Conceptualize the percentage of sales method of forecasting with examples.

Financial forecasting is a process by which the firm is able to predict its future assets and
liabilities through different methods which helps in identifying asset requirements and the
corresponding need for external financing. There are several ways of financial forecasting;
amongst which percentage of sales method is one of them.
Percentage of sales method is the process of forecasting the financial statements namely, income
statement and the balance sheet using sales as a reference point. By forecasting sales in near
future, the various accounts under balance sheet and income statement are assumed to increase
(or decrease) in proportionate to the sales thereby, enabling us to determine required additional
financing to meet the forecasted sales if necessary.
In this way, percentage of sales method helps us determine the requirement of additional
financing.
However, a few assumptions are made while forecasting the financial statements. They are:

The firm is operating at full capacity, so all the assets grow in proportionate to sales.
Payables and accruals also grow in proportionate to sales.
Financial accounts like notes payable, bonds, stock, etc do not grow.
Dividend payout ratio and net profit margin are constant.

For eg. Consider the following balance sheet and income statement of ABC Co. for the year
2010.

Assets
Current
Assets
Cash
Accounts
Receivables
Inventory
Total CA
Fixed
Assets

Balance Sheet
(Amount in Million)
Amount %
Liabilities
and Equity
Current
Liabilities
200
16.6 Accounts
7
Payable
400
33.3 Notes
3
Payable
600
50.0
0
1200
Total CL
800
66.6 Long Term
7
Liabilities
Owners
Equity
Common
stock
Retained
Earnings
Total

Amoun
t
400
400

800
500

300
400
700

33.3
3
NA

NA

NA

Income Statement
(Amount in Million)
Particulars
Amount %
Sales

1200

Cost of Goods
Sold
Taxable
Income
Taxes

900

75

300

25

90

30

Net Income
Dividends

210
70

Addition to
Retained
Earnings

140

17.5
33.3
3
66.6
7

Total

Equity
Total

2000

2000

Here the ratios of various accounts to under balance sheet are calculated in relation to sales.
Sales are predicted to increase by 25% in the year 2011. Thus, the predicted balance sheet and
income statement are:

Assets
Current
Assets
Cash
Accounts
Receivables
Inventory
Total CA
Fixed
Assets

Total

Balance Sheet
(Amount in Rs. Millions)
2010
2011 Liabilities
and Equity
Current
Liabilities
200
250
Accounts
Payable
400
500
Notes
Payable
600
750
1200
1500 Total CL
800
1000 Long Term
Liabilities
Owners
Equity

2000

2500

Common
stock
Retained
Earnings
Total
Equity
Total

2010

2011

400

500

400

400

800
500

900
500

300

300

400

575

700

875

2000

2275
*

Income Statement
(Amount in Rs. Millions)
Particulars
2010
2011
Sales

1200

1500

Cost of Goods
Sold
Taxable
Income
Taxes
Net Income
Dividends

900

1125

300

375

90
210
70

112.5
262.5
87.5

Addition to
Retained
Earnings

140

175

*Here the balance of 2011 in the assets side and liabilities side arent equal which shows the
need for external financing. The additional financing required is hence calculated as follows:
AFN = Rs. 2500 Rs. 2275 million = Rs. 225 million

If excess capacity exists, how will that affect the AFN?

Excess capacity refers to the capacity in a firm to increase output without having to invest further
in its assets thereby reducing the average cost of production to a minimum. When excess
capacity exists, sales in a firm can grow upto a certain level with no increase in the fixed assets
of the firm. Sales beyond that level only would require additional financing. Hence, in

comparison to the firm with no excess capacity, the additional fund needed (AFN) for a firm with
excess capacity is lower; given the sales are at the same level in both the firms.
What is the implication of regression analysis and percentage of sales method in corporate
world?