(19BII) Modified Percentage of Sales Method

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An extract from Managing Bank Risk, an Introduction to Broad-Base Credit Engineering, Projections & Risk Assessment, Sensitivity Financial Forecasting, Academic Press, 2003, pgs 241-242

"    Historical relationships that have held firm generally will not change much, at least into the near term. Finding relationships in historical statements improves forecast accuracy - it's as simple as that. If historical relationships, say accounts receivable to revenue, change significantly, the lender's ability to predict results becomes murky until he or she has identified and justified the new relationship.
     That is where forecasting financial statements comes in. It is arguably the best way to complement or reinforce statistical methods.
     One widely used technique is the modified percentage of sales method. This method is based on the premise that the balance sheet is correlated to changes in sales. Whether a firm restructures or just grows normally, variations in revenue generally require asset/liability adjustments. In the process of developing a forecast, the lender works with two important equations: the financial needs formula (F) and the the projected percentage of sales externally financed formula (E):

     F = A/S(∆S) + ∆NFA - L1/S(∆S) - P(S)(1-d) + R

     The F formula determines the external financing need of the firm. If used in conjunction with the percentage of sales method, both techniques render the same answer. The formulas are easy to enter into the HP 19BII Solver. 19BII Business Consultant's Solver creates menus of variables from equations enter and lists those menus to run calculations. Equations are stored in the Solver's equation list. The equation list can include as many equations as you want, limited by the calculator's memory.

     E = (A/S - L1/S) - (P/g)(1+g)(1-d) + R/∆S

     F = Cumulative financial needs
     A = Projected spontaneous assets
     S = Projected sales
   ∆S = Change in sales
∆NFA = change in net fixed assets
    L1 = Spontaneous liabilities
     P = Projected profit margin
     d = Dividend payout rate
     R = Debt maturities
     T = Targeted growth rate
     L = Leverage
     g = Sales growth rate
 
     The E formula identifies the percentage of sales growth requiring external financing. "

Example follow in exhibits II & III of pages 245 & 246, respectively.

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