9.6: The EFN Formula Explained

You will observe that the EFN formula has three parts (separated by two minus signs).

E FN = [(A 0 /S 0 ) Δ S )] – [( AP 0 /S 0 ) Δ S ] – [(M 0 ) (S 1 ) ( R R 0 )]

The first part represents the required increase in total assets [(A 0 /S 0 ) Δ S )] needed to sustain the projected sales increase. Last year, assets equal to A 0 were required by the firm to sustain a sales level equal to S 0 . Hence, we formulate the ratio A 0 /S 0 . Assuming this ratio remains static, next year, the firm will require so much more in assets ; this is arrived at by multiplying the ratio by Δ S , the projected sales increase ; Δ S = S 1 – S 0 .

However, some of this “gross requirement ” will be “ spontaneously ” or “automatically” met by the normal business generation of “ internal ” funds in the manner of spontaneous liabilities, by which we primarily refer to accounts payable (not notes payable o r the current portion of long-term debt payable). Last year, such internal funds represented a certain percentage of sales: (A 0 /S 0 ) . If we multiply this dollar figure by the projected sales increase ( Δ S ) , we may see to what extent spontaneous liabilities reduce the original “gross requirement. ”

Finally, the firm will also – hopefully – generate and retain some of its earnings, thereby further reducing its “gross requirement . ” If we take the firm ’ s net profit margin (NI/S = M 0 ) and multiply it by next year’s sales (S 1 ) , we get next year’s projected net profits: ( M 0 ) (S 1 ) = NI 1 . If we the net profit margin (i.e., M 0 = NI/S) times next year’s sales, we get next year’s net profits. I f we further multiply this by the firm’s retention rate ( R R 0 ), we get the firm’s projected retained earnings.

After all is said and done, we have a figure – the dollar amount of EFN – that enables the firm to plan for next year’s acquisition of external financing , and hence increased asset levels in support of the planned sales increase . Interesting ly , this formula does not instruct us relative to the extent to which the external requirement should be met by either debt or equity , and in what Debt-to-Equity proportion.

• ΔS = S 1 – S 0
• M 0 = NI / S
• RR = (NI – D) / NI = A.R.E. / NI = 1 – PR