CP

Financial Statement Forecasting: The Percent of Sales Method 413

Although it is useful to calculate the past growth rate in sales, much more is in-

volved in estimating future sales. Future sales will depend on the economy (both do-

mestic and global), the industry’s prospects, the company’s current product line, pro-

posed products that are in the pipeline, and marketing campaigns. When MicroDrive

incorporated these issues into its analysis, the expected growth for the upcoming year

was estimated to be 10 percent.

If the sales forecast is off, the consequences can be serious. First, if the market

expands by morethan MicroDrive has prepared, the company will not be able to meet

demand. Its customers will end up buying competitors’ products, and MicroDrive will

lose market share. On the other hand, if its projections are overly optimistic, Micro-

Drive could end up with too much plant, equipment, and inventory. That would

mean low turnover ratios, high costs for depreciation and storage, and write-offs of

obsolete inventory. All of this would result in low profits, a low rate of return on

equity, low free cash flows, and a depressed stock price. If MicroDrive

had financed an unnecessary expansion with debt, high interest charges would com-

pound its problems. Thus, an accurate sales forecast is critical to the firm’s well-

being.^3

List some factors that should be considered when developing a sales forecast.

Explain why an accurate sales forecast is critical to profitability.

Financial Statement Forecasting:

The Percent of Sales Method

Once sales have been forecasted, we must forecast future balance sheets and income

statements. The most commonly used technique is the percent of sales method,

which begins with the sales forecast, expressed as an annual growth rate in dollar

sales revenues. Many items on the income statement and balance sheets are assumed

to increase proportionally with sales, with their values for a particular year esti-

mated as percentages of the forecasted sales for that year. The remaining items on

the forecasted statements—items that are not tied directly to sales—depend on the

company’s dividend policy and its relative use of debt and equity financing.

In the following sections we explain the percent of sales method and use it to fore-

cast MicroDrive’s financial statements.

Step 1. Analyze the Historical Ratios

The first step is to analyze the historical ratios. This differs somewhat from the ratio

analysis of Chapter 10, since the objective here is to forecast the future, or pro forma,

financial statements. The percent of sales method assumes that costs in a given year

will be some specified percentage of that year’s sales. Thus, we begin our analysis by

calculating the ratio of costs to sales for several past years. We illustrate the method

using only two years of data for MicroDrive, but a thorough analysis should have at

least five years of historical data. Table 11-1 shows MicroDrive’s ratio of cost to sales

for the past two years for MicroDrive. In 2001, MicroDrive had an 87.6 percent ratio

(^3) A sales forecast is actually the expected value of a probability distribution, so there are many possible levels of
sales. Because any sales forecast is subject to uncertainty, financial planners are just as interested in the de-
gree of uncertainty inherent in the sales forecast, as measured by the standard deviation, as in the expected
level of sales.

410 Financial Planning and Forecasting Financial Statements