Business Forecasting

By

As a business owner you probably spend a great deal of time trying to figure out how to grow your business by increasing sales. But are you also taking the time to analyze how an increase in sales would affect your financing needs?

If not, then you may be setting yourself up for a nasty surprise instead of a celebration when your company achieves its sales targets. Fortunately though, by employing a relatively simple technique known as percent of sales forecasting, you can forecast and plan for the financing requirements that are likely to accompany an increase in sales.

In order to conduct this analysis all that you need is a copy of your latest balance sheet and an understanding of which items on it will change when your level of sales changes.

For our purposes here, we’ll use the following simple balance sheet for the fictitious ABC Corp., which has $2 million annual sales.

ABC Corp. Balance Sheet as of December 31, 2011

         
Assets     Liabilities & Equity  
Cash

 $100,000

  Accounts Payable

 $200,000

Accounts Receivable

 $300,000

  Bank Loan Payable

 $200,000

Inventory

 $300,000

  Other Current Liabilities

 $100,000

Plant and Equipment

 $500,000

  Long-Term Debt

 $300,000

Total Assets

 $1,200,000

  Equity

 $400,000

      Total Liabilities & Equity

 $1,200,000

If ABC’s sales are going to increase, we’ll need to identify the items on its balance sheet that will also automatically increase. On the asset side of things, a higher level of sales means that ABC will need to stock more inventory and that its cash and accounts receivable balances will both be higher. And on the liability side ABC will see its accounts payable increase as it increases its purchases on credit from its suppliers.

Now that we know which items will increase along with sales, it’s time to forecast how much they will increase. To do this we simply take each item that will increase, divide it by ABC’s $2 million in total sales, and express the result as a percentage, as seen in the table below.

ABC Corp. Percent of Sales Worksheet

         
Assets     Liabilities  
Cash

5%

  Accounts Payable

10%

Accounts Receivable

15%

     
Inventory

15%

     
Total

35%

   Total

10%

So now we can see that for any increase in sales ABC’s assets will increase by 35% and that its liabilities will increase by 10%. For example, say ABC is forecasting its sales to rise to $2.4 million (an increase of 20%) in its next fiscal year. What will happen to its cash, accounts receivable, inventory, and accounts payable?

To answer this question we simply take the percentages from the preceding worksheet and multiple them by the new total sales figure of $2.4 million, and we come up with the following results.

Assets     Liabilities  
Cash

 $120,000

 

 Accounts Payable

 $240,000

Accounts Receivable

 $360,000

     
Inventory

 $360,000

     

A quick comparison with our original balance sheet reveals that assets will increase by $140,000 while liabilities will only increase by $40,000. But a balance sheet has to balance, so what exactly is our forecast telling us?

It’s telling us that ABC’s liabilities will now be $100,000 short of funding its assets. Of course, if ABC operates at a profit then it can expect that some of the additional earnings it retains from making that extra $400,000 in sales will help fund the shortfall, but will it be enough? That’s the question that all finance managers at large corporations, and business owners at small ones, need to answer.

To answer it you’ll need to calculate whether or not your new sales figure generates enough earnings to fund your new higher level of assets. To continue with our example, say that ABC earns 5% ($120,000) on its total sales and retains 60% ($72,000) of that amount after taxes. It will still have a shortfall of  $28,000 ($100,000 - $72,000).

But luckily for ABC, they practice percent of sales forecasting and were able to see the need for additional funding back when they set their sales forecast at the start of the year. So they had the option of borrowing additional money from a bank or dipping into their cash reserves. If they hadn’t gone through this exercise when making their sales forecasts they could have wound up short of cash despite realizing higher sales.

So try to include a percent of sales forecast the next time that you are setting sales targets for your business. While it is not a perfect predictor of the future, it is a simple and pragmatic way to get a handle on how your financing needs may change as your business grows.

More By Gregg Schoenberg
Leave a Comment
* Required
* Required, will not be published