The EFN Formula Explained

You will observe that the EFN formula has three parts (separated by two minus signs).

EFN = [(A₀/S₀) ΔS)]    –    [(AP₀/S₀) ΔS]    –    [(M₀) (S₁) (RR₀)]

The first part represents the required increase in total assets [(A₀/S₀) ΔS)] needed to sustain the projected sales increase. Last year, assets equal to A₀ were required by the firm to sustain a sales level equal to S₀.Hence, we formulate the ratio A₀/S₀. Assuming this ratio remains static, next year, the firm will require so much more in assets; this is arrived at by multiplying the ratio by ΔS, the projected sales increase; ΔS = S₁ – S₀.

However, some of this “gross requirement” will be “spontaneously” or “automatically” met by the normal business generation of “internal” funds in the manner of spontaneous liabilities, by which we primarily refer to accounts payable (not notes payable or the current portion of long-term debt payable). Last year, such internal funds represented a certain percentage of sales: (A₀/S₀). If we multiply this dollar figure by the projected sales increase (ΔS), we may see to what extent spontaneous liabilities reduce the original “gross requirement.”

Finally, the firm will also – hopefully – generate and retain some of its earnings, thereby further reducing its “gross requirement.” If we take the firm’s net profit margin (NI/S = M₀) and multiply it by next year’s sales (S₁), we get next year’s projected net profits: (M₀) (S₁) = NI₁. If we the net profit margin (i.e., M₀= NI/S) times next year’s sales, we get next year’s net profits. If we further multiply this by the firm’s retention rate (RR₀), we get the firm’s projected retained earnings.