PERCENT-OF-SALES METHOD OF FINANCIAL FORECASTING

When constructing a financial forecast, the sales forecast is used traditionally to estimate various expenses, assets, and liabilities. The most widely used method for making these projections is the percent of- sales method, in which the various expenses, assets, and liabilities for a future period are estimated as a percentage of sales.

These percentages, together with the projected sales, are then used to construct pro forma (planned or projected) balance sheets.

The calculations for a pro forma balance sheet are as follows:

1. Express balance sheet items that vary directly with sales as a percentage of sales. Any item that does not vary directly with sales (such as long-term debt) is designated not applicable (n.a.).

2. Multiply the percentages determined in step 1 by the sales projected to obtain the amounts for the future period.

3. Where no percentage applies (such as for long-term debt, common stock, and capital surplus), simply insert the figures from the present balance sheet in the column for the future period.

4. Compute the projected retained earnings as follows:
Projected retained earnings ¼ present retained earnings
þ projected net income cash dividends paid
(You will need to know the percentage of sales that constitutes net income and the dividend payout ratio.)

5. Sum the asset accounts to obtain a total projected assets figure. Then add the projected liabilities and equity accounts to determine the total financing provided. Since liability plus equity must balance the assets when totaled, any difference is a shortfall, which is the amount of external financing needed.


One important limitation of the percent-of-sales method is that the firm is assumed to be operating at full capacity. On the basis of this assumption, the firm does not have sufficient productive capacity to absorb projected increases in sales and thus requires an additional investment in assets.

The major advantage of the percent-of-sales method of financial forecasting is that it is simple and inexpensive to use. To obtain a more precise projection of the firm’s future financing needs, however, the preparation of a cash budget is required.