Question

When doing short-term financial projections, is it reasonable to forecast the Total Assets as depending on sales forecasts?

Explain your answer.

Answer 1

A financial projection is a forecast of future revenues and expenses. In general, you will need to develop both short- and mid-term financial projections. A short-term projection accounts for the first year of your business, normally outlined month by month. These are the tangible objects of financial value owned by your company.

Businesses use financial forecasting to help them anticipate future problems, set budgets and make key decisions regarding external financing. The forecasts often take the form of “pro forma” balance sheets and income statements for future periods. You can choose among various methods to make financial forecasts. The percentage of sales method relies on relationships between sales and other items.

Many accounts vary with sales. If you can accurately forecast sales growth, you can exploit these relationships to predict changes to other accounts. You begin by dividing current sales revenue into each related account’s current balance. You then apply the resulting factors to forecast future account balances based upon your sales forecasts. To be effective, you need to limit the use of the percent-of-sales method only to accounts that vary closely with sales.

1. Determine which Balance Sheet accounts vary with Sales (such as accounts receivable). Calculate the % of sales for each account that varies with sales.

2. For accounts that do not vary with sales (such as long-term debt and equity), simply list the current balances from the last Balance Sheet.

3. Calculate the future Retained Earnings balance by adding projected net income and subtracting any future dividends from the Beginning Balance for Retained Earnings. Don't forget to calculate a % of sales for Net Income and Dividends.

4. Add up your assets to determine total projected assets. Now add up your liabilities and equity to determine the financing of assets. If total assets are greater than total liabilities and equity, then you will need to raise additional capital.

To complete your pro forma balance sheet based on the percent-of-sales method, you first carryover at current values the accounts that do not closely tie to sales. You next calculate total assets, liabilities and owner’s equity. You will need external financing if two conditions are true: assets exceed the sum of liabilities and equity, and you are using fixed assets at capacity. You then decide how to procure the necessary funding -- you might issue stock, bonds or short-term debt. You will have to perform addition computations if you predict excess assets but you are not using fixed assets at capacity. When you plug in the predicted additional funding, your pro forma balance sheet is complete.