), we use the following formula:EFN=(AssetsSales×ΔSales)−(Spontaneous LiabilitiesSales×ΔSales)−(PM×Projected Sales×(1−d))\text{EFN} = \left(\frac{\text{Assets}}{\text{Sales}} \times \Delta \text{Sales}\right) – \left(\frac{\text{Spontaneous Liabilities}}{\text{Sales}} \times \Delta \text{Sales}\right) – \left(\text{PM} \times \text{Projected Sales} \times (1 – d)\right)EFN=(SalesAssets×ΔSales)−(SalesSpontaneous Liabilities×ΔSales)−(PM×Projected Sales×(1−d))
Where:
- Assets/Sales is the ratio of total assets to sales (reflects how much asset investment is needed per dollar of sales),
- Spontaneous liabilities/Sales is the ratio of liabilities that vary with sales (like accounts payable and accrued expenses) to sales,
- Δ Sales is the change in sales from 2019 to 2020,
- PM is the profit margin (Net income / Sales),
- d is the dividend payout ratio.
Step-by-step Calculation:
1. Gather values:
- 2019 Sales = $790.9
- 2020 Projected Sales = Let’s assume they increased by 15%. So, ΔSales=790.9×0.15=118.635\Delta \text{Sales} = 790.9 \times 0.15 = 118.635ΔSales=790.9×0.15=118.635 Projected Sales=790.9+118.635=909.535\text{Projected Sales} = 790.9 + 118.635 = 909.535Projected Sales=790.9+118.635=909.535
2. Asset/Sales Ratio:Total AssetsSales=3,799.9790.9≈4.803\frac{\text{Total Assets}}{\text{Sales}} = \frac{3,799.9}{790.9} \approx 4.803SalesTotal Assets=790.93,799.9≈4.803
3. Spontaneous Liabilities/Sales Ratio:
Spontaneous liabilities usually include:
- Accrued expenses = 192.8
- Accounts payable (missing here but likely in total current liabilities)
- Let’s assume spontaneous liabilities = 192.8 + 348.9 = 541.7
Spontaneous LiabilitiesSales=541.7790.9≈0.685\frac{\text{Spontaneous Liabilities}}{\text{Sales}} = \frac{541.7}{790.9} \approx 0.685SalesSpontaneous Liabilities=790.9541.7≈0.685
4. Profit Margin (PM):Addition to Retained Earnings=174.9Dividends=498.6Net Income=174.9+498.6=673.5\text{Addition to Retained Earnings} = 174.9 \text{Dividends} = 498.6 \text{Net Income} = 174.9 + 498.6 = 673.5Addition to Retained Earnings=174.9Dividends=498.6Net Income=174.9+498.6=673.5PM=673.5790.9≈0.8517d=498.6673.5≈0.74\text{PM} = \frac{673.5}{790.9} \approx 0.8517 \quad d = \frac{498.6}{673.5} \approx 0.74PM=790.9673.5≈0.8517d=673.5498.6≈0.74
5. Apply EFN formula:EFN=(4.803×118.635)−(0.685×118.635)−(0.8517×909.535×(1−0.74))\text{EFN} = \left(4.803 \times 118.635\right) – \left(0.685 \times 118.635\right) – \left(0.8517 \times 909.535 \times (1 – 0.74)\right)EFN=(4.803×118.635)−(0.685×118.635)−(0.8517×909.535×(1−0.74))=569.79−81.28−(0.8517×909.535×0.26)= 569.79 – 81.28 – (0.8517 \times 909.535 \times 0.26)=569.79−81.28−(0.8517×909.535×0.26)=569.79−81.28−201.51≈287.0= 569.79 – 81.28 – 201.51 \approx 287.0=569.79−81.28−201.51≈287.0
If the actual EFN is 121.21, that would imply a lower increase in sales than 15%, or a different set of spontaneous liabilities.
Summary:
The EFN equation helps companies estimate how much external financing they need to support projected growth. It considers the investment in new assets, funding from spontaneous liabilities, and retained earnings generated from projected profits. Accurate inputs are essential. Even small errors in estimating sales growth, liabilities, or profit margins can lead to significant changes in EFN. The formula is a helpful planning tool to avoid underestimating or overestimating financing needs.
