Corporate Accounting and Financial Management · Forecasting Financial Statements

External Funds Requirement and Cash Budget Explained

Updated 11 October 2026 · Fact-checked

External Funds Requirement (EFR or AFN) is the extra financing a company must raise from outside when sales grow. You find it as the rise in assets, less the spontaneous rise in liabilities, less the retained profit. A cash budget forecasts receipts and payments period by period to show surplus or deficit.

Understand External Funds Requirement and Cash Budget

When sales grow, a firm needs more assets: more stock, more debtors, often more fixed assets. Some of this growth is funded automatically. Creditors and accrued expenses rise with sales. Retained profit also adds to equity. Whatever is left must come from external funds, such as bank loans, debentures or fresh shares.

The percentage of sales method assumes that certain items move in proportion to sales. Usually these are current assets, fixed assets (if running at full capacity), trade creditors and accruals. Items like share capital, long-term debt and reserves do not move with sales. They change only by decisions or by retained profit.

A cash budget looks at a shorter horizon, usually monthly or quarterly. It lists expected cash receipts and cash payments, then shows the closing cash balance. If the closing balance falls below the minimum cash you want to hold, you need to borrow. If it is high, you can invest the surplus.

The two tools answer different questions. EFR asks how much long-term financing growth needs. The cash budget asks when cash will be short or in excess. In the exam, EFR is a short formula-based sum. The cash budget is a layout-based sum where accuracy of timing matters most.

Key rules to remember

External Funds Requirement (AFN): EFR = (A/S) × ΔS − (L/S) × ΔS − [PM × S1 × (1 − d)]; A/S = spontaneous assets as a ratio of sales; L/S = spontaneous liabilities as a ratio of sales; ΔS = increase in sales; S1 = projected sales; PM = net profit margin on projected sales; d = dividend payout ratio.
Retained earnings for the year: Retained earnings = PM × S1 × (1 − d); Use projected sales S1, not current sales, unless the question says otherwise.
Increase in sales: ΔS = S1 − S0; If growth is given as a percentage g, then ΔS = S0 × g.
Cash budget closing balance: Closing cash = Opening cash + Receipts − Payments; Opening cash of one period is the closing cash of the previous period.
Financing need in cash budget: Surplus or deficit = Closing cash before financing − Minimum cash balance; A negative figure means borrowing is needed; a positive figure means surplus.

How to solve External Funds Requirement and Cash Budget questions

Decide first whether the question asks for a funds requirement for a year or a period-wise cash forecast. Then follow the matching steps.

1Read the question and mark whether it is EFR (growth in sales, projected balance sheet) or a cash budget (months or quarters).
2For EFR, list which assets and liabilities vary with sales. Ignore items the question says are fixed.
3Compute the increase in sales, then the increase in spontaneous assets and spontaneous liabilities.
4Compute retained earnings using the projected sales, margin and payout ratio. Then EFR = increase in assets − increase in liabilities − retained earnings.
5For a cash budget, draw columns for each period. Write opening cash, then list receipts, then payments.
6Convert sales and purchases into cash using the credit period given. Drop non-cash items such as depreciation. Place each payment in the month it is actually paid.
7Compute closing cash each period and compare with the minimum balance. Show borrowing or surplus clearly.
8Check that each closing balance carries forward as the next opening balance, and state a short conclusion.

Quickest way: Fast EFR and cash budget approach

When to use it: Use it when time is short and the question gives clear ratios or credit terms.

For EFR, compute net spontaneous funding as (A/S − L/S) and multiply by ΔS in one step.
Subtract retained earnings and you have the answer. Write the formula first so you earn method marks.
For a cash budget, make a receipts schedule first, then a payments schedule, then the summary. Do not mix them.
Cross out depreciation, provisions and other non-cash items at the start.
Finish by checking that closing cash equals total receipts less total payments plus opening cash.

Common mistakes in External Funds Requirement and Cash Budget

Using current sales instead of projected sales to compute retained earnings.
Students pick the first sales figure they see.
Fix: Profit for the coming year comes from projected sales. Write S1 beside the formula before substituting.
Treating all liabilities as spontaneous.
Students assume everything on the balance sheet grows with sales.
Fix: Only trade creditors and accruals normally rise with sales. Loans, debentures and share capital do not, unless stated.
Including depreciation as a cash payment in the cash budget.
It appears in the list of expenses.
Fix: Depreciation is non-cash. Leave it out. Also leave out any other non-cash write-offs.
Ignoring the credit period on sales and purchases.
Students record cash in the month of sale or purchase.
Fix: Shift each amount by the credit period. For example, a one-month credit sale made in January is received in February.
Forgetting the minimum cash balance when computing borrowing.
The closing balance looks positive, so no borrowing seems needed.
Fix: Compare closing cash with the required minimum. Borrow the shortfall against that minimum.
Subtracting dividends wrongly in retained earnings.
Payout ratio and retention ratio get confused.
Fix: Retention ratio = 1 − payout ratio. Multiply profit by the retention ratio.

Worked examples

Example 1

A company has sales of ₹10,00,000 and expects sales to rise to ₹12,00,000. Spontaneous assets are 60% of sales and spontaneous liabilities are 20% of sales. Net profit margin is 5% on sales and the dividend payout ratio is 40%. Find the external funds requirement.

Show the solution

Increase in sales ΔS = 12,00,000 − 10,00,000 = ₹2,00,000.
Increase in assets = 60% × 2,00,000 = ₹1,20,000.
Increase in spontaneous liabilities = 20% × 2,00,000 = ₹40,000.
Net profit on projected sales = 5% × 12,00,000 = ₹60,000.
Retained earnings = 60,000 × (1 − 0.40) = ₹36,000.
EFR = 1,20,000 − 40,000 − 36,000 = ₹44,000.

Answer: The external funds requirement is ₹44,000.

Example 2

Prepare a cash budget for January to March. Opening cash on 1 January is ₹50,000. Credit sales: January ₹2,00,000; February ₹2,40,000; March ₹3,00,000; December sales were ₹1,80,000. Customers pay one month after the sale. Purchases paid in the month of purchase: January ₹1,00,000; February ₹1,20,000; March ₹1,50,000. Wages and other cash expenses are ₹40,000 each month. Depreciation is ₹10,000 a month. Minimum cash balance required is ₹60,000.

Show the solution

Receipts: January = December sales ₹1,80,000; February = January sales ₹2,00,000; March = February sales ₹2,40,000.
Payments: January = 1,00,000 + 40,000 = ₹1,40,000; February = 1,20,000 + 40,000 = ₹1,60,000; March = 1,50,000 + 40,000 = ₹1,90,000. Depreciation is excluded as it is non-cash.
January: opening 50,000 + receipts 1,80,000 − payments 1,40,000 = closing ₹90,000. This is ₹30,000 above the minimum.
February: opening 90,000 + 2,00,000 − 1,60,000 = closing ₹1,30,000. Surplus over minimum is ₹70,000.
March: opening 1,30,000 + 2,40,000 − 1,90,000 = closing ₹1,80,000. Surplus over minimum is ₹1,20,000.

Answer: Closing cash is ₹90,000 in January, ₹1,30,000 in February and ₹1,80,000 in March. It stays above the ₹60,000 minimum, so no borrowing is needed.

Exam tips

Write the formula and label every term before substituting. Method marks are given even if arithmetic slips.
State your assumptions, such as which items vary with sales, when the question is silent.
In a cash budget, show the receipts and payments schedules separately. Examiners can then award marks for each.
Always add a one-line conclusion: the amount of external funds needed, or the months of deficit and surplus.
Check the answer for reasonableness. EFR is usually smaller than the increase in assets.

Practice questions from Forecasting Financial Statements

External Funds Requirement and Cash Budget: frequently asked questions

What is the external funds requirement formula?

EFR = increase in spontaneous assets − increase in spontaneous liabilities − retained earnings. Retained earnings equal projected sales × net profit margin × (1 − payout ratio).

Is AFN the same as EFR?

Yes. Additional Funds Needed (AFN) and External Funds Requirement (EFR) mean the same thing: financing that must come from outside the business to support growth.

Why is depreciation excluded from a cash budget?

A cash budget tracks actual cash flows. Depreciation is an accounting charge that does not involve any cash payment, so it is left out.

What happens if EFR comes out negative?

A negative EFR means internal sources are more than enough to fund the growth. The firm has surplus funds that it can use to repay debt, pay extra dividends or invest.