Question

1. The Additional Funds Needed equation AFN = (A₀/S₀) (ΔS) – (L₀/S₀) – MxS₁x(1-POR) is an easy way to determine external financing needs. What are the key assumptions we make when using the Additional Funds Needed equation and what would cause those assumptions to not hold?

Answer 1

Answer:-

The key assumptions that one makes when using the additional funds for external financial ratios are

1) The company's financial ratio's do not change
2) The increase in sales proportionally met by increase in assets such as Property plant and equipment (PP&E) and accounts receivable etc.
3) The increase in assets in the above point 2 is partially offset by some part with increase in liabilities such as accounts payables and other part by increase in retained earnings of the equity portion in the firm.
4) These funds required are not generated internally but are raises through external sources such as long term debt and notes payable.
5) The company is operating at full capacity.

The assumptions of keeping the financial ratios constant may not hold if the company is not operating at its full capacity and sales are increasing till the full capacity is achieved. This will cause to increase in sales but no increase in assets required to achieve the additional amount in sales.