INTRODUCTION TO FINANCIAL MANAGEMENT-unit 4, question #3 - Essay Example

Question # 3: Discuss the shortcomings of the percent of sales method of financial forecasting. The percent of sales is a method of financial forecasting based on the fact that the statement of financial position of a business and the statement of income vary with the sales level. This assists businesses in identifying external financial needs based on their forecasted financial statements. The method involves identifying the items in the statement of financial position and income statements that vary directly with the sales.

Once these items are identified, they are expressed as a percentage of the sales. For example if the debtors balance stands at $8000 and the sales balance at $1500, this translates to 53.33%. Forecasted sales level is then determined for the year in question. This is done by multiplying the sale for a given year by the forecasted growth in sales to give the forecast sales. The method of financial forecasting using the percentage of sales, however, has some shortcomings associated with it. Since the method is based on the premise of allocation of internal resources as a growth or decline, this is so subjective and in most cases would not be the best way to forecast future expenditures.

Some factors other than those used to determine the sales percentages may affect the budget and this may require the business to adjust these percentages in order to increase the growth in sales forecast (Keown et al, 1998). The method is not the best to forecast financial needs of a company since it is only based on approximation (Keown et al’ 1998). No proper details are given when making the forecast or calculating the percentages. It may also lead to a wrong conclusion especially where the balances in the income statement, that is, incomes and expenditures, and the balance sheet items are wrongly calculated.

The same will also be witnessed in case the sale figures are wrong. Keown et al (1998) observed that items that are acquired by the business in large units are not taken into account when making a financial forecast using the percent of sales method. However these items also influence the financial position and incomes and should be taken into consideration when calculating the percentage forecasts. Leaving out items acquired in bulk may lead to a poor forecast for the company. It is therefore evident that a forecast done leaving out items acquired in large quantities does not give the right budget forecast.

The determination of the external financial needs using the percentage of sales involves very complex calculations which require high degree of expertise and knowhow. It also requires that the fixed assets are assumed to be in excess capacity and this makes it a subjective method to use in budgeting. The method is also subjective in that in case there is a change in the fixed assets during a period of forecast, the method of percentage of sales would not give an accurate forecast (Keown et al, 1998).

Reference Keown, A.J., & Martin, J.D., & Petty, J. W. & Scott Jr., D. F. (1998). Foundations of finance: The logic and practice of financial management: 6th edition. New Jersey. Pearson Education Publishers.