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Financial Forecasting using Percent of Sales Method & How to Calculate Projected Retained Earnings

Financial forecasting is an essential part of all financial planning of a corporation as it is the basis for budgeting activities and estimating future financing needs of the company. Financial forecasting typically involves forecasting sales and expenses incurred to generate those sales. When making a financial forecast, directors typically use an estimate of various expenses, sales & liabilities and the most widely used method for making such projections is the percent-of-sales method. In the percent of sales method, assets, liabilities & total expenses are estimated as a percentage of sales that are then compared with projected sales. These numbers are then used to design a pro forma (panned or projected) balance sheet.

The steps necessary to compute a pro forma balance sheet is as follows:

1. Express balance sheet items that vary directly with sales as a percentage of sales. Any items that do not vary directly with sales e.g. long term debt, retaining earnings, common stock & property/plant/equipment are designated as not applicable (n/a).

2. Multiply the percentages from step 1 by the sales projected to obtain the amounts for future periods.

3. Where no percentage applies (e.g. for long term debt, common stock or retained earnings numbers), take the figures from the present balance sheet in the column for the future period.

4. Calculate the projected retained earnings using the below formula:

 Projected Retained Earnings = Present retained earnings + Projected Net Income – Cash Dividends Paid

5. Total up the assets account to obtain a total projected assets number, then add projected liabilities & equity accounts to determine the total shortfall. This shortfall indicates the total external financing that is required to keep the company running at present operational levels.

Example of Financial Forecasting Using Percent of Sales Method

Let’s do a financial forecast for Bongo Corp. for the year 2009 assuming net income is to be 10% of sales and the dividend payout ratio is 5%. Also, projected sales are estimated to be at \$60 million (using an estimate of 2 x current assets).

 Bongo Corp. Pro Forma Balance Sheet (in millions of \$) As at December 31st, 2009 Assets Percent of Sales Method Projected Sales (Percent of Sales x \$60) Current Assets \$30.00 15% \$9.00 Fixed Assets \$288.00 20% \$12.00 Total Assets \$318.00 \$21.00 Liabilities & Shareholder's Equity Current Liabilities \$18.00 15% \$9.00 Long term debt \$45.00 n/a \$45.00 Total liabilities \$63.00 \$54.00 Common Stock \$200.00 n/a \$200.00 Capital Surplus \$20.00 n/a \$20.00 Retained Earnings \$35.00 38.1* Total equity \$255.00 258.1 Total liabilities & shareholder's equity \$318.00 \$312.10 \$291.10 ** External Financing Required

Key Terms

 n/a - These figures are assumed to NOT vary with sales, thus we use the present balance sheet numbers. *Retained Earnings = Present retained earnings + Projected net income - cash dividends paid \$35 + 0.1 (\$60) - [(5% x \$60) = \$38.1 *** External Financing Required = Projected total assets - (projected total liabilities - projected total equity) *** External Financing Required = 21 - (\$54 + 258.1) *** External Financing Required = 21 - \$312.10 *** External Financing Required = \$291.10