Percentage of Sales Method

Percentage of Sales Method
of Financial Statement
Forecasting
Prepared by
Ken Hartviksen
Financial Forecasting
Financial Statement Analysis and
Forecasting
Purpose
Business Owners must produce forecasts for the

financial results of corporate plans to:
Determine whether the corporate plans will require
additional external financing
Determine whether the corporate plans will produce
surplus cash resources that could be distributed to
shareholders as dividends
Assess the financial forecasts to determine the financial
feasibility of corporate plans if poor financial results are
forecast, this gives management the opportunity to
reexamine and amend corporate plans to produce better
results before resources and people are committed.
Financial Statement Analysis and Forecasting
4-3
The basis for all financial forecasts is the sales forecast.
The most recent balance sheet values are the starting point.
Pro forma (forecast) balance sheets are projected assuming
some relationship with projected sales (constant percentage
of sales)
Current liabilities are usually assumed to rise and fall in a
constant percentage with sales we call them spontaneous
liabilities because they change without negotiation with
creditors.
4-4
The Percentage of Sales Method
The percentage of sales method involves the

following steps:
1. Determine which financial policy variables you are
interested in
2. Set all the non-financial policy variables as a
percentage of sales
3. Extrapolate the balance sheet based on a percentage
of sales
4. Estimate future retained earnings
5. Modify and re-iterate until the forecast makes sense.
This process most often results in a balance sheet that does not
balance a plug (balancing) amount is the external funds
required (or surplus funds forecast)
4-5
The historical balance sheet.
If sales
increase,
assets
used to
produce
those
sales
must
grow.
Spontaneous
liabilities
Table 4-11 Balance Sheet
Cash
Securities
Receivables
Inventory
Current assets
Net fixed assets
5
10
10
25
50
100
Total assets
150
Accruals
Payables
Bank debt
5
5
20
Current liabilities
Long-term debt
Common equity
30
40
80
Total Liabilities
Policy
variables
requiring
decision.
150
4-6
Table 4-12 Initial Forecast
Sales
120
%
100.0%
132
145
160
Cash
Securities
Receivables
Inventory
Net fixed assets
Total assets
5
10
10
25
100
150
4.2%
8.3%
8.3%
20.8%
83.3%
125.0%
5.5
11.0
11.0
27.5
110.0
165.0
6.0
12.1
12.1
30.2
120.8
181.3
6.7
13.3
13.3
33.3
133.3
200.0
Accruals
Payables
Short-term debt
Long-term debt
Equity
Total liabilities and equity
Cumulative (EFR)
5
5
20
40
80
150
4.2%
4.2%
16.7%
33.3%
66.7%
125.0%
5.5
5.5
20.0
40.0
80.0
151.0
14.0
6.0
6.0
20.0
40.0
80.0
152.1
29.2
6.7
6.7
20.0
40.0
80.0
153.3
46.7
Sales
Nave
projections
increases
the
inand
balance
base
case
sheet
of $120
percentages
accounts
Accounts
First
passin
of sales
same
requiring
funding
proportion
decision
Balance
shortfall
to
are
Sheet
projected.
projected
assumed
Values to
sales
remain
calculated
constant
as a on
first pass.
percentage
of sales.
4-7
Percentage of Sale Method

Improving the Pro Forma Balance Sheet
The prior pro form balance sheet was developed

using very nave assumptions:
Policy variables held constant
Asset growth in all accounts held at the same
percentage of sales
Spontaneous liabilities increased at a constant
percentage of sales.
One improvement is to realize that the firms equity

will grow by the amount of retained earnings.
(See the following income statement)
4-8
Table 4-13 Income Statement

Sales
Gross operating profit
Fixed costs
EBIT
Interest
Taxes @ 50%
Net Income
Dividends
120
48
31
17
5
6
6
3
Retained
earnings = net
income less
dividends.
Assuming the
firm holds this
percentage
constant we can
project increases
in equity on the
balance sheet as
50% of the 5%
profit margin or
2.5% of sales.
4-9
Table 4-14 First Revision of Forecast
Sales
120
%
100.0%
132
145
160
Cash
Securities
Receivables
Inventory
Net fixed assets
Total assets
5
10
10
25
100
150
4.2%
8.3%
8.3%
20.8%
83.3%
125.0%
5.5
11.0
11.0
27.5
110.0
165.0
6.0
12.1
12.1
30.2
120.8
181.3
6.7
13.3
13.3
33.3
133.3
200.0
Accruals
Payables
Short-term debt
Long-term debt
Equity
Cumulative (EFR)
5
5
20
40
80
150
4.2%
4.2%
16.7%
33.3%
66.7%
125.0%
5.5
5.5
20.0
40.0
83.3
154.3
10.7
6.0
6.0
20.0
40.0
86.9
159.0
22.3
6.7
6.7
20.0
40.0
90.9
164.2
35.8
Equity
Notice
how
accounts
the
increased
retained
by
earnings
projected
has
retained
reduced
earnings
the
that
projected
increase
Externalin
proportion
Funds
to sales.
Required.
4 - 10

Second Revision the Pro Forma Balance Sheet
Further improvements to the pro forma balance sheet include:

Recognizing that cash balances may not have to rise as a pure
constant percentage of sales
Cash balances are required for a variety of reasons
To support transaction
As a safety cushion against unforeseen cash needs
As a speculative balance to take advantage of unforeseen opportunities
Even at low levels of sales, cash balances are required

As sales increase, additional cash on hand may be required, but at
a lower percentage of sales. (lower slope to the trend line between
cash balances and sales)
(See Figure 4 3 on the following slide for a more realistic forecast for cash)
4 - 11
Percentage of Sales Method

44-3
- 3FIGURE
FIGURE
Cash Forecast
14.0
Simple %
Cash
12.0
Linear with
constant
10.0
8.0
6.0
4.0
2.0
0.0
20
40
60
80 100 120 140 160 180 200 220 240 260 280 300
Sales
4 - 12

Further improvements to the pro forma balance sheet include

reexamining asset growth assumptions:
Refinement of the cash forecast (as per the previous two slides)
Realization that EFR can be offset by marketable securities that can easily
be liquidated to finance growth needs.
Reexamine our assumptions about growth in Accounts Receivable and
whether we want to change our credit policies in the context of the forecast
macro economic and competitive environment
Reexamine our inventory management policies taking into account the
macroeconomic and competitive environment
Realization that increases in net fixed assets is lumpy and not continuously
incremental (if we have excess production capacity, we may not need to
invest any further in fixed assets until we are forecast to exceed that
capacity)
Further improvements to the pro forma balance sheet include

reexamining assumptions regarding the growth in
spontaneous liabilities
(See the effects of these changes on the following slide)
4 - 13
Table 4-15 Second Revision of Forecast
Sales
120
%
100.0%
132
145
160
Cash
Securities
Receivables
Inventory
Net fixed assets
Total assets
5
10
10
25
100
150
4.2%
8.3%
8.3%
20.8%
83.3%
125.0%
5.0
0.0
11.0
27.5
100.0
143.5
5.0
0.0
12.1
30.2
90.0
137.3
5.0
0.0
13.3
33.3
80.0
131.7
Accruals
Payables
Short-term debt
Long-term debt
Equity
Cumulative (EFR)
5
5
20
40
80
150
4.2%
4.2%
16.7%
33.3%
66.7%
125.0%
5.5
5.5
20.0
40.0
83.3
154.3
-10.8
6.0
6.0
20.0
40.0
86.9
159.0
-21.7
6.7
6.7
20.0
40.0
90.9
164.2
-32.6
Assuming
cash remains
constant, we
liquidate
marketable
securities and
we retain 50%
of our profits
dramatically
affects the
forecast.
We now have
surplus
resources!
4 - 14

Final Revisions to the Pro Forma Income Statement
Given our assumptions about capacity, and there being no need for
further expansion in plant and equipment to support anticipated sales
growth, we can reexamine our assumptions about the cost structure of
the firm.
Variable Costs
Variable costs (direct materials and direct labour) will likely grow in proportion to sales.
Fixed Costs
Fixed costs, however should remain fixed.
By modifying the income statement for this change in assumptions, we see the net result of
this is an increase in forecast net income.
Dividends
Most firms do not follow a constant payout ratio, but hold dividends constant over multiple
years.
Assume that we hold dividends at $3 for the next three years.
(See the effects of these changes on the final pro forma income statement on the following slide)
4 - 15
Table 4-16 Profit Margin and Sales

Sales
Gross operating profit
Fixed costs
EBIT
Interest
Taxes @ 50%
Net Income
Net profit margin
Dividends
Additions to Retained earnings
$120
48
31
17
5
6
6.0
5.0%
$132
53
31
22
5.0
8.5
8.5
6.4%
$145
58
31
27
5.0
11.0
11.0
7.6%
$3.0
$3.0
$3.0
$5.5
$3.0
$8.0
$160
64
31
33
5.0
14.0
14.0
8.8%
$3.0
$11.0
4 - 16

Final Revisions to the Pro Forma Balance Sheet
Given our modified income statement and assumptions

regarding net profit and cash dividends we can prepare a
final revised balance sheet
This balance sheet now shows that we forecast
significant surplus cash resources and must make some
decisions about how we will manage them:
Investment temporarily in marketable securities in anticipation of further
investment opportunities in growing the firm?
Distribute them in the form of cash dividends?
(See the effects of these changes on the final pro forma balance sheet on the following
slide)
4 - 17
Table 4-17 Final Revision of Forecast
Sales
120
%
100.0%
132
145
160
Cash
Securities
Receivables
Inventory
Net fixed assets
Total assets
5
10
10
25
100
150
4.2%
8.3%
8.3%
20.8%
83.3%
125.0%
5.0
0.0
11.0
27.5
100.0
143.5
5.0
0.0
12.1
30.2
90.0
137.3
5.0
0.0
13.3
33.3
80.0
131.7
Accruals
Payables
Short-term debt
Long-term debt
Equity
Cumulative (EFR)
5
5
20
40
80
150
4.2%
4.2%
16.7%
33.3%
66.7%
125.0%
5.5
5.5
20.0
40.0
85.5
156.5
-13.0
6.0
6.0
20.0
40.0
93.5
165.6
-28.3
6.7
6.7
20.0
40.0
104.5
177.8
-46.2
4 - 18
Summary and Conclusions

In this slide set you have learned:
The importance of understanding the sources of
a firms profitability or where the challenges to
profitability exist.
How to prepare financial forecasts and
understand the assumptions underlying the
percentage of sales method of financial
forecasting.
4 - 19
Copyright
Copyright 2007 John Wiley & Sons
Canada, Ltd. All rights reserved.
Reproduction or translation of this work
beyond that permitted by Access
Copyright (the Canadian copyright
licensing agency) is unlawful. Requests
for further information should be
addressed to the Permissions
Department, John Wiley & Sons Canada,
Ltd. The purchaser may make back-up
copies for his or her own use only and
not for distribution or resale. The author
and the publisher assume no
responsibility for errors, omissions, or
damages caused by the use of these files
or programs or from the use of the
information contained herein.
4 - 20

Percentage of Sales Method

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Percentage of Sales Method

Uploaded by

Copyright:

Available Formats

Percentage of Sales Method

Business Owners must produce forecasts for the

Financial Statement Analysis and Forecasting

Financial Statement Analysis and Forecasting

The percentage of sales method involves the

Financial Statement Analysis and Forecasting

Financial Statement Analysis and Forecasting

Percentage of Sale Method

The prior pro form balance sheet was developed

One improvement is to realize that the firms equity

Financial Statement Analysis and Forecasting

Table 4-13 Income Statement

Financial Statement Analysis and Forecasting

Financial Statement Analysis and Forecasting

Percentage of Sale Method

Further improvements to the pro forma balance sheet include:

Even at low levels of sales, cash balances are required

Financial Statement Analysis and Forecasting