in this video we will discuss the additional funds needed our AFN equation the AFN equation is based on this simple accounting formula that assets equals liabilities plus equity this term is the increase in assets that increase in assets has to be financed with increases in liability increases in equity retained earnings and then whatever is left over would be financed by either selling new stock our new debt which is the additional funds needed the Assumption on AFN is these terms increase linearly with sales so assets is assumed to go up linearly with sales so are at least these so-called spontaneously increasing liabilities and then this is whatever is addition to equity and retained earnings specifically this is called the capital intensity ratio and is an indication of how much capital and industry needs a factory is going to need a lot of capital to increase sales a computer science company might not need very much so we have the assets that are increased divided by sales times the change in sales minus the so called spontaneously increase in liability divided by sales times the change in sales minus the profit margin times next year's sales times 1 minus the dividend payout ratio we will look at two different examples in this video the first one for full capacity sales when all of the fixed assets are used at full capacity and the second one at below full capacity sales when the fixed assets are not used at full capacity and therefore will not be need to be increased to increase sales only the current assets would be an even more complex example would be when you start below full capacity sales and then go to above full capacity sales for our example we will consider a company with initial sales of a hundred thousand an increase in sales of five thousand our five percent so that final sales 5,000 the assets for the company are 7,000 and cash 10,000 an inventory 10,000 and accounts receivable and net fixed assets of 90,000 the liabilities are accounts payable of 9,000 occurs of 3000 so the spontaneously increasing liabilities are going to be the sum of these to the 9 and the 3 which will be down here at 12,000 9 plus 3 the spontaneously increasing assets are going to be the sum of cash inventory and accounts receivable are 20,000 and the total assets is that plus the net fixed assets of 90,000 for 117 thousand the profit margin is given at 7 percent and the company is assumed to pay 50% of its net income in dividends ratios we will calculate our the current asset ratio D 15 over D 5 so d 5 is the initial sales D 15 is the current assets or the spontaneously increasing assets the total capital intensity ratio which that includes the 90,000 of net fixed assets that added to these spontaneously increasing assets gives us the total assets divided by sales of 100,000 gives us a capital intensity ratio of 1.17 and then a liability intensity ratio of the total spontaneously increasing liabilities of 12,000 again divided by sales of 100,000 we can then use all these numbers to calculate the additional funds needed in the case of full capacity sales so we're going to have D 22 our capital intensity ratio of 1.17 times d 6r increase in sales minus d 23 our liability intensity ratio a point 1/2 times the 6 again our increase in sales minus the 18 which is our profit margin of 7% x e7 our final sales after the growth which is 100 plus 1 plus 5,000 or 105 thousand and then times 1 minus d 19 which is our dividend payout ratio so we have the necessary funds to increase assets minus the dollars of that that are financed with spontaneously increasing liabilities minus the dollars that are financed with retained earnings leaves us one thousand five hundred and seventy five dollars that will have to be financed as additional funds and the company will have to choose whether to sell new stock or borrow more money for that funding if we look at the same company in the case where there are fixed assets their factory is partially idle so they don't need to increase fixed assets so they're operating up below full capacity sales then they're going to need obviously less money to expand the difference from this formula and this formula is we have d21 as opposed to D 22 and D 21 is just this current asset ratio of point two seven which is much less than the capital intensity ratio 1.17 so in this case the company needs more funds to operate 1575 in this case the company is generating more funds than it needs to operate and it has an extra two thousand nine hundred and twenty-five dollars it can use that money to pay back debt to buy back stock to increase the dividends that are paid it back any of those are options we can also try and examine a little bit more about how this formula operates look at how the variables that if changed will change AFN for example let's look at D the dividend payout ratio well if that goes up that means the company is pay out more in dividends so it has less of its own money you have a negative in front of the D and a negative here the two together make a positive so if D goes up AF in goes up if the company pays out more in dividends they have less money to finance expansion how about if the profit margin goes up the profit margin goes up there's only one negative in front of it so if p.m. goes up AFN goes down if the company is making more money than it needs to borrow less to finance future operations how about the capital intensity ratio if that goes up that means you are in a more capital intensive company and you're going to need more money to invest in assets how about the liability intensity ratio if that goes up for example you could borrow more from your suppliers and pay them later so if this goes up there's a negative in front of it this goes down if I borrow more money for my own suppliers that I need to borrow less from banks and AFN it goes down as missioned this equation is an approximation it is generally not true that the assets a company needs increase linearly with sales it is not always true that the liabilities to finance those assets increase linearly with sales companies are a lot more complex with that so there are a lot more complicated ways of dealing with this same kind of formula some of those complexities include issues like lumpy assets generally you have a company that is created you start creating automobiles we'll say and then you sell enough cars that you are fully using one factory then you have to build another factory so you have the so-called increase in lumpy assets it is not linear with sales same issues can happen with things like economies of scale if we're going to create a retail store initially you have to invest a lot of money you to look at Walmart buying a big building stocking the building with inventory etc but then once all that investment is done to increase sales you just need to put a bit more stuff in the building so the amount of assets necessary to add our this is called an economy of scale these kind of complications make this formula reasonably limited but it is a good starting point for students to learn about how companies are financed I thank you for watching this video