When you are trying to grow your business, you need to tackle some large projects, such as adding a new store or factory. However, businesses face the same problem that individuals face. Few have the cash needed on hand to undertake major projects. That's where external financing comes into play.
For an individual, this might mean getting a home mortgage. For a business, external financing can mean either borrowing the money or finding investors. External financing needed, or EFN, is the term used for an estimate of the amount of outside funding a business will require to complete a proposed transaction.
The Concept of External Financing Needed
EFN is an estimate of the funding required to complete a proposed transaction or project based on the current financial status of the business. This external financing summary is derived from pro forma financial statements that project the probable financial condition of the company, such as a pro forma income statement and balance sheet.
The pro forma financial statements used to calculate EFN include the information usually found on the current statements. They do not include allowances for one-time or unusual expenses or income that is not part of the firm's normal operations. External financing may mean additional debt, equity provided by investors or both.
Businesses can access a range of sources to raise capital, including banks, credit vehicles such as lines of credit, bonds and the sale of stock. Small businesses may rely on venture capital, small investors and even friends and family members.
Preparing Pro Forma Statements
In order to calculate EFN, you first need to collect the necessary data. Typically, this is accomplished by preparing a pro forma income statement that covers the period for which you want to figure EFN. Start with the current income statement and make a realistic estimate of sales and costs for the period. Assume the same profit margin as the current income statement.
Suppose the income statement for the Deluxe Widgets Company shows $4 million in sales and a 5% profit of $200,000 for the previous year. The project for which you want to know EFN will be completed within the next year. If you assume a 10% growth in sales and net profit, this gives you a sales projection of $4.4 million on the pro forma income statement and net profit of $220,000.
Deluxe Widgets pays $40,000 in stock dividends annually, so the firm will have $180,000 in retained earnings to enter on the pro forma balance sheet.
The EFN Formula
Assets must equal the sum of liabilities and owner's or shareholders equity on a normal balance sheet. However, assets on a pro forma balance sheet created to calculate EFN will exceed the sum of liabilities and equity. The difference is the external financing needed.
The assets section will list the firm's existing assets, the assets required to complete the proposed project and any other items that must be acquired in the coming year. The liabilities section will list existing obligations plus any other borrowing that is required. The equity section will include the projected retained earnings from the pro forma income statement.
For Deluxe Widgets, existing assets total $3 million. The projected assets, including the project cost, appear as $3.5 million on the pro forma balance sheet. Liabilities will increase from $1 million to $1.1 million due to other commitments, and current equity is expected to rise from $2 million to $2.18 million with the addition of $180,000 in retained earnings. Liabilities and equity together total $3.28 million. Subtract this amount from assets of $3.5 million and you get EFN equal to $220,000.