Are you up for looking what is percentage of sales forecasting method and what is it for? You are on the right spot to know the answer of this question.
Two methods are commonly used for preparation of pro forma statements. Percentage of Sales is one of them and below this post is all about the complete detail of percentage of sales method.
What is Percentage of Sales Forecasting Method?
A financial forecasting method in which all the financial items, such cost of goods item sold, inventory and cash are calculated on the basis of sales percentage is known as percentage of sales method. Percentage of sales method has the following steps.
- The sales revenue & expenses are estimated year by year.
- Levels of investment requirements (in assets) are estimated needed meeting estimated sales (employing financial ratios).
- Financial needs (Liabilities) are estimated.
Explanation:
The cash flow would be estimated on the basis of sales revenue while using percentage of sales method. Alterations in the sales revenue in the successive years is forecasted in the first step.
Expenses would also be estimated that incurred during the successive period. The expenses include administrative expense, cost of goods sold expense, depreciation expenses, marketing expenses and other expenses.
However, rather than on accrual basis, these expenses and revenues would be estimated on cash.
As a result of changes in sales, it is required to forecast the anticipated alteration in liabilities & assets after estimating expenses & revenue.
The business organization would be able to identify how much capital it has to invest in assets and how much the business organization requires borrowing as a result of any shortfall, after having forecasted assets & liabilities as a consequence of changes in sales.
Here different heads of assets & liabilities would be examined along with their relationship with sales.
Certain assumptions require to be considered when the business organization builds these relations by identifying the alteration in liabilities & assets as a result of change in sales.
General Assumptions
- Current Assets: Normally increase in proportion to sales.
- Fixed Assets: Always does not increase in proportion to sales. Ask if business organization require expanding office, factory space, property, machinery in order to achieve the sales target of the business organization.
- Current Liabilities: Also known as spontaneous financing. Usually increase in proportion to sales.
- Long Term Liabilities: Also known as discretionary financing. It does not increase in proportion to sales.
Explanation
Current assets contain marketable securities, cash, inventory, accounts receivables and prepaid expenses. Out of these current assets, changes in accounts receivables, cash and inventory can be directly associated with sales.
On the other hand prepaid expenses and marketable securities are independent of sales, which mean these two heads may not be affected by changes in sales.
It is also significant to note that in real life situation current assets do not alter in same proportion as the sales.
For example, an increase in 20% sales does not essentially guarantee that the current assets also enhanced by 20%.
However, for making simple it is to be assumed that current assets alter proportionally as alteration in sales.
On the other hand, with the alteration in sales, fixed assets do not alter. For example, if the business organization plan to enhance the sales by 10% than it is not essential to enhance the fixed assets by 10%.
But the business organization has to enhance its fixed assets if it plans to enhance double its sales in the next three years. However, fixed assets are not affected by small year-to-year changes in sales.
Current liabilities contain short term portion of long term liabilities, accounts payable and accrued expenses. With any growth in sales, current liabilities are assumed to increase proportionally just like current assets.
If sales of business organization enhances by 15%, than its current liabilities would also enhanced by 15%.
As current liability move in direct relation with sales therefore, these are also known as spontaneous financing. However, long term liabilities do not directly alter in proportion to alteration in sales revenue.
