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Prepared by

Ken Hartviksen

Percentage of Sales Method
of Financial Statement
Forecasting
Financial Forecasting
Financial Statement Analysis and
Forecasting
Financial Statement Analysis and Forecasting 4 - 3
Financial 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 - 4
Financial Forecasting
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.
Financial Statement Analysis and Forecasting 4 - 5
Financial Forecasting
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)
Financial Statement Analysis and Forecasting 4 - 6
Financial Forecasting
The Percentage of Sales Method
Cash 5 Accruals 5
Securities 10 Payables 5
Receivables 10 Bank debt 20
Inventory 25
Current assets 50 Current liabilities 30
Net 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.
Financial Statement Analysis and Forecasting 4 - 7
Financial Forecasting
The Percentage of Sales Method
%
Sales 120 100.0% 132 145 160
Cash 5 4.2% 5.5 6.0 6.7
Securities 10 8.3% 11.0 12.1 13.3
Receivables 10 8.3% 11.0 12.1 13.3
Inventory 25 20.8% 27.5 30.2 33.3
Net fixed assets 100 83.3% 110.0 120.8 133.3
Total assets 150 125.0% 165.0 181.3 200.0
Accruals 5 4.2% 5.5 6.0 6.7
Payables 5 4.2% 5.5 6.0 6.7
Short-term debt 20 16.7% 20.0 20.0 20.0
Long-term debt 40 33.3% 40.0 40.0 40.0
Equity 80 66.7% 80.0 80.0 80.0
Total 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.
Nave
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.
Financial Statement Analysis and Forecasting 4 - 8
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)
Financial Statement Analysis and Forecasting 4 - 9
Financial Forecasting
The Percentage of Sales Method
Sales 120
Gross operating profit 48
Fixed costs 31
EBIT 17
Interest 5
Taxes @ 50% 6
Net Income
6
Dividends 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.
Financial Statement Analysis and Forecasting 4 - 10
Financial Forecasting
The Percentage of Sales Method
%
Sales 120 100.0% 132 145 160
Cash 5 4.2% 5.5 6.0 6.7
Securities 10 8.3% 11.0 12.1 13.3
Receivables 10 8.3% 11.0 12.1 13.3
Inventory 25 20.8% 27.5 30.2 33.3
Net fixed assets 100 83.3% 110.0 120.8 133.3
Total assets 150 125.0% 165.0 181.3 200.0
Accruals 5 4.2% 5.5 6.0 6.7
Payables 5 4.2% 5.5 6.0 6.7
Short-term debt 20 16.7% 20.0 20.0 20.0
Long-term debt 40 33.3% 40.0 40.0 40.0
Equity 80 66.7% 83.3 86.9 90.9
Total liabilities and equity 150 125.0% 154.3 159.0 164.2
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.
Financial Statement Analysis and Forecasting 4 - 11
Percentage of Sale Method
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)
Financial Statement Analysis and Forecasting 4 - 12
Percentage of Sales Method
Second Revision the Pro Forma Balance Sheet
4-3 FIGURE 4 - 3 FIGURE
C
a
s
h

Sales
14.0

12.0







10.0






8.0






6.0







4.0






2.0

0.0
0 20 40 60 80 100 120 140 160 180 200 220 240 260 280 300
Cash Forecast
Linear with
constant
Simple %
Financial Statement Analysis and Forecasting 4 - 13
Percentage of Sale Method
Second Revision the Pro Forma Balance Sheet
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)
Financial Statement Analysis and Forecasting 4 - 14
Financial Forecasting
The Percentage of Sales Method
%
Sales 120 100.0% 132 145 160
Cash 5 4.2% 5.0 5.0 5.0
Securities 10 8.3% 0.0 0.0 0.0
Receivables 10 8.3% 11.0 12.1 13.3
Inventory 25 20.8% 27.5 30.2 33.3
Net fixed assets 100 83.3% 100.0 90.0 80.0
Total assets 150 125.0% 143.5 137.3 131.7
Accruals 5 4.2% 5.5 6.0 6.7
Payables 5 4.2% 5.5 6.0 6.7
Short-term debt 20 16.7% 20.0 20.0 20.0
Long-term debt 40 33.3% 40.0 40.0 40.0
Equity 80 66.7% 83.3 86.9 90.9
Total liabilities and equity 150 125.0% 154.3 159.0 164.2
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!
Financial Statement Analysis and Forecasting 4 - 15
Percentage of Sale Method
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)
Financial Statement Analysis and Forecasting 4 - 16
Financial Forecasting
The Percentage of Sales Method
Sales $120 $132 $145 $160
Gross operating profit 48 53 58 64
Fixed costs 31 31 31 31
EBIT 17 22 27 33
Interest 5 5.0 5.0 5.0
Taxes @ 50% 6 8.5 11.0 14.0
Net Income
6.0 8.5 11.0 14.0
Net profit margin 5.0% 6.4% 7.6% 8.8%
Dividends $3.0 $3.0 $3.0 $3.0
Additions to Retained earnings $3.0 $5.5 $8.0 $11.0
Table 4-16 Profit Margin and Sales
Financial Statement Analysis and Forecasting 4 - 17
Percentage of Sale Method
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)
Financial Statement Analysis and Forecasting 4 - 18
Financial Forecasting
The Percentage of Sales Method
%
Sales 120 100.0% 132 145 160
Cash 5 4.2% 5.0 5.0 5.0
Securities 10 8.3% 0.0 0.0 0.0
Receivables 10 8.3% 11.0 12.1 13.3
Inventory 25 20.8% 27.5 30.2 33.3
Net fixed assets 100 83.3% 100.0 90.0 80.0
Total assets 150 125.0% 143.5 137.3 131.7
Accruals 5 4.2% 5.5 6.0 6.7
Payables 5 4.2% 5.5 6.0 6.7
Short-term debt 20 16.7% 20.0 20.0 20.0
Long-term debt 40 33.3% 40.0 40.0 40.0
Equity 80 66.7% 85.5 93.5 104.5
Total liabilities and equity 150 125.0% 156.5 165.6 177.8
Cumulative (EFR) -13.0 -28.3 -46.2
Table 4-17 Final Revision of Forecast
Financial Statement Analysis and Forecasting 4 - 19
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.
Financial Statement Analysis and Forecasting 4 - 20
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