Budgeting Basics and Beyond

6.16. Financial Forecasting – The Percent-of-Sales Method

Financial forecasting, an essential element of planning, is the basis for budgeting activities. It is also needed when estimating future financing requirements. The company may look either internally or externally for financing. Internal financing refers to cash flow generated by the company's normal operating activities. External financing refers to capital provided by parties external to the company. You need to analyze how to estimate external financing requirements. Basically, forecasts of future sales and related expenses provide the firm with the information to project future external financing needs.

The basic steps in projecting financing needs are:

1. Project the firm's sales. The sales forecast is the initial most important step. Most other forecasts (budgets) follow the sales forecast.

2. Project additional variables such as expenses.

3. Estimate the level of investment in current and fixed assets required to support the projected sales.

4. Calculate the firm's financing needs.

The most widely used method for projecting the company's financing needs is the percent-of-sales method. This method involves estimating the various expenses, assets, and liabilities for a future period as a percent of the sales forecast and then using these percentages, together with the projected sales, to construct forecasted balance sheets.

The following example illustrates how to develop a pro forma balance sheet and determine the amount of external ...