Financial Statement Forecasting: The Percent of Sales Method 415
However, some companies do have a fixed relationship between sales and plant and
equipment, even in the short term. For example, new stores in many retail chains
achieve the same sales during their first year as the chain’s existing stores. The only
way such retailers can grow (beyond inflation) is by adding new stores. Such compa-
nies therefore have a strong proportional relationship between fixed assets and sales.
Finally ,in the long term there is a strong relationship between sales and net plant
and equipment for virtually all companies: Few companies can continue to increase sales
unless they eventually add capacity. Therefore ,as a first approximation it is reasonable
to assume that the long-term ratio of net plant and equipment to sales will be constant.
For the first years in a forecast, managers generally build in the actual planned ex-
penditures on plant and equipment. If those estimates are not available, it is generally
best to assume a constant ratio of net plant and equipment to sales.
Some items on the liability side of the balance sheet can be expected to increase
spontaneously with sales, producing what are called spontaneously generated funds.
The two primary types of spontaneous funds are accounts payable and accruals. Re-
garding payables, as sales increase, so will purchases of raw materials, and those larger
purchases will spontaneously lead to a higher level of accounts payable. Similarly, more
sales will require more labor, while higher sales normally result in higher taxable in-
come and thus taxes. Therefore, accrued wages and taxes both increase.
All of the historical ratios are shown in Table 11-1. Using these ratios, along with
the industry composite ratios and a knowledge of MicroDrive’s operating plans and
industry trends, its managers are ready to begin forecasting the projected, or pro
forma, financial statements.
Step 2. Forecast the Income Statement
In this section we explain how to forecast the income statement, and in the following
section we forecast the balance sheet. Although we cover these topics in two separate
sections, the forecasted financial statements are actually integrated with one another
and with the previous year’s statements. For example, the income statement item “de-
preciation” depends on net plant and equipment, which is a balance sheet item, and
“retained earnings,” which is a balance sheet item, depends on the previous year’s re-
tained earnings, the forecasted net income, and the firm’s dividend policy. Keep this
interrelatedness in mind as you go through the forecast.
Forecast Sales Table 11-2 shows the forecasted income statement. Management
forecasts that sales will grow by 10 percent. Thus, forecasted sales, shown in Row 1,
Column 3, is the product of $3,000 million prior year’s sales and (1 g), or
$3,000(1.1) $3,300 million.
Forecast Earnings before Interest and Taxes (EBIT) Table 11-1 shows that Mi-
croDrive’s ratio of costs to sales for the most recent year was 87.2 percent
($2,616/$3,000 0.872). Thus, to get a dollar of sales, MicroDrive had to incur 87.2
cents of costs. Initially, we assume that the cost structure will remain unchanged. Later
on, we explore the impact of changes in the cost structure, but for now we assume that
forecasted costs will equal 87.2 percent of forecasted sales. See Row 2 of Table 11-2.
The most recent ratio of depreciation to net plant and equipment, shown in Table
11-1, was 10 percent ($100/$1,000 0.10), and MicroDrive’s managers believe this is
a good estimate of future depreciation rates. As we show later in Table 11-3 on page
420, the forecasted net plant and equipment is $1,100 million. Therefore, forecasted
depreciation is 0.10($1,100) $110 million. Notice how a balance sheet item, net
plant and equipment, affects the charge for depreciation, which is an income state-
ment item.
See Ch 11 Tool Kit.xls
for all calculations.
412 Financial Planning and Forecasting Financial Statements
