                                                       Financial Forecasting  Concepts  Percentage of Sales Method  External Financing Needed  Financial Forecasting Equations  Tools & Problems  Financial Forecasting Exercise  EFN Calculator  EFN Exercise  Financial Forecasting Quiz     ## Percentage of Sales Method

The Percentage of Sales Method is a Financial Forecasting approach which is based on the premise that most Balance Sheet and Income Statement Accounts vary with sales. Therefore, the key driver of this method is the Sales Forecast and based upon this, Pro-Forma Financial Statements (i.e., forecasted) can be constructed and the firms needs for external financing can be identified. The calculations illustrated on this page will refer to the Balance Sheet and Income Statement which follow. The forecasted Sales growth rate in this example is 25%

 Balance Sheet (\$ in Millions) Assets 1999 Liabilities and Owners' Equity 1999 Current Assets Current Liabilities Cash 200 Accounts Payable 400 Accounts Receivable 400 Notes Payable 400 Inventory 600 Total Current Liabilities 800 Total Current Assets 1200 Long-Term Liabilities Long-Term Debt 500 Fixed Assets Total Long-Term Liabilities 500 Net Fixed Assests 800 Owners' Equity Common Stock (\$1 Par) 300 Retained Earnings 400 Total Owners' Equity 700 Total Assets 2000 Total Liab. and Owners' Equity 2000
 Income Statement (\$ in Millions) 1999 Sales 1200 Cost of Goods Sold 900 Taxable Income 300 Taxes 90 Net Income 210 Dividends 70 Addition to Retained Earnings 140

### Percentages of Sales

The first step is to express the Balance Sheet and Income Statement accounts which vary directly with Sales as percentages of Sales. This is done by dividing the balance for these accounts for the current year (1999) by sales revenue for the current year.

The Balance Sheet accounts which generally vary closely with Sales are Cash, Accounts Receivable, Inventory, and Accounts Payable. Fixed Assets are also often tied closely to Sales, unless there is excess capacity. (The issue of excess capacity will be addressed in External Financing Needed section.) For this example, we will assume that Fixed Assets are currently at full capacity and, thus, will vary directly will sales.

Retained Earnings on the Balance Sheet represent the cumulative total of the firm's earnings which have been reinvested in the firm. Thus, the change in this account is linked to Sales; however, the link comes from relationship betwen Sales growth and Earnings

The Notes Payable, Long-Term Debt, and Common Stock accounts do not vary automatically with Sales. The changes in these accounts depend upon how the firm chooses to raise the funds needed to support the forecasted growth in Sales.

On the Income Statement, Costs are expressed as a percentage of Sales. Since we are assuming that all costs remain at a fixed percentage of Sales, Net Income can be expressed as a percentage of Sales. This indicates the Profit Margin.

Taxes are expressed as a percentage of Taxable Income (to determine the tax rate). Dividends and Addition to Retained Earnings are expressed as a percentage of Net Income to determine the Payout and Retention Ratios respectively.

Percentage of Sales Calculations

The examples in this box illustrate the calculations which were used to determine the percentages provided in the following Balance Sheet and Income Statement.

 Cash Cash/Sales = \$200/\$1200 = .1667 = 16.67% Inventory Inventory/Sales = \$600/\$1200 = .5 = 50% Accounts Payable (Accounts Payable)/Sales = \$400/\$1200 = .3333 = 33.33% Costs Costs/Sales = \$900/\$1200 = .75 = 75% Taxes Taxes/(Taxable Income) = \$90/\$300 = .3 = 30% Net Income (Net Income)/Sales = \$210/\$1200 = .175 = 17.5% Dividends Dividends/(Net Income) = \$70/\$210 = .3333 = 33.33%

 Balance Sheet (\$ in Millions) Assets 1999 % Liabilities and Owners' Equity 1999 % Current Assets Current Liabilities Cash 200 16.67% Accounts Payable 400 33.33% Accounts Receivable 400 33.33% Notes Payable 400 N/A Inventory 600 50.00% Total Current Liabilities 800 Total Current Assets 1200 Long-Term Liabilities Long-Term Debt 500 N/A Fixed Assets Total Long-Term Liabilities 500 Net Fixed Assests 800 66.67% Owners' Equity Common Stock (\$1 Par) 300 N/A Retained Earnings 400 N/A* Total Owners' Equity 700 Total Assets 2000 Total Liab. and Owners' Equity 2000
 Income Statement (\$ in Millions) 1999 % Sales 1200 Cost of Goods Sold 900 75% Taxable Income 300 25% Taxes 90 30%* Net Income 210 17.5% Dividends 70 33.33%* Addition to Retained Earnings 140 66.67%*

### Partial Pro-Forma

The next step is to construct the Partial Pro-forma Financial Statements. First, determine the forcasted Sales level. This is done my multiplying Sales for the current year (1999) by one plus the forecasted growth rate in Sales.

S1= S0(1 + g) = \$1200(1 + .25) = \$1500

where

• S1 = the forecasted Sales level,
• S0 = the current Sales level, and
• g = the forecasted growth rate in Sales.

Once the forecastes Sales level has been determined, the Balance Sheet and Income Statement accounts which vary directly with Sales can be determined by multiplying the percentages by the Sales forecast. The accounts which do not vary directly with Sales are simply transferred to the Partial Pro-Forma Financial Statements at their current levels.

Retained Earnings on the Balance Sheet are the one item whose amount is determined using a slightly different procedure. The Partial Pro-Forma balance for Reatined Earnings equals Retained Earnings in the current year plus the forecasted Addition to Retained Earnings from the Partial Pro-Forma Income Statement. The balances for summary accounts, such as Total Current Assets and Total Current Liabilities, are determined by summing their constituent accounts.

Partial Pro-Forma Calculations

The examples in this box illustrate the calculations which were used to derive the following Partial Pro-Forma Balance Sheet and Income Statement.

 Cash (Cash%)(Sales Forecast) = (16.67%)(\$1500) = \$250 Inventory (Inventory%)(Sales Forecast) = 50%(\$1500) = \$750 Costs (Costs%)(Sales Forecast) = 75%(1500) = \$1200 Addition toRetained Earnings (Addition to Retained Earnings%)(Net Income Forecast) = 66.67%(\$262.5) = \$175 Retained Earnings(Balance Sheet) Retained Earnings + Addition to Retained Earnings Forecast = \$400 + \$175

 Balance Sheet (\$ in Millions) Assets 1999 2000 Liabilities and Owners' Equity 1999 2000 Current Assets Current Liabilities Cash 200 250 Accounts Payable 400 500 Accounts Receivable 400 500 Notes Payable 400 400 Inventory 600 750 Total Current Liabilities 800 900 Total Current Assets 1200 1500 Long-Term Liabilities Long-Term Debt 500 500 Fixed Assets Total Long-Term Liabilities 500 500 Net Fixed Assests 800 1000 Owners' Equity Common Stock (\$1 Par) 300 300 Retained Earnings 400 575 Total Owners' Equity 700 875 Total Assets 2000 2500 Total Liab. and Owners' Equity 2000 2275
 Income Statement (\$ in Millions) 1999 2000 Sales 1200 1500 Cost of Goods Sold 900 1125 Taxable Income 300 375 Taxes 90 112.5 Net Income 210 262.5 Dividends 70 87.5 Addition to Retained Earnings 140 175

### External Financing Needed (EFN)

The External Financing Needed (EFN) can be determined from the Partial Pro-Forma Balance Sheet. It is simply equal to the difference between Partial Pro-Forma Total Assets and Partial Pro-Forma Total Liabilities and Owners' Equity.

EFN = \$2500 - \$2275 = \$225

Please note that the External Financing Needed section explores the calculation of EFN when there is excess capacity.

### Pro-Forma Financial Statements

The final step is to determine how the EFN is to be raised. Firms can choose to raise the EFN by borrowing on short-term basis (Notes Payable), borrowing on a long-term basis (Long-Term Debt), issuing equity (Common Stock), or some combination of the above. The chosen method is called the Plug.

In this example we shall assume that the EFN is to be raised through long-term borrowing. Thus the plug is Long-Term Debt. To determine the Pro-Forma Financial Statements simply increase Long-Term Debt by the EFN of \$225 determined in the previous step.

 Balance Sheet (\$ in Millions) Assets 1999 2000 Liabilities and Owners' Equity 1999 2000 Current Assets Current Liabilities Cash 200 250 Accounts Payable 400 500 Accounts Receivable 400 500 Notes Payable 400 400 Inventory 600 750 Total Current Liabilities 800 900 Total Current Assets 1200 1500 Long-Term Liabilities Long-Term Debt 500 500 Fixed Assets Total Long-Term Liabilities 725 725 Net Fixed Assests 800 1000 Owners' Equity Common Stock (\$1 Par) 300 300 Retained Earnings 400 575 Total Owners' Equity 700 875 Total Assets 2000 2500 Total Liab. and Owners' Equity 2000 2500
 Income Statement (\$ in Millions) 1999 2000 Sales 1200 1500 Cost of Goods Sold 900 1125 Taxable Income 300 375 Taxes 90 112.5 Net Income 210 262.5 Dividends 70 87.5 Addition to Retained Earnings 140 175 © 2002 - 2010 by Mark A. Lane, Ph.D.