Introduction to Corporate Finance

PART 5: SPECIAL TOPICS

The Sales Forecast

The process of creating pro forma financial statements varies from company to company, but there are

some common elements. Most pro forma statements begin with a sales forecast. The sales forecast may

be derived through either a ‘top-down’ or ‘bottom-up’ approach.

Top-down sales forecasts rely heavily on macroeconomic and industry forecasts. Some companies use

complex statistical models or subscribe to forecasts produced by econometric modelling companies. In the

top-down approach, senior managers establish a company-wide objective for increased sales. Next, individual

divisions or business units receive targets that, in aggregate, collectively achieve the company’s overall growth

target. Division heads pass down sales targets to product line managers and other smaller-scale units. The

sales targets will vary across units within the division, but they must add up to achieve the division’s goal.

Companies that use a bottom-up sales forecast begin by assessing demand in the coming year on a

customer-by-customer basis. Managers add up these figures across sales territories, product lines and

divisions to arrive at the overall sales forecast for the company. Bottom-up forecasting approaches

generally do not rely on mathematical or statistical models.

Unsurprisingly, many companies use a blend of these two approaches. For example, a company may

generate a set of assumptions regarding the macroeconomic environment to which all divisions must

adhere. It then can generate forecasts from the customer level, and aggregate them to an overall forecast

for the entire company that is consistent with the macro assumptions. Some companies produce two sets

of forecasts, one that uses a statistical approach and another that relies on customer feedback. Senior

managers then compare the two forecasts before setting a final sales objective.

Constructing Pro Forma Statements

Starting with the sales forecast, financial analysts construct pro forma income statements and balance

sheets using a mix of facts and assumptions. For example, if a company’s strategic plan calls for major

investments in fixed assets, then the analyst will incorporate those projections in the forecast of total

fixed asset requirements as well as in the forecast of depreciation expense. In the absence of any specific

knowledge of capital spending plans, an analyst may assume that total fixed assets will remain at a fixed

percentage relative to sales or total assets; this assumption would, in turn, drive the depreciation line

item on the income statement.

Similarly, an analyst can make projections for line items that vary with sales volume. For example, by

assuming a constant gross profit margin, the analyst can estimate cost of goods sold directly from the sales

forecast. When companies construct pro forma statements by assuming that all items grow in proportion to

sales and by extending that percentage to all income statement and balance sheet accounts, they are using

the percentage-of-sales method. This is a convenient way to construct pro forma statements, and it is usually a

good starting point when making financial projections. Such balance sheet items as receivables, inventory

and payables do typically increase with sales, although not always in a linear fashion. For example, a company

with $100 billion in sales may not need 100 times as much inventory as a company with $1 billion in sales.

In constructing pro forma statements, analysts usually leave one line item on the balance sheet as

a plug figure, which is adjusted after making all other projections. For example, an analyst may make

projections for all asset, liability and equity accounts except for the cash balance; then, after the

projections are complete, the analyst could simply adjust the cash account to make the balance sheet

balance. Alternatively, the analyst might leave a short-term liability account open to serve as the plug

figure. The analyst could, for example, use the line item representing the amount borrowed on a bank

line of credit to make the right-hand and left-hand sides of the balance sheet equal. If this assumed

amount of borrowing on the credit line seems unreasonable, the company may need to recalculate the

other assumptions underlying its planning process.

top-down sales forecast

A sales forecast that relies

heavily on macroeconomic and

industry forecasts

bottom-up sales forecast

A sales forecast that relies

on the assessment by sales

personnel of demand in the

coming year on a customer-by-

customer basis

percentage-of-sales

method

Method of constructing pro

forma statements by assuming

all items grow in proportion

to sales

LO 16.4

John Eck, President of

Broadcast and Network

Operations, NBC

‘We put together

assumptions ... that

we believe the whole

company should follow,

and then we leave it up

to each division to give

us their forecast.’

See the entire interview on

the CourseMate website.

COURSEMATE
SMART VIDEO

Source: Cengage Learning

plug figure

A line item on the pro

forma balance sheet that

represents an account that

can be adjusted after all other

projections are made