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The Afn Formula

This document discusses how to calculate a company's additional funds needed (AFN) using an equation that considers increases or decreases in assets, liabilities, and retained earnings from an increase in sales. It provides definitions for the variables in the equation: AFN is the additional funds needed, A* is the assets tied to sales that must increase with sales, S0 is last year's sales, L* are liabilities that spontaneously increase, S1 is next year's projected sales, ΔS is the change in sales, M is the profit margin, and RR is the retention ratio. The document also discusses how managers can identify projects to create value for their company, the importance of a strategic plan with elements

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8K views1 page

The Afn Formula

This document discusses how to calculate a company's additional funds needed (AFN) using an equation that considers increases or decreases in assets, liabilities, and retained earnings from an increase in sales. It provides definitions for the variables in the equation: AFN is the additional funds needed, A* is the assets tied to sales that must increase with sales, S0 is last year's sales, L* are liabilities that spontaneously increase, S1 is next year's projected sales, ΔS is the change in sales, M is the profit margin, and RR is the retention ratio. The document also discusses how managers can identify projects to create value for their company, the importance of a strategic plan with elements

Uploaded by

splendidhcc
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Additional Required Spontaneous Increase in

Funds = increase - increase in - retained


needed in assets liabilities earnings
AFN =(A*/S0)ΔS - (L*/S0)ΔS - MS1(RR).
Here
AFN =additional funds needed.
A* =assets that are tied directly to sales, hence which must increase if sales are to increase. Note that A
designates total assets and A* designates those assets that must increase if sales are to increase. When the firm
is operating at full capacity, as is the case here, A* = A. Often, though, A* and A are not equal, and either the
equation must be modified or we must use the projected financial statement method.
S0 =sales during the last year.
A*/S0 =percentage of required assets to sales, which also shows the required dollar increase in assets per $1
increase in sales. .
L* =liabilities that increase spontaneously. L* is normally much less than total liabilities (L). Spontaneous
liabilities include accounts payable and accruals, but not bank loans and bonds.
L*/S0 =liabilities that increase spontaneously as a percentage of sales, or spontaneously generated financing
per $1 increase in sales.
S1 =total sales projected for next year. Note that S0 designates last year’s sales,
ΔS =change in sales = S1 - S0
M =profit margin, or profit per $1 of sales.
RR =retention ratio, which is the percentage of net income that is retained.
For Allied,RR_$56/$114_0.491.RRis also equal to 1_payout ratio, since the retention ratio and the payout
ratio must total to 1.0 _ 100%.

To make their firms more valuable, managers must identify, evaluate, and implement projects that meet or
exceed investor expectations. However, value creation for a firm is impossible unless a company has a well-
articulated strategic plan.
The firm’s strategic plan begins with a mission statement.
Key elements of a firm’s strategic plan include corporate purpose, corporate scope, corporate objectives,
and corporate strategies.
Operating plans provide detailed implementation guidance to help meet corporate objectives.
The planning process can be divided into six steps: (1) project financial statements and analyze them; (2)
determine the funds needed to support the 5-year plan; (3) forecast funds availability over the next five years;
(4) establish and maintain a system of controls for the allocation and use of funds; (5) develop procedures for
adjusting the basic plan if the economic forecasts don’t materialize; and (6) establish a performance-based
management compensation system.
Virtually all corporate forecasts are made using computerized forecasting models based on spreadsheet
programs. Spreadsheets have two major advantages over pencil-and-paper calculations: (1) Spreadsheet
models are faster than by-hand calculations and (2) models can be instantaneously recalculated making it
easier to determine the effects of changes in variables.
Financial forecasting generally begins with a forecast of the firm’s sales, in terms of both units and dollars.
Either the projected, or pro forma, financial statement method or the AFN formula method can be used to
forecast financial requirements. The financial statement method is more reliable, and it also provides ratios
that can be used to evaluate alternative business plans.
A firm can determine its additional funds needed (AFN) by estimating the amount of new assets necessary
to support the forecasted level of sales and then subtracting from that amount the spontaneous funds that will
be generated from operations. The firm can then plan how to raise the AFN most efficiently.
The higher a firm’s sales growth rate, the greater will be its need for additional financing. In addition, the
greater the firm’s capital intensity ratio, the greater the need for external financing. Similarly, the smaller
its retention ratio, the greater its need for additional funds. However, the higher the profit margin, the
lower the need for external financing.

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