How to Calculate External Financing
Calculating the amount of financing required is one of the greatest challenges that corporate managers face. Capital markets are extremely complex, and it can be difficult to determine how much, if any, external financing to raise. The external financing requirements for your company will depend upon the operating budget for your business as well as the company’s current capital resources. Determining how much external financing to raise will be much easier if you develop a solid operating budget for your company.
Project the amount of sales you expect your company to generate next year. The best way to project sales is to use the annual sales growth over the most recent five-year period. For example, if the company has grown sales at an annual rate of 5% over the past five years, and current year sales are $100, you can budget sales of $100 x (1 + 5%) = $105 for next year.
Calculate the company’s cost of goods sold and operating expenses using the average percentage of sales method. If cost of goods sold as a percentage of sales averaged 20% over the past five years, you can budget cost of goods sold equal to $105 x 20% = $21 for next year. If operating expenses as a percentage of sales averaged 15% over the past five years, you can budget operating expenses equal to $105 x 15% = $16 for next year.
Subtract cost of goods sold and operating expenses from sales to determine pre-tax income. In this example, pre-tax income would equal $105 - $21 - $16 = $68.
Calculate the company’s taxes for next year, and subtract taxes from pre-tax income to compute net income. If the company’s tax rate averaged 35% over the past five years, net income would equal $68 – (35% x $68) = $44.
Project next year’s current assets using the same percentage of sales method. Current assets include cash, inventory and accounts receivable. If current assets as a percentage of sales averaged 25% , you can budget next year’s current assets at 25% x $105 = $26.
Project next year’s current liabilities using the historical percentage of cost of goods sold. If current liabilities as a percentage of cost of goods sold averaged 40% over the past five years, you can budget next year’s current liabilities at 40% x $21 = $8.
Subtract current liabilities from current assets to determine the company’s working capital needs. Working capital is the short-term funding requirements that are needed to run the day-to-day operations of a business. In this example, the company’s working capital needs will equal $26 - $8 = $18.
Estimate the company’s projected capital expenditures using the percentage of sales method. If capital expenditures as a percentage of sales has averaged 30%, you can budget next year’s capital expenditure needs as $105 x 30% = $32.
Subtract the company’s projected working capital needs and capital expenditures from net income to determine the amount of external financing needed. In this example, the company will need to raise $44 - $18 - $32 = ($6), which means $6 in external financing is needed.
If this calculation results in a positive number, no external financing needs to be raised. The company can fund its operations through internal funds, although you may want to raise external financing if the terms are attractive. For example, external financing and growth often go together, so if your company is considering expanding, you may still want to seek extra funds.
Note that these steps assume that all costs as a percentage of sales remain fixed from year to year. Only make this assumption if you do not expect any major changes in the company’s operations. For example, if a key input to the company’s products is plastic and you expect plastic prices to rise significantly next year, you should assume that cost of goods sold as a percentage of sales will increase next year.