Question

describe in your own words what you learned providing an explanation of 200 words for the percentage of sale Approach

Answer 1

Analysts and financial modeling experts have come up with multiple techniques (from simple to rigorous) to project financials statements on the basis of several assumptions.

One such method is to create financial statements on the basis of “percentage of sales method”. This method:

1. Is simple to understand and apply
2. Is also most preferred method because of its simplicity
3. Avoids the lengthy exercise of preparation of various operating budgets such as production budget, Direct material and direct labour budget to get budgeted income statement
4. Assumes constant relationship between various constituents of Income Statement and Balance Sheet. For example: Sales will impact cost of goods sold, Selling expenses, account receivables, inventory etc. Relevant items in these financial statements grow in proportion of sales.
5. Is less time consuming

How to apply percentage of sales method?

1. First sales growth is figured out and next year’s sales are calculated
2. All the activities required to support the forecast level of sales are assumed to grow in proportion of sales. Examples: Cost of goods sold, S, G & A expenses, current assets, net fixed assets, accounts payables and accruals.
3. The financing activities are not assumed to grow proportionately with sales. They are calculated as demonstrated subsequently.

Example:

Alpha Beta Corporation has reported an aggregate revenue of $ 200 Million this year. The think tanks of the organization feel that a 20% growth rate from here can definitely be achieved in revenue. Sonali Sundaram, Head – Strategy, has been assigned the task to quantify the next year’s anticipated net income and retained earnings. After going through the historical figures, she has noted down the following pieces of information:

• Costs of goods sold and S, G & A expenses are typically 60% and 10% of sales respectively
• Alpha Beta pays interest @ 10% on the short term notes payables (current outstanding $ 50 Million) and @ 12% on the long term debt (current outstanding $ 75 Million)
• Income tax rate applicable to the company is 33.33%
• The company has a policy to pay out 30% of its earnings as dividend to the shareholder

Help Sonali achieve her objectives.

Solution:

The proforma income statement should look like as shown below: All financials in $ million

Sl. No.	Parameter	% of Sales	Current Year	Next Year
1	Revenue		200.00	240.00
2	[-] Costs of goods sold	60%	120.00	144.00
	Gross Margin		80.00	96.00
3	[-] S, G & A expenses	10%	20.00	24.00
	EBIT (Operating Income)		60.00	72.00
4	[-] Interest expenses		15.00	14.00
	PBT		45.00	58.00
5	Taxes @ 33.33%		15.00	19.33
	Net Income		30.00	38.67
6	[-] Dividend pay out		9.00	11.60
	Retained Earnings		21.00	27.07