Financial Management
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The percentage of Sales approach to financial forecasting requires items found in the Income Statement and Balance Sheet to be separated into two groups – those that vary directly with sales and those that do not. This approach is used to develop quick and practical pro forma financial statements (statements projecting the future, not tracking the past). Organizations use the percent of sales method to estimate future financial figures based on projected sales. This method is implemented as follows:
Use data from the most recent available years balance sheet and income statement.
Using the Income Statements for financial forecasting:
Forecast sales figures for the coming year.
Review historical financial statements to identify financial figures that are correlated with sales figures and those that arent. Only items that are in correlation with sales can be forecasted in this model.
One assumption that is made during calculation is that items affected by sales (such as costs) are affected at a constant percentage of sales and we can verify this by calculating the profit margin with current financial figures and pro forma financial figures.
Organizations also forecast dividend payments and addition to retained earnings ratio (retention ratio) by assuming the cash dividend payout and addition to retained earnings will remain a constant fraction of net income.
Using the Balance Sheet for financial forecasting:
As discussed above, some items on the balance sheet vary directly with sales and items that do not. Items that vary directly with sales are expressed as a percentage of sales. The ratio of total assets to sales is called the capital intensity ratio which indicates the amount of assets to create $1 in sales
Some items on a balance sheet do not directly correlate with sales. Liabilities do not directly correlate with sales, but they do change “spontaneiously” with an increase/decrease percentage of sales.
Using the information from historical income statements and balance sheets along with the projected percentage of sales to create pro forma Income Statements and Balance Sheets.
What is the External Funding (EFN) that is required in your model? How would you recommend that management either meet the external funding need or utilize any surplus? Make a recommendation and address the advantages and disadvantages of your recommendation.
Organizations can raise external funding to facilitate growth. The two most common ways of raising this needed external financing includes borrowing money that will be repaid with interest and selling a stake in the ownership of the