9.8 EFN Solution
EFN = [(A0/S0) ΔS] – [(AP0/S0) ΔS] – [(M0) (S1) (RR0)]
= [(1,000/2,000) (500)]– [(100/2,000) (500)] – [(50.40/2,000) (2,500) (0.70)]
= $250 – 25 – 44.10
= $180.90
Question #1: What does this number mean?
Answer: It means that, if my company wishes to grow its sales next year by $500, it will need to add on $250 worth of assets, of which $180.90 will be funded externally.
Remember: If it wishes to increase assets by $250 in order to achieve its sales objective, it will have to increase the other side of the balance sheet by the same amount. In this case, $25 will be provided internally by accounts payable, $44.10 will be provided internally through retained earnings, and $180.90 will be provided externally by some mix of debt and equity.
Note 1:
- Use spontaneous changes only, that is, AP for liabilities, exclude Notes Payable (NP) and Long-term debt (LTD).
- This was based on a static ratio analysis – our restrictive assumption.
- This has been an incremental analysis; we were only interested in the additional amount of funds needed, and that’s what we got!
Question #2: How much of the $180.90 will be externally funded by debt and how much by equity?
Question #2, Answer 1:
The present debt/equity ratio is 3:7, i.e., 30% debt and 70% equity. Total capital is $1,000, with $300 of debt and $700 of equity (D ÷ TA = 30%). Assuming static analysis, 30% of the $180.90 will be financed by debt and 70% by equity. This will maintain the capital ratios in the same proportions as prior to the new external funding.
Question #2, Answer 2:
Another, perhaps better, way of calculating the debt ratio, for this purpose, would be by excluding internal capital from the figures. In this way, we would be establishing only how much external debt and external equity should be raised, an approach, which would be more consistent with the purpose of the EFN formula. We agreed that the firm needs $180.90 of external funds.
Thus presently, external debt ÷ external equity = 200 ÷ 500; that is 28.5% (2/7) in debt as compared to the total of external capital. We had raised $2 of external debt for every $5 of external equity. Total external capital was $700 (5/7) (not the $1,000 in total capital used in the prior calculation). In this alternate calculation, we have ignored internal accounts payable ($100) and retained earnings ($200). Incremental internal funds will be provided over the coming year as in the past.
Below we illustrate both answers.
Note 2:
In the first two expressions in the EFN model, i.e., [(A0/S0) ΔS] and [(AP0/S0) ΔS], we utilize the incremental, projected sales increase (i.e., ΔS) whereas the third portion [(M0) (S1) (1 – PR0)], we utilize the entire projected sales amount (S1).
Why, in fact, may Financial Ratios change?
In the foregoing analysis, we assumed that financial ratios do not change over time. In fact, ratios are dynamic. Here are some reasons why, in fact, ratios will change.
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- Economies of scale – as companies grow larger and p