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How to Identify the External Financing Needed (EFN)

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  • 0:04 Planning the Future
  • 0:52 Internal Growth Rate
  • 1:36 Sustainable Growth Rate
  • 2:47 What Determines Growth
  • 3:25 How Much Is Needed?
  • 4:45 Lesson Summary
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Lesson Transcript
Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

It's important for businesses to think ahead about growth and financing needs. We'll cover three important formulas that will, in turn, cover when and how much external financing will be needed to accommodate growing the business.

Planning the Future

Don and Dan had always been in love with technology. They were always first to have the latest gizmos when they were growing up. When drones became popular, they were ahead of the curve and were flying theirs around the campus where they attended. Dan, who's a business major, found out that not only were hobbyists like themselves interested in drones, but so were businesspersons like architects, construction companies, and farmers, who wanted them for aerial views of their fields and worksites, so he convinced Don, who's the technology whiz, that they could each put up $25,000 and go into business for themselves selling drones. Thus, Eye in the Sky Drones was born.

The retail location they have is booming. Since they expect the business to keep growing, they're thinking about the future and what it'll mean for their finances.

Internal Growth Rate

One number the boys need to be aware of is the internal growth rate, which is the rate of growth that can be generated without borrowing any cash from outside sources. Dan pulled out the balance sheet and a few other numbers to use for calculations, which looks like this:

Eye in the Sky Drones - Balance Sheet
Cash $5,000 A/P $40,000
A/R $3,000 Wages payable $1,000
Inventory $100,000 Lease payable $1,500
Supplies $10,000
Investments $10,000 Current Liabilities $42,500
Current Assets $128,000
Bank Credit Line $5,500
Office Equip $10,000
Total Liabilities $48,000
Total Assets $138,000
Partners Capital $50,000
Retained Earnings $40,000
Revenues $250,000 Total Equity $90,000
Net Income $25,000
Profit Margin 10% Total Liabilities + Equity $138,000

The formal for internal growth rate is the return on assets, and it looks like this:

Internal Growth Rate = Net Income / Total Assets

So their rate is $25,000 / $138,000, which equals 0.1811, or 18%. Dan explained that means they could add the new models that Don wants by using the cash they generate from existing sales, as long as sales and profits won't go up by more than 18%, they won't need outside borrowing.

Sustainable Growth Rate

Don is glad to hear about the new model drones, but he's wondering about the situation ongoing. Is growing by 18% sustainable in the long run without the need for a big cash loan? Dan works up the sustainable growth rate, which is how much they can continue to grow with external borrowing, but without changing the degree of leverage by increasing the debt ratio. The formula is:

Sustainable Growth Rate = ROE * (1 - distribution payout ratio)

The dividend payout ratio for Eye in the Sky is 40%, since Dan and Don have always taken 40% of the profits as a distribution and left 60% to the business, so here are the calculations for sustainable growth rate:

ROE = Net Income / Total Equity
$25,000 / $90,000 = 0.2777
= 28%

28% * (1 - 0.40)
=28% * 0.60
= 0.168
=17%

17% will hold as long as they keep profits as high as they are now and keep putting 60% of them back into the business.

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