What Is the Percent of Sales Method?

The percent of sales method is a financial forecasting tool used by businesses to project future financial statement accounts. It helps anticipate resource needs by assuming many accounts maintain a consistent relationship with sales. Its purpose is to provide a quick estimate of how financial statements might look given expected sales growth, aiding preliminary financial planning.

Understanding the Core Principle

The percent of sales method assumes certain financial statement accounts, on both the income statement and the balance sheet, fluctuate directly with sales volume. These are known as “spontaneous” accounts. Examples of spontaneous assets include cash, accounts receivable, and inventory, as their levels rise or fall with sales. Spontaneous liabilities include accounts payable and accrued expenses like wages payable and taxes payable, which also adjust with business activity.

These accounts automatically increase or decrease as a company’s sales change. For instance, if sales grow, a company needs more inventory and will have more accounts receivable. Purchases from suppliers will also increase, leading to higher accounts payable.

In contrast, “non-spontaneous” or “discretionary” accounts do not directly vary with sales. These include fixed assets, notes payable, long-term debt, and common stock. Adjustments to non-spontaneous accounts require explicit management decisions, such as taking out a new loan or issuing new shares, rather than changing automatically with sales fluctuations.

Steps for Calculation

The percent of sales method begins with projecting future sales, which serves as the foundation for all forecasts. This projection can be based on historical sales data combined with expected growth rates.

Next, calculate the historical percentage of sales for each spontaneous asset and liability account from past financial statements. For example, if accounts receivable were historically 10% of sales, this percentage is applied to the projected sales to estimate future accounts receivable. These calculated percentages are then used to project the future values for all spontaneous accounts. Simultaneously, retained earnings must be projected, considering projected net income (derived from projected sales and expenses) and the company’s dividend policy. Net income contributes to retained earnings, while dividends reduce them.

Finally, the External Financing Needed (EFN) is calculated. EFN represents the additional funding a company requires to support its projected sales growth if internal funds are insufficient. This is determined by balancing the projected balance sheet: if projected assets exceed the sum of projected liabilities and equity (including retained earnings), the difference is the EFN. A positive EFN indicates a need for external financing, while a negative EFN suggests a surplus of funds.

Common Applications

The percent of sales method is a tool for business and financial management. It aids financial planning by helping businesses anticipate future resource needs, such as inventory or accounts receivable with increased sales.

This method informs budgeting by providing estimates for operational and capital expenditures linked to sales forecasts. Businesses can allocate resources more efficiently when they understand how financial items will scale with sales.

The method also supports strategic decision-making related to growth initiatives, expansion plans, or potential financing requirements. Identifying potential funding shortfalls or surpluses allows management to assess requirements early.

This enables companies to explore options like securing additional loans or equity, or planning for investment of excess funds. The method’s simplicity makes it useful for quickly generating initial financial forecasts.