The Relationship Between Growth Rate and EFN

Imagine your business is like a car driving on the road of growth.

The faster you want to go (meaning a higher growth rate), the more fuel you need.
In business terms, that extra fuel is money — and usually, it comes from external financing.

That’s what we call EFN (External Financing Needed) — the amount of extra funding your company needs to support its growth.

• When your growth is slow, your company can grow using its own money (retained earnings, spontaneous liabilities, etc.).

• But when your growth is fast, internal funds usually aren’t enough — so you’ll need to bring in external funds.

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How Growth Increases EFN

Let’s break it down step by step:

1. Sales increase → You need to produce or buy more goods.

2. To produce more → You need more assets (machines, materials, employees, inventory).

3. More assets → You need more money.

4. But internal funds are limited → So you turn to external financing.

That’s why a higher growth rate often means a higher EFN — because fast growth needs more resources than the company can generate internally.

Let’s say your company’s sales in 2025 are 100 billion $ and you plan to grow next year.

Sales Growth Rate	Approximate EFN	Explanation
5%	1 billion	Low growth → internal funds are enough
20%	5 billion	Moderate growth → some external financing needed
40%	12 billion	High growth → strong need for external financing

 As sales growth increases, EFN also rises.

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 But Here’s the Caveat

This relationship isn’t perfectly linear. A smart company can manage its finances to reduce EFN even while growing quickly.
Here’s how:

1. Improve profitability → generate more internal funds.

2. Use assets more efficiently → produce more with less investment.

3. Negotiate longer payment terms with suppliers → more spontaneous liabilities.

4. Reduce dividend payout → keep more earnings inside the business.

5. Control growth → avoid expanding faster than your finances can handle.

 Summary

Growth Rate	EFN Level	What It Means
Low	Low EFN	Growth is supported by internal funds
Moderate	Medium EFN	Mix of internal and external financing
High	High EFN	Heavy reliance on external capital

In result:

Fast growth feels exciting — but without enough financial “fuel,” it can be risky.
A truly successful business doesn’t just grow quickly; it grows wisely, balancing expansion with smart EFN management.

Understanding Growth Rates: Internal vs. Sustainable

When a business grows, it’s exciting — but how fast can it grow before running out of money or taking on too much debt? To answer that, we use two key financial growth rates: the Internal Growth Rate (IGR) and the Sustainable Growth Rate (SGR).

Both tell us how fast a company can grow — but they look at growth from slightly different angles.

🌱 What Is a Growth Rate (in general)?

A growth rate simply shows how fast a company’s sales, assets, or earnings are increasing over time — usually year over year.

But there’s a catch:
Every bit of growth needs money — to buy inventory, hire people, or invest in equipment.
So, understanding how much growth a company can afford helps managers plan smarter and avoid financial stress.

That’s where Internal and Sustainable growth rates come in.

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 1. Internal Growth Rate (IGR)

The Internal Growth Rate is the maximum rate of growth a company can achieve using only internal financing — meaning no external borrowing or new equity.

In other words:

It’s how fast a company can grow using only its retained earnings.

$$\text{Internal Growth Rate}=\frac{ROA\times b}{1- (RO\mathrm{A }\times b)}$$

Where:

• ROA (Return on Assets) = Net Income ÷ Total Assets
  → measures how efficiently the company uses its assets to make profit.

• b (Retention Ratio) = Retained Earnings ÷ Net Income
  → shows what portion of profits is kept in the company (not paid out as dividends).

 Example:

If a company’s ROA = 10% and it retains 60% of its earnings (b = 0.6):

$$IGR=\frac{0.10\times 0.6}{1-(0.10\times 0.6) }= 6.38\mathrm{\%}$$

👌 So the company can grow about 6.4% per year without borrowing or issuing new shares.

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 2. Sustainable Growth Rate (SGR)

The Sustainable Growth Rate is the maximum growth rate a company can maintain without issuing new equity, while keeping its debt-to-equity ratio constant.

In simple words:

It’s how fast the company can grow using both internal funds and normal borrowing, but without taking on extra financial risk.

$$\text{Sustainable Growth Rate}=\frac{ROE\times b}{1- (RO\mathrm{E }\times b)}$$

Where:

• ROE (Return on Equity) = Net Income ÷ Total Equity
  → shows how efficiently the company uses shareholders’ money.

• b (Retention Ratio) = Retained Earnings ÷ Net Income

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💦 Bonus:  Dupont Analysis for ROE

We can break ROE into smaller parts using the DuPont formula:

$$ROE=\text{Profit Margin }\times \text{Asset Turnover }\times \text{Financial Leverage}$$

This helps us see how profitability, efficiency, and leverage work together to drive growth.

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 Example:

If ROE = 15% and the retention ratio b = 0.6:

$$SGR=\frac{0.15\times 0.6}{1-(0.15\times 0.6) }= 9.9\mathrm{\%}$$

👌 The company can grow around 9.9% per year sustainably — using internal funds and its normal level of borrowing.

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🔗 The Relationship Between IGR and SGR

Concept	Internal Growth Rate (IGR)	Sustainable Growth Rate (SGR)
Financing source	Only internal funds (retained earnings)	Internal funds + normal debt
Debt policy	No borrowing	Constant debt-to-equity ratio
Growth potential	Lower	Higher
Risk level	Lower risk	Moderate risk
Flexibility	Very limited	More flexible

SO,

• IGR < SGR → because adding a reasonable amount of debt allows faster growth.

• If a company grows faster than SGR, it must raise new equity or increase its debt ratio — which could be risky.

• If it grows slower than IGR, it may be underusing its resources.

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 Final 

Both IGR and SGR help you understand how fast your business can grow safely.
If you push growth beyond these limits, you’ll need external equity or more debt — and that can change your entire financial picture.

🌿 Smart growth isn’t just about going faster — it’s about growing sustainably within your financial capacity.

Understanding EFN (External Financing Needed) in Simple Terms

Have you ever wondered how companies know whether they need to borrow money or attract new investors to grow? That’s where EFN, or External Financing Needed, comes in.

 What is EFN?

EFN tells us how much extra money a company needs from outside sources to support its growth plans. When a company wants to increase sales or expand, it often needs more assets like equipment, inventory, or buildings. If the company’s internal funds (profits and automatic liabilities) aren’t enough, the remaining amount that must come from external sources is called EFN.

In short:

EFN = the extra money a company must raise to grow.

EFN = Assets / Sales × Change in sales - Liabilities / Sales × Change in sales - Profit margin × Projected Sales × (1 - Dividend payout ratio)

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💥 Example

Let’s take a simple example to make it clear:

Item	Amount (billion $)
Sales (current year)	100
Total assets	80
Liabilities (spontaneous)	30
Net profit	10
Dividend payout ratio	40%

The company plans to increase sales by 25% next year.

Now, step by step:

• New sales (S1) = 100 × 1.25 = 125

• Change in sales (ΔS) = 25

Using the ratios:

• A/S = 80 / 100 = 0.8

• L/S = 30 / 100 = 0.3

• M = 10 / 100 = 0.1

Plug everything into the formula:

EFN = (0.8 × 25) - (0.3 × 25) - (0.1 × 125 × (1 - 0.4)) = 20 - 7.5 - 7.5 = 5

👌 EFN = 5 billion $

That means the company needs 5 billion $ in additional external financing to support its 25% growth goal.

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💨Understanding better

Understanding EFN helps business owners and managers make smarter growth decisions. 

• If EFN is positive, you’ll need to find external financing. 
• If it’s negative, great — you have extra funds you can reinvest or use to pay off debt.
• If EFN of Zero, the company's internal funds will be sufficient to support its projected growth.

Understanding DuPont Analysis

If you've ever wondered how companies measure their financial profitability or why some companies seem to be more profitable than others, DuPont Analysis is a calculation that can break it down for you. Don't panic if finance is not your specialty—this blog post will explain DuPont Analysis in straightforward language so that you can get a sense of what makes a company profitable.

What is DuPont Analysis?

DuPont Analysis is a magnifying glass for a company's financial health. It takes a key number—Return on Equity (ROE), which represents how good a company is at generating money for shareholders with their own cash—and breaks it into three parts. By doing so, it explains to you why a company is (or isn't) profitable.

Think of a recipe:  ROE is the final meal, and DuPont Analysis tells you what ingredients were utilized to cook it.

The Three Ingredients of DuPont Analysis:

ROE = Profit Margin × Asset Turnover × Financial Leverage

 Profit Margin: How Much of Profit from Sales?

• What it measures: This measures how much profit a firm keeps out of every dollar of sales after subtracting all expenses.
• Formula: Net Income ÷ Sales
• Example: If a company makes $100 in sales and keeps $20 as profit, its profit margin is 20%. A higher margin means the company is good at controlling costs or charging premium prices.

Asset Turnover: How Efficiently Are Assets Used?

• What it measures: This shows how well a company uses its assets (like equipment, inventory, or property) to generate sales.
• Formula: Sales ÷ Total Assets
• Example: If a company has $1,000 in assets and generates $500 in sales, its asset turnover is 0.5. A higher number means the company is generating more sales from its assets.

Financial Leverage: How Much Debt Is Being Used?

• What it measures: This analyzes how much debt a company is using to finance its assets. More debt can boost ROE but adds risk, too.
• Formula: Total Assets ÷ Shareholders’ Equity
• Example: If a company has $1,000 in assets and $400 in equity, its leverage is 2.5. It's borrowing money to pay for some of its assets, and that can amplify returns (or losses)

Why Does DuPont Matter?

DuPont Analysis is like a financial detective. It helps you figure out where a company’s strengths or weaknesses lie. For example:

Low ROE? DuPont can tell you if it's because of unprofitable margins (maybe costs are too high), low asset turnover (maybe assets aren't being put to optimal use), or too much/the least leverage (maybe too much or too little debt).

Comparing companies: You can use DuPont to compare two companies in the same industry and see why one company is more profitable.
Strategic decisions: Managers use it to determine where to cut, such as cutting costs or making better use of assets

Limitations to Keep in Mind

DuPont is not perfect:

• It relies on accurate financial data. If the numbers for an organization are wrong, so is the analysis.
• It doesn’t consider non-financial factors, like market trends or management quality.
• Different industries have different standards, so comparing across sectors can be tricky

How to analysis financial statements and interpret financial ratio?

When deciding where to invest your money, comparing companies can be tricky, especially if they differ in size or industry. Two powerful tools can help: common-size statements and financial ratios. These tools make it easier to understand a company’s financial health and compare it with others. In this post, I’ll break down these concepts using simple language, explain how they work.

What Are Common-Size Statements?

Common-size statements turn financial data into percentages, making it easier to compare companies of different sizes.
Why Use It? It helps you see how a company allocates its resources compared to competitors, regardless of their size.

• common size balance sheets by expressing each item as a percentage of total assets.
• common size income statements by expressing each item as a percentage of total sales.

Frameworks of Financial Reports

💦Assumption on Financial Reporting:

• Fair presentation
• Going concern
• Accrual Basic
• Materiality and aggregation
• No offsetting
• Frequency of reporting
• Consistency
• Comparative Information

💦Fundamental characteristics of useful information:

• Relevance (Information that can affect a decision and encompasses the notion of materiality)
• faithful Representation (complete, natural, free from error)

💦Enhancing characteristics of useful information:

• Comparability
• Verifiability
• Timeliness
• Understandability

Cash flow of the Firm

The cash flow statement explains the change in a company's cash and cash equivalents over a period by categorizing cash flows into three main activities:

1. Operating Cash Flow (CFO): Reflects cash generated from core business operations.
2. Investing Cash Flow (CFI): Reflects cash used for or generated from investments in long-term assets
3. Financing Cash Flow (CFF): Reflects cash transactions with shareholders and creditors.

So,

$$CFO=\text{Net Income}+\text{Non-Cash Items}-\Delta \text{Net Working CapitalNet Income: From the income statement.Non-Cash Items: Typically include depreciation and amortization, as these reduce net income but do not involve cash outflows.Net Working Capital (NWC): Change in current assets (excluding cash) minus current liabilities. An increase in NWC (more inventory or receivables) reduces cash, while a decrease in NWC increases cash.}$$

         CFI= −Cash Paid for Fixed Assets + Cash Received from Sale of Fixed Assets Investing 

• Cash Paid for Fixed Assets: Capital expenditures (purchasing equipment or property).
• Cash Received from Sale of Fixed Assets: Proceeds from selling assets like machinery or buildings.

         CFF=Cash from Issuing Debt/Equity−Cash Paid to Retire Debt/Stock−

                     Cash Dividends Paid−Stock Repurchased

• Includes issuing or repaying debt, issuing or repurchasing stock, and paying dividends.

The net change in cash is:

$$\Delta \text{Cash} = \text{Operating Cash Flow} + \text{Investing Cash Flow} + \text{Financing Cash Flow}$$

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👉Why Cash Flow Analysis is Popular

We mentioned that cash flow analysis is popular because it’s difficult to manipulate. because:

• Cash-based: Unlike net income, which can be affected by accounting policies (e.g., revenue recognition, depreciation methods), cash flows reflect actual cash movements, making them harder to "spin."
• Transparency: Cash flows provide a clear picture of a company’s liquidity and ability to meet obligations, invest, or return capital to shareholders.
• Decision-making: Investors and creditors rely on cash flows to assess a company’s financial health and sustainability.

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Free Cash Flow (FCF)

Free Cash Flow represents the cash a company can distribute to creditors and stockholders after funding operations and necessary investments.

$$FCF = \text{Net Income} + \text{Non-Cash Charges} + \text{Interest Expense} \times (1 - \text{Tax Rate}) - \text{Capital Expenditures} - \Delta \text{Working Capital}$$

                         FCF=Net Income+ Non-Cash Charges+ Interest Expense× (1−Tax Rate) −Capital Expenditures−ΔWorking Capital

• Non-Cash Charges: Typically, depreciation and amortization.
• Interest Expense × (1 - Tax Rate): Adjusts for the tax shield on interest, as interest is tax-deductible.
• Capital Expenditures (Capex): Cash spent on acquiring or maintaining fixed assets.
• Change in Working Capital: Increase in NWC reduces FCF, as it ties up cash.

Capital Expenditures (Capex):

$$\text{Capex}=\text{Ending Net Fixed Assets}-\text{Beginning Net Fixed Assets}+\text{Depreciation}$$

• This formula accounts for the change in net fixed assets (after depreciation) and adds back depreciation to capture the actual cash spent on new assets.