Are you up for looking at what is the percentage of sales forecasting method and what it is for? You are on the right spot to know the answer to 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 details of the percentage of sales method.
What is Percentage of Sales Forecasting Method
A financial forecasting method in which all the financial items, such as cost of goods sold, inventory, and cash, are calculated on the basis of sales percentage is known as the percentage of sales method. The percentage of sales method has the following steps:
- The sales revenue and expenses are estimated year by year.
- Levels of investment requirements (in assets) are estimated as needed to meet 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 the percentage of sales method. Alterations in the sales revenue in successive years are forecasted in the first step. Expenses are then estimated for the successive period. The expenses include:
- Administrative expense
- Cost of goods sold expense
- Depreciation expenses
- Marketing expenses
- Other expenses
However, rather than on an accrual basis, these expenses and revenues would be estimated on a cash basis. As a result of changes in sales, it is required to forecast the anticipated alteration in liabilities and assets after estimating expenses and revenue.
The business organization would be able to identify how much capital it has to invest in assets and how much it requires borrowing as a result of any shortfall, after forecasting assets and liabilities as a consequence of changes in sales.
Here, different heads of assets and liabilities would be examined along with their relationship with sales. Certain assumptions require consideration when the business organization builds these relations by identifying the alteration in liabilities and assets as a result of changes in sales.
General Assumptions
- Current Assets: Normally increase in proportion to sales.
- Fixed Assets: Do not always increase in proportion to sales. Determine if the business organization requires expanding office, factory space, property, or machinery to achieve the sales target.
- Current Liabilities: Also known as spontaneous financing. Usually increase in proportion to sales.
- Long-Term Liabilities: Also known as discretionary financing. Do not increase in proportion to sales.
Explanation
Current assets contain marketable securities, cash, inventory, accounts receivable, and prepaid expenses. Out of these current assets, changes in accounts receivable, cash, and inventory can be directly associated with sales.
On the other hand, prepaid expenses and marketable securities are independent of sales, which means these two heads may not be affected by changes in sales. It is also significant to note that in real-life situations, current assets do not alter in the same proportion as sales.
For example, an increase of 20% in sales does not necessarily guarantee that current assets will also increase by 20%. However, for simplicity, it is assumed that current assets alter proportionally with changes in sales.
With the alteration in sales, fixed assets do not alter. For example, if the business organization plans to increase sales by 10%, it is not essential to increase fixed assets by 10%.
However, the business organization has to enhance its fixed assets if it plans to double its sales in the next three years. Fixed assets are generally not affected by small year-to-year changes in sales.
Current liabilities contain the 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 the business organization increase by 15%, then its current liabilities would also increase by 15%.
As current liabilities move in direct relation with sales, they are also known as spontaneous financing. However, long-term liabilities do not directly alter in proportion to changes in sales revenue.
