Question

AFN equation

Broussard Skateboard's sales are expected to increase by 25% from $7.0 million in 2019 to $8.75 million in 2020. Its assets totaled $3 million at the end of 2019.

Broussard is already at full capacity, so its assets must grow at the same rate as projected sales. At the end of 2019, current liabilities were $1.4 million, consisting of $450,000 of accounts payable, $500,000 of notes payable, and $450,000 of accruals. The after-tax profit margin is forecasted to be 4%, and the forecasted payout ratio is 50%. Use the AFN equation to forecast Broussard's additional funds needed for the coming year. Enter your answer in dollars. For example, an answer of $1.2 million should be entered as $1,200,000. Do not round intermediate calculations. Round your answer to the nearest dollar.

Answer 1

Additional Funds Needed is a part of corporate financial planning and management. It is defined as the additional financing a company requires to grow in terms of its sales figures for the next year as well as for its further expansion of operations. It can also be defined as the amount of external funding required by a company to finance its increase of assets so as to support the growth in sales. The AFN equation helps the firm to find out whether they would be able to generate the extra funds needed to support the increased level of sales.

The AFN method shows that to support sales growth, the company must increase its assets like plant & machinery, properties, inventories, accounts receivables etc. However, the increase in assets is partly offset by a spontaneous increase in liabilities (like accounts payables, accruals, taxes etc.) and as well as an increase in retained earnings.

Hence, the AFN equation can be expressed as:-

AFN = Increase in assets – Spontaneous increase in liabilities – Addition to Retained earnings

If this AFN equation is positive, that means the company is required to generate external/additional financing. However, if the equation is negative, then the company has more financing than needed which it can use for activities like buyback shares, pay off debts, purchase some short term investments etc.

Spontaneous liabilities are those current liabilities which arise as a result of a company’s day to day operations like increase in its sales activity, an increase in its cost of goods sold. It includes the accounts payables, wages, salaries, taxes etc. Here, it is to be noted, that those liabilities which require specific negotiations with the lender are not considered to be spontaneous liabilities. For example, the notes payable, in which the normal credit period is extended and the liability is transferred from the accounts payable to notes payable, is not considered as spontaneous liability. Similarly, bank loans, bonds are also not considered spontaneous.

From the data given in the aforementioned problem,

Sales expected in 2020 = $8.75 million = $8,750,000

The forecasted after tax profit margin = 4%

Therefore, the after-tax profit margin = $8,750,000 * 0.04 = $350,000

The forecasted dividend payout ratio = 50%

Therefore, the dividend payout = After Tax profit Margin * Dividend Payout Ratio

= $350,000 * 50% = $350,000 * 0.50 = $175,000

Hence, Addition to Retained Earnings = After Tax Profit Margin – Dividend Payout

= $350,000 - $175,000 = $175,000

{The after tax profit amount remained after dividend payment is an addition to retained earnings}.

A the end of 2019, the total assets = $3,000,000

Since the assets of the company are already at full capacity, all the assets should increase at the sales growth rate.

Therefore, Increase in total Assets = Total assets * Sales Increase Percentage

Hence, Increase in assets = $3,000,000 * 25%

= $3,000,000 * 0.25    = $750,000

Increase in Spontaneous Liabilities = {Accounts Payables + Accruals} * Percentage increase in Sales

[Notes payables not considered for the aforesaid reason]

Therefore, Increase in Spontaneous Liabilities:-

= ($450,000 + $450,000) * 25%

= $9,000,000 * 0.25

= $225,000

Therefore, Additional Funds Needed:-

AFN = Increase in assets – Spontaneous increase in liabilities – Addition to Retained earnings

Additional Funds Needed = $750,000 - $225,000 - $175,000 = $350,000

Therefore, the Broussard's additional funds needed for the coming year is $350,000.