4.2 External Funds Needed Formula (EFN)
A company needs additional “capital” (i.e., financial resources) in order to grow and to maintain its existing plant and equipment, and to acquire additional inventory. It cannot achieve a sales increase (“growth”) without adding on productive “capital assets” (not to mention maintaining existing assets). Thus, increases in Free Cash Flow are necessary to achieve corporate growth and will require investment in numerous assets. Again, in order to grow, the company must invest. Investment creates the capacity to produce more goods for sale and, hopefully, increases both accounting income and Free Cash Flow.
Some of the company’s capital needs will be met “spontaneously,” i.e., in the normal course of doing business, by retaining some, or all, of its earnings. Such funds may be thought of as having been generated “internally.” Some further internal funds will be generated by accounts payable, also in the normal course of business conduct. Payables are, essentially, free, short-term loans provided by the firm’s suppliers for, usually 30 days. Payables are thus, financially speaking, free sources of funds. We call these funds, including payables and retained earnings, by numerous names: “spontaneous,” automatic,” or “internal.”
For the balance of its capital requirements, the corporation will need to go outside – to bank lenders, and/or to bond and stock investors for its “external” funds requirements.
Internal Funds:
- Accounts Payable
- Addition to Retained Earnings
We also said that, to the extent that internal funding is insufficient to satisfy all the investment needs, it may seek additional funding externally.
External Funds:
- Short-term bank lines of credit
- Short-term bank loans – “notes”
- Long-term (bank) loans – “debt”
- Issuance (sale) of corporate notes or bonds
- Issuance (sale) of equity
One less recognized manner in which an asset can be acquired is by means of a lease, the discussion of which follows next.
For information regarding the calculation of the External Funds Needed requirement, please refer to the Introduction to Financial Analysis text by this author, available online on Pressbooks (https://pressbooks.pub/introductiontofinancialanalysis).