percentage of sales method

Prepared byPrepared byKen HartviksenKen Hartviksen

Percentage of Sales Method Percentage of Sales Method of Financial Statement of Financial Statement ForecastingForecasting

Financial ForecastingFinancial Forecasting

Financial Statement Analysis and Financial Statement Analysis and ForecastingForecasting

Financial Statement Analysis and Forecasting 4 - 3

Financial ForecastingFinancial ForecastingPurposePurpose

Business Owners must produce forecasts Business Owners must produce forecasts for the financial results of corporate plans for the financial results of corporate plans to:to:– Determine whether the corporate plans will require Determine whether the corporate plans will require

additional external financing additional external financing – Determine whether the corporate plans will produce Determine whether the corporate plans will produce

surplus cash resources that could be distributed to surplus cash resources that could be distributed to shareholders as dividendsshareholders as dividends

– Assess the financial forecasts to determine the financial Assess the financial forecasts to determine the financial feasibility of corporate plans – if poor financial results are feasibility of corporate plans – if poor financial results are forecast, this gives management the opportunity to forecast, this gives management the opportunity to reexamine and amend corporate plans to produce better reexamine and amend corporate plans to produce better results before resources and people are committed.results before resources and people are committed.


Financial ForecastingFinancial Forecasting

The basis for all financial forecasts is the sales The basis for all financial forecasts is the sales forecast.forecast.

The most recent balance sheet values are the starting The most recent balance sheet values are the starting point.point.

Pro forma (forecast) balance sheets are projected Pro forma (forecast) balance sheets are projected assuming some relationship with projected sales assuming some relationship with projected sales (constant percentage of sales)(constant percentage of sales)

Current liabilities are usually assumed to rise and fall Current liabilities are usually assumed to rise and fall in a constant percentage with sales – we call them in a constant percentage with sales – we call them ‘‘spontaneous liabilitiesspontaneous liabilities’ because they change without ’ because they change without negotiation with creditors.negotiation with creditors.


Financial ForecastingFinancial ForecastingThe Percentage of Sales MethodThe Percentage of Sales Method

The percentage of sales method involves The percentage of sales method involves the following steps:the following steps:

1.1. Determine which financial policy variables you are Determine which financial policy variables you are interested ininterested in

2.2. Set all the non-financial policy variables as a Set all the non-financial policy variables as a percentage of salespercentage of sales

3.3. Extrapolate the balance sheet based on a percentage Extrapolate the balance sheet based on a percentage of salesof sales

4.4. Estimate future retained earningsEstimate future retained earnings5.5. Modify and re-iterate until the forecast makes sense.Modify and re-iterate until the forecast makes sense.

This process most often results in a balance sheet that This process most often results in a balance sheet that does not balance – a ‘plug’ (balancing) amount is the does not balance – a ‘plug’ (balancing) amount is the external funds required (or surplus funds forecast)external funds required (or surplus funds forecast)



Cash 5 Accruals 5Securities 10 Payables 5Receivables 10 Bank debt 20Inventory 25Current assets 50 Current liabilities 30Net fixed assets 100 Long-term debt 40

Common equity 80

Total assets 150 Total Liabilities 150

Table 4-11 Balance Sheet

The historical balance sheet.

If sales increase,

assets used to produce

those sales must grow.

Spontaneous liabilities

Policy variables requiring decision.



%Sales 120 100.0% 132 145 160

Cash 5 4.2% 5.5 6.0 6.7Securities 10 8.3% 11.0 12.1 13.3Receivables 10 8.3% 11.0 12.1 13.3Inventory 25 20.8% 27.5 30.2 33.3Net fixed assets 100 83.3% 110.0 120.8 133.3Total assets 150 125.0% 165.0 181.3 200.0

Accruals 5 4.2% 5.5 6.0 6.7Payables 5 4.2% 5.5 6.0 6.7Short-term debt 20 16.7% 20.0 20.0 20.0Long-term debt 40 33.3% 40.0 40.0 40.0Equity 80 66.7% 80.0 80.0 80.0Total liabilities and equity 150 125.0% 151.0 152.1 153.3

Cumulative (EFR) 14.0 29.2 46.7

Table 4-12 Initial Forecast

percentages of sales

Sales projections

and the base case

of $120

Balance Sheet Values

calculated as a

percentage of sales.

Naïve increases in balance

sheet accounts in

same proportion

to projected sales

Accounts requiring decision

are assumed to

remain constant on first pass.

First pass funding shortfall

projected.


Percentage of Sale MethodPercentage of Sale MethodImproving the Pro Forma Balance SheetImproving the Pro Forma Balance Sheet

• The prior pro form balance sheet was The prior pro form balance sheet was developed using very naïve assumptions:developed using very naïve assumptions:– Policy variables held constantPolicy variables held constant– Asset growth in all accounts held at the same Asset growth in all accounts held at the same

percentage of salespercentage of sales– Spontaneous liabilities increased at a constant Spontaneous liabilities increased at a constant

percentage of sales.percentage of sales.• One improvement is to realize that the firm’s One improvement is to realize that the firm’s

equity will grow by the amount of retained equity will grow by the amount of retained earnings.earnings.

(See the following income statement)(See the following income statement)



Sales 120Gross operating profit 48Fixed costs 31EBIT 17Interest 5Taxes @ 50% 6Net Income 6Dividends 3

Table 4-13 Income Statement

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.



%Sales 120 100.0% 132 145 160



Cumulative (EFR) 10.7 22.3 35.8

Table 4-14 First Revision of Forecast Equity accounts increased

by projected retained earnings

that increase in proportion to sales.

Notice how the

retained earnings

has reduced

the projected External Funds

Required.


Percentage of Sale MethodPercentage of Sale MethodSecond Revision the Pro Forma Balance SheetSecond Revision the Pro Forma Balance Sheet

• Further improvements to the pro forma balance sheet Further improvements to the pro forma balance sheet include:include:– Recognizing that cash balances may not have to rise as a pure Recognizing that cash balances may not have to rise as a pure

constant percentage of salesconstant percentage of sales• Cash balances are required for a variety of reasonsCash balances are required for a variety of reasons

– To support transactionTo support transaction– As a safety cushion against unforeseen cash needsAs a safety cushion against unforeseen cash needs– As a speculative balance to take advantage of unforeseen opportunitiesAs a speculative balance to take advantage of unforeseen opportunities

• Even at low levels of sales, cash balances are required Even at low levels of sales, cash balances are required • As sales increase, additional cash on hand may be required, but at As sales increase, additional cash on hand may be required, but at

a lower percentage of sales. (lower slope to the trend line between a lower percentage of sales. (lower slope to the trend line between cash balances and sales)cash balances and sales)

(See Figure 4 – 3 on the following slide for a more realistic forecast for cash)(See Figure 4 – 3 on the following slide for a more realistic forecast for cash)


Percentage of Sales MethodPercentage of Sales MethodSecond Revision the Pro Forma Balance SheetSecond Revision the Pro Forma Balance Sheet

4-3 FIGURE4 - 3 FIGURE

Cas

h

Sales

14.0

12.0

10.0

8.0

6.0

4.0

2.0

0.00 20 40 60 80 100 120 140 160 180 200 220 240 260 280 300

Cash Forecast

Linear with constant

Simple %


Percentage of Sale MethodPercentage of Sale MethodSecond Revision the Pro Forma Balance SheetSecond Revision the Pro Forma Balance Sheet

• Further improvements to the pro forma balance sheet Further improvements to the pro forma balance sheet include reexamining asset growth assumptions:include reexamining asset growth assumptions:– Refinement of the cash forecast (as per the previous two slides)Refinement of the cash forecast (as per the previous two slides)– Realization that EFR can be offset by marketable securities that can easily be Realization that EFR can be offset by marketable securities that can easily be

liquidated to finance growth needs.liquidated to finance growth needs.– Reexamine our assumptions about growth in Accounts Receivable and Reexamine our assumptions about growth in Accounts Receivable and

whether we want to change our credit policies in the context of the forecast whether we want to change our credit policies in the context of the forecast macro economic and competitive environmentmacro economic and competitive environment

– Reexamine our inventory management policies taking into account the Reexamine our inventory management policies taking into account the macroeconomic and competitive environment macroeconomic and competitive environment

– Realization that increases in net fixed assets is ‘lumpy’ and not continuously Realization that increases in net fixed assets is ‘lumpy’ and not continuously incremental (if we have excess production capacity, we may not need to 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) invest any further in fixed assets until we are forecast to exceed that capacity)

• Further improvements to the pro forma balance sheet Further improvements to the pro forma balance sheet include reexamining assumptions regarding the growth include reexamining assumptions regarding the growth in spontaneous liabilitiesin spontaneous liabilities

(See the effects of these changes on the following slide)(See the effects of these changes on the following slide)



%Sales 120 100.0% 132 145 160



Cumulative (EFR) -10.8 -21.7 -32.6

Table 4-15 Second Revision of Forecast Assuming cash remains constant, we

liquidate marketable

securities and we retain 50% of our profits dramatically affects the forecast.

We now have surplus

resources!


Percentage of Sale MethodPercentage of Sale MethodFinal Revisions to the Pro Forma Income StatementFinal Revisions to the Pro Forma Income Statement

• Given our assumptions about capacity, and there being no Given our assumptions about capacity, and there being no need for further expansion in plant and equipment to support need for further expansion in plant and equipment to support anticipated sales growth, we can reexamine our assumptions anticipated sales growth, we can reexamine our assumptions about the cost structure of the firm.about the cost structure of the firm.

Variable CostsVariable Costs• Variable costs (direct materials and direct labour) will likely grow in proportion Variable costs (direct materials and direct labour) will likely grow in proportion

to sales.to sales.Fixed CostsFixed Costs• Fixed costs, however should remain fixed.Fixed costs, however should remain fixed.• By modifying the income statement for this change in assumptions, we see the By modifying the income statement for this change in assumptions, we see the

net result of this is an increase in forecast net income.net result of this is an increase in forecast net income.DividendsDividends• Most firms do not follow a constant payout ratio, but hold dividends constant Most firms do not follow a constant payout ratio, but hold dividends constant

over multiple years.over multiple years.• Assume that we hold dividends at $3 for the next three 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)(See the effects of these changes on the final pro forma income statement on the following slide)



Sales $120 $132 $145 $160Gross operating profit 48 53 58 64Fixed costs 31 31 31 31EBIT 17 22 27 33Interest 5 5.0 5.0 5.0Taxes @ 50% 6 8.5 11.0 14.0Net Income 6.0 8.5 11.0 14.0Net profit margin 5.0% 6.4% 7.6% 8.8%

Dividends $3.0 $3.0 $3.0 $3.0Additions to Retained earnings $3.0 $5.5 $8.0 $11.0

Table 4-16 Profit Margin and Sales


Percentage of Sale MethodPercentage of Sale MethodFinal Revisions to the Pro Forma Balance SheetFinal Revisions to the Pro Forma Balance Sheet

• Given our modified income statement and Given our modified income statement and assumptions regarding net profit and cash assumptions regarding net profit and cash dividends we can prepare a final revised balance dividends we can prepare a final revised balance sheetsheet

• This balance sheet now shows that we forecast This balance sheet now shows that we forecast significant surplus cash resources and must make significant surplus cash resources and must make some decisions about how we will manage them:some decisions about how we will manage them:– Investment temporarily in marketable securities in anticipation of further Investment temporarily in marketable securities in anticipation of further

investment opportunities in growing the firm?investment opportunities in growing the firm?– Distribute them in the form of cash dividends?Distribute them in the form of cash dividends?

(See the effects of these changes on the final pro forma balance sheet on the (See the effects of these changes on the final pro forma balance sheet on the following slide)following slide)



%Sales 120 100.0% 132 145 160



Cumulative (EFR) -13.0 -28.3 -46.2

Table 4-17 Final Revision of Forecast


Summary and ConclusionsSummary and Conclusions

In this slide set you have learned:In this slide set you have learned:

– The importance of understanding the sources of The importance of understanding the sources of a firm’s profitability or where the challenges to a firm’s profitability or where the challenges to profitability exist.profitability exist.

– How to prepare financial forecasts and How to prepare financial forecasts and understand the assumptions underlying the understand the assumptions underlying the percentage of sales method of financial percentage of sales method of financial forecasting.forecasting.


CopyrightCopyright

Copyright © 2007 John Wiley & Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights Sons Canada, Ltd. All rights reserved. Reproduction or reserved. Reproduction or translation of this work beyond that translation of this work beyond that permitted by Access Copyright (the permitted by Access Copyright (the Canadian copyright licensing Canadian copyright licensing agency) is unlawful. Requests for agency) is unlawful. Requests for further information should be further information should be addressed to the Permissions addressed to the Permissions Department, John Wiley & Sons Department, John Wiley & Sons Canada, Ltd.Canada, Ltd. The purchaser may The purchaser may make back-up copies for his or her make back-up copies for his or her own use only and not for distribution own use only and not for distribution or resale.or resale. The author and the The author and the publisher assume no responsibility publisher assume no responsibility for errors, omissions, or damages for errors, omissions, or damages caused by the use of these files or caused by the use of these files or programs or from the use of the programs or from the use of the information contained herein.information contained herein.

percentage of sales method

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