Corporate Finance PowerPoint presentation. In this presentation we will discuss the percent of sales method, the percent of sales method been a tool that can help us with our projections out into the future help us to think about where we will stand, think about what our balance sheet accounts will be in the future. If we, if we estimate some type of growth into the future also help us to determine whether or not we may need additional funding to support our growth plans that we have set in place. Get ready, it’s time to take your chance with corporate finance percent of sales method. Now this method can be a little bit confusing when you first look at it in the calculation or formula for it can be a little bit intimidating as well, I highly recommend to get a better understanding of this formula and how to apply it to go through the practice problems, we will have practice problems related to this formula in terms of Excel problems, as well as working through the practice problems and presentations in one note.
So the formula is going to be based on the assumption that the balance sheet asset and liability accounts will maintain given percentage relationships to sales. So in other words, if we’re thinking about the sales and thinking about projections in sales, what about the balance sheet account, what’s going to happen to the balance sheet accounts because the balance sheet account as you’ll recall, when we thought through these projection processes represents where we stand at a point in time. So when we think about what our projections will be, we often think in terms of the income statement, what their performance will be. But it can be a little bit tricky to think about the balance sheet, when we start to think about different projections where we will stand at the endpoint.
Now we can think well, we would think then the balance sheet accounts would have some type of relationship to the changes, or at least some of those balance sheet accounts would have a relationship to the changes in the sales volume as well. And particularly, we will think that types of accounts like cash, accounts receivable, accounts payable, basically current assets and current liabilities may change, you know, in proportion to the sales volume changes, things like long term liabilities, common stock and retained earnings will not will not maintain direct relationship with the sales volume. So other accounts on the balance sheet are not going to have the same kind of relationship. And that’s going to be including the equity section. So the common stock is not going to change with regards to sales volume, of course, because the common stock may not change at all.
And once we had more financing in the company, the retained earnings is going to change with regards to relationship to net income and dividends. But that might not have a direct relationship with the change in the sales. And when we think about long term liabilities, we would think that those may not change with relation to sales as well, because the long term liabilities are financing type of options. So they might not change as well, whereas accounts payable and short term liabilities, those things you would think could fluctuate and probably will fluctuate with a change in the sales volume. So those are kind of the assumptions that we have, when we’re going to apply out the formula, then we can think about our formula. And it’s usually based in this term, we’re gonna we’re looking at the idea of the non required new funds. So that’s what the are in F will be. So we’re gonna say required new funds, and then we’re gonna have this long formula over here.
Now when we think about this formula, it’s it’s useful to kind of break this thing down and compare it to what we would think about as basically our accounting equation. So we’ve got three components to the formula, we’ve got this component here. And that’s going to be related to basically our assets. And then we got this component here, which is related to basically our liabilities. And this here, basically related to our equity. And so if we have it in this format, then we’re going to think about whether or not we have enough funding to support the growth that we want to have. So let’s break this out in terms of the accounting equation, assets, equal liabilities plus equity, we see that if we have assets, of course, then the assets are financed either through debt liabilities third party, or through equity, basically, the owner resulting in the owner putting money in and or the increase in the retaining of the earnings, the net income that has been retained in the company. So if we consider this formula in terms of our projections out into the future, how might this formula, you know change as we project out into the future. So if we project that there’s going to be some increase in sales into the future, we can assume then that the assets are basically going to change in proportion to the sales. Now, we could make some variants on this.
And we’ll talk more about this in a second. Because we’ve got like the current assets you would think with would possibly change with regards to sales, but the long term assets may or may not. And that’s going to depend on whether we’re at capacity or not. In other words, property and plant and equipment may not increase with our sales increased projections, due to the fact that we weren’t producing that capacity and our current property, plant and equipment will be enough to support the added growth whereas, or you could be in a situation would you Where the added growth is going to necessarily need to increase property, plant and equipment because we’re at capacity and we’re assuming growth. So, asset if the assets then increase if we’re going to assume that assets here are going to be increasing, then we got to say, Well, how is that increase in the assets going to be financed? Is it going to be financed by liabilities debt? Including increases in like accounts payable and whatnot, which you would think would naturally increase with an increase in sales volume?
Or is it going to be an increase with the equity, which would include like the net income, the net income being increased? So that’s basically what this formula looks like, right? If we, if we take a look at this up here, we’re gonna say, well, the assets are going to be increasing here, right? The assets are going to go up, and then we’re going to subtract the basically the liability component, and we’re going to subtract basically the equity component. So why would we put it in this format, you’ve got basically assets minus liabilities minus equity, because assets in our accounting equation assets equal liabilities plus equity. So if there’s going to be an increase in the assets, then that increase needs to be supported by an increase in the equity and increase in liabilities and increase in equity, if the increase in assets are greater than the increase in the liabilities and the increase in equity, then we’re going to need required new funds, that means we’re going to need new fund some more funding in order to support that. So breaking this down a little bit more, we got the assets up top, we got that divided by the current sales number, the prior period sales number that has passed, and then the change or delta as a change in assets what the delta is.
So that means that you can have the current sales number minus the the prior sales number, which is going to be your increase in sales is going to be the change in sales. So you’re going to be taking a look at the relationship. Basically, the idea being that if you take the the current assets that you have that would generate the same amount of sales, if you want to increase the sales volume, then you would need more assets. Basically, in order to do that, how many more assets? Were you going to take the current relationship assets to sales, and then multiply times to change or increase in sales? That’s going to give you your increase in the assets? And then you’re going to see, well, how will those be financed? Do we have enough liabilities and equity to finance that, we’ll do a similar formula for the liabilities, assuming that the liabilities will change in relation to the sales.
Now typically, when we’re thinking about the liabilities, we’re only thinking about current liabilities changing related to sales, because the long term liabilities like the notes, possibly will not unless we need unless we’re gonna take out more financing, right. So we got the liabilities compared to the current sales number, times the Delta as with a change in sales, the increase that we think are going to happen in sales, that’s what we think are going to be increasing the liabilities, which will be in part financing the assets. And then we’ve got this calculation, which is a little bit more confusing, I’ll go and basically, it just means this calculation basically comes down to you’re going to take the net income calculation in in the sales to so the net income, that’s going to happen in your projected sales, which would increase equity. So the equity would be increasing by the net income. And then you are going to take into consideration the amount of dividends that you’re going to pay out.
That’s what the equity is going to do. Right. So this equation basically does that, we’ll break it out more in the practice problem if you want to work through a practice problem. But the increase in equity then represents our net income that we’re going to earn, which you would hope would be sufficient maybe to pay off the increase in the assets, but then we’re also going to have to pay out dividends. So it depends how much of those increases that we’re going to earn in equity that we’re going to pay off in dividends. And so if the liabilities and equity do not increase sufficiently enough to support the increase in the assets, then we’re going to end up needing more funding. That’s why we have the required new funds. So that’s why it’s formatted this way you got that basically, the asset change that’s going to increase is that asset change is going to be supported by the liabilities and equity.
Well, if I take the assets minus the liabilities, minus the equity, and I come up with a positive number, then it’s not right, we’re gonna need more funding in order to in order to support this increase, if it’s if it’s a negative number, the assets minus the liabilities and basically the equity component is negative, then we have sufficient funds in order to support the increase in the assets. So then a little quirk on this, this type of calculation if the company is operating at full capacity, meaning you know, their equipment, property, plant and equipment like you can think about you like a movie theater, that’s, that’s basically packing their theater all the time. So they’re already at capacity, meaning they’re using their their facilities as much as they can in order to to generate revenue. If that’s the case, they’re going to need to purchase new property, plant and equipment to produce more goods. So that means that the assets here in our formula would probably include With the property, plant and equipment, because they’re, they’re already at capacity if they’re going to grow, they’re going to have to buy more property plants and equipment in order to get a return on, on the property plants and equipment.
However, if the company is not operating at full capacity, so you can think about that movie theater that’s basically only you know, half empty, then they don’t need to buy another movie theater in order to basically increase revenue, they just need to to increase the capacity, they’re not going to buy more property plants and equipment, then they’re simply going to have an increase, then we’ll see we’ll need to add more current assets and increase sales. So that means that this increase in the assets here would basically be not an increase in property, plant and equipment but simply an increase in the current assets. The property, plant and equipment the capital assets are sufficient to support more growth.