Financial Statement Forecasting: The Percent of Sales Method 419
Fifth, many firms use short-term bank loans, shown on the balance sheet as notes
payable, as a financial “shock absorber.” When extra funding is needed, they draw
down their lines of credit, thus increasing notes payable, until their short-term debt
has risen to an unacceptably high level, at which point they arrange long-term financ-
ing. When they secure the long-term financing, they pay off some of their short-term
debt to bring it down to an acceptable level. We will explain how to forecast the final
level of notes payable shortly, but initially we assume that MicroDrive will simply
maintain its current level of notes payable.
At this point, all of the items on the liability and equity side of the balance sheet
have been specified. If we were extraordinarily lucky, the sources of financing would
exactly equal the required assets. In this case, we would have exactly enough financing
to acquire the assets needed to support the forecasted level of sales. But in all our years
of forecasting, we have never had this happen, and you probably won’t be any luckier.
Therefore, we define the term additional funds needed (AFN)as the required assets
minus the specified sources of financing. If the required additional financing is posi-
tive, then we need to raise additional funds, and we “plug” this amount into the bal-
ance sheet as additional notes payable. For example, suppose the required assets equal
$2,500 million and the specified sources of financing total $2,400 million. The
required additional financing is $2,500 $2,400 $100 million. We assume that the
firm would raise this $100 million as notes payable, thus increasing the old notes
payable by $100 million.
If the AFN were negative, this would mean that we are forecasting having more cap-
ital than we need. Initially, we assume that any extra funds will be used to purchase addi-
tional short-term investments, so we would “plug” the amount (the absolute value of
the AFN) into short-term investments on the asset side of the balance sheet. For exam-
ple, suppose the required assets equal only $2,200 million and the specified sources of
financing total $2,400 million. The required additional financing is $2,200 $2,400
$200 million. Thus, the firm would have an extra $200 million that it could use to
purchase short-term investments. Notice that total assets would now equal $2,200
$200 $2,400 million, which is exactly equal to the total sources of financing.
Before we apply this model to MicroDrive, a couple of points are worth noting.
First, financial policies are not etched in stone. For example, if the forecast is for a very
large need for financing, the firm might decide to issue more long-term debt or equity
rather than finance the entire shortfall with notes payable. Similarly, a company with
negative required additional financing might decide to use the funds to pay a special
dividend, to pay off some of its debt, or even to buy back some of its stock. As we discuss,
managers generally go over the initial forecast and then go back and make changes to
the plan. Financial planning is truly an iterative process—managers formulate a plan,
analyze the results, modify either the operating plan or their financial policies, observe
the new results, and repeat the process until they are comfortable with the forecast.
Second, the plug approach that we outlined specifies the additional amount of ei-
thernotes payable or short-term investments, but not both. If the AFN is positive, we
assume that the firm will add to notes payable but leave short-term investments at
their current level. If the AFN is negative, it will add to short-term investments but
not to notes payable. Now let’s apply these concepts to MicroDrive.
Forecast Operating Assets As noted earlier, MicroDrive’s assets must increase if
sales are to increase. The company’s most recent ratio of cash to sales was approxi-
mately 0.33 percent ($10/$3,000 0.003333), and its management believes this ratio
should remain constant. Therefore, the forecasted cash balance, shown in Row 1 of
Table 11-3 is 0.003333($3,300) $11 million.
The ratio of accounts receivable to sales was $375/$3,000 0.125 12.5 percent.
For now we assume that the credit policy and customers’ paying patterns will remain
416 Financial Planning and Forecasting Financial Statements
