Question

What are the key factors on which external financing depends, as indicated by the AFN equation? Please explain your answer and give examples

Answer 1

	AFN is given by the equation:
	AFN = (A/S) x (Δ Sales) - (L/S) x (Δ Sales) - (PM x FS x (1-d))
	where,
	A / S = Assets that change directly with sales.
	Δ sales = Change in sales [10*g]
	L / S = Liabilities that change directly with sales
	PM = Profit Margin on Sales = net income / sales.
	FS = Forecasted Sales [10*(1+g)]
	d = dividend payout ratio
	Per the above equation the key factors are:
	*The growth rate in sales, all operating assets are
	expected to grow at that rate.
	*Profit margin. Profit margin determines the cash
	flow from operating activities.
	*Retention ratio. Retention ratio tells how much of
	the profits would be retained to finance the fixed
	and working capital needs.
	*Current capacity utilization. If the current capacity
	utilization is 100%, then growth in sales requires
	almost equivalent increase in fixed assets..
	If current capacity utilization is less than 100%, then
	additional investment in fixed assets would be
	required.
	Consider the following income statement and balance sheet for the just concluded year:
	Income Statement
		Last Year
	Net sales	$         200,000
	Expenses	$         158,000
	EBIT	$            42,000
	Interest paid	$              2,000
	Taxable income	$            40,000
	Taxes [50%]	$            20,000
	Net income	$            20,000
	Dividends [50%]	$            10,000
	Addition to retained earnings	$            10,000
	Assets	Liabilities and Stockholders' Equity
		Last Year		Last Year
	Current assets:		Current liabilities:
	Cash	$              5,000	Accounts payable	$                 5,000
			Accrued wages	$                 1,000
	Accounts receivable	$            10,000	Accrued taxes	$                 2,000
	Inventory	$            15,000	Total current liabilities	$                 8,000
	Total	$            30,000	Notes payable	$                 7,000
	Net fixed assets	$            70,000	Long term debt	$              15,000
			Total debt	$              30,000
			Common stock	$              20,000
			Retained earnings	$              50,000
	Total assets	$         100,000	Total liabilities and stockholders equity	$            100,000
	If the expected growth rate is 20% for the next year and fixed assets are already utilized 100%, then the AFN per the
	equation is [assuming 10% profit margin and 50% dividend payout]:
	EFN = (100000/200000)*200000*20%-(8000/200000)*200000*20%-200000*120%*10%*(1-50%) =	$              6,400