Business owners who want to grow their firms must find sufficient money to fund the projects they have in mind. It is rare for a company to have enough ready cash on hand for major investments, so most businesses must seek outside funding from investors or lenders. It's essential to determine the amount of capital needed to complete the project accurately. Typically, companies do this by preparing an estimate of the external funds needed (EFN) using a pro forma balance sheet. Lenders, investors and other stakeholders use this EFN estimate to guide their decision-making.
EFN Definition and Explanation
Most business owners want to take advantage of opportunities to expand their firms. Whether the opportunity comes in the form of a merger, acquisition or investment in new capital assets, companies usually don't have the required cash on hand, and that's where external funds needed, or EFN, becomes important.
The EFN definition is the difference between the money a firm can raise from its own profits and savings and the total capital required to complete the proposed project or transaction. A business owner who goes to potential lenders or investors must be prepared to provide an accurate estimate of the money required. Potential stakeholders need this information to assess the risk and profit potential of the transaction.
Estimates of EFN are based on a company's current financial status using pro forma financial statements. A pro forma statement is a projection of the firm's current condition at a future time. For an EFN calculation, you prepare a pro forma income statement and balance sheet that projects the company's status when a proposed project is completed.
Reasons and Sources for External Funding
A person who starts a business might want to avoid outside funding. When lenders and other investors are not involved, the business owner is free to make decisions without negotiating with other stakeholders and does not have to pay interest on loans or share profits with shareholders. However, few businesses can accumulate the ready cash needed to take advantage of available growth opportunities. Accessing external sources of capital can fuel expansion and increase profitability.
Small businesses borrow money from banks or other lenders via loans, credit lines, credit cards and inventory financing. An owner who chooses to seek equity financing may find funding from venture capitalists, angel investors, small investors, friends and family members.
The EFN Formula
To calculate EFN for a project, begin by preparing a pro forma income statement and balance sheet. The actual external funding needed formula is the difference between the assets section of the pro forma balance sheet and the sum of the liabilities and shareholders' sections. The income statement is needed to calculate the projected retained earnings on the pro forma balance sheet.
Estimate the sales for the company. Assume the profit margin will be the same as on the current actual income statement. Subtract the cost of goods sold, operating expenses, interest paid and other expenses to project the net future earnings. Subtract dividends that will be paid to estimate retained earnings.
To create the pro forma balance sheet, add the existing assets, the assets needed to complete the project, and any other assets the firm must acquire by the time the project is completed. For the liabilities section, add existing liabilities and any required borrowing. For the shareholders' equity, add the projected retained earnings to the existing equity section. Subtract the sum of the liabilities and equity section from total assets to find the EFN.
EFN Formula Example
Suppose the ABC Baking Company has $5 million in sales with a net profit of $300,000 on the current income statement. Sales are projected to grow by 10%, so earnings are expected to equal $330,000. The company will pay $80,000 in dividends, leaving $250,000 retained earnings.
ABC Baking has $3 million in assets and will add a projected project cost of $1 million, bringing total assets to $4 million. Existing liabilities equal $1 million with no other borrowing required. Current shareholder equity equals $2 million, to which you add the $250,000 in retained earnings. From projected assets of $4 million, subtract liabilities of $1 million and equity of $2.25 million. The EFN equals $750,000.