“When EFN (External Financing Needed, aka AFN) is negative, it indicates that the company is holding excessive money than that is needed. When company is merely holding the surplus of money is often as bad as holding the surplus of debt. It is because money laying unused creates opportunity costs, so the firm should use it to clear high interest debt, to repurchase shares, or to increase dividends.”
The statement above is basically wrong for two reasons:
1) Why is the AFN not about “holding”?
2) Why is the AFN not about “money”?
The Correct Answer and Explanation is :
The statement is incorrect for two main reasons:
1) Why is the AFN not about “holding”?
External Financing Needed (EFN), also known as Additional Financing Needed (AFN), is a financial metric used to determine how much external financing a company will require to support its projected growth. The AFN is calculated based on a firm’s anticipated increase in assets, sales, and other factors that might require financing, taking into account the internally generated funds (like retained earnings). It is not about “holding” money or liquid cash reserves.
In reality, EFN is an estimate of the financing gap between a company’s projected assets and its internally available funds. If EFN is negative, this means that the company has more internal funds than it needs to support its growth. It suggests that the company’s internal financing (e.g., retained earnings) exceeds the growth in assets, and therefore, no additional external financing is needed. This is not about holding surplus cash, but rather, about a situation where a company might be generating more funds than required for its operations or expansion.
2) Why is the AFN not about “money”?
EFN (AFN) is not about holding liquid cash or money. It’s more focused on how much additional external financing (typically debt or equity) a company would need to fund its future growth. When EFN is negative, it suggests the company has excess internal funds that can be used in various ways, but this is not directly related to holding cash.
Rather than simply “holding” money, EFN reflects the need for financing based on projected changes in assets and liabilities. If AFN is negative, it means that the company may not need external financing for its projected expansion, and instead, it can use excess internal funds. This could involve paying down debt, repurchasing shares, or increasing dividends. However, this is a decision about allocating surplus funds rather than simply holding them as cash, which would involve a different financial strategy related to liquidity management.
In summary, AFN is not about holding money but about determining whether a company will need external funds to support its growth. A negative AFN simply indicates that the company is in a position where it has more than enough internal resources to cover its growth needs.