Gross profits are recorded on a company's income statement and are equal to net sales minus cost of goods sold. The percentage of sales method is one of the more widely used techniques for preparing financial forecasts. Its underlying premise is that a company's historical performance is an accurate indicator of its expected performance. This method involves applying individual income statement items, expressed as a percentage of sales, to forecast sales, which are derived using trends in the company's past sales growth.
The Percentage of Sales Method
Analyze historical sales to obtain historical growth percentages. If historical sales are stable, you can use a simple average. If you have reason to believe that the most recent years are more indicative of the future, use a time-weighted average allocating greater weighting to recent years. Account for any relevant factors, such as if the company operates in a cyclical industry, and analyze those factors to determine what sales might be moving forward. Once you select a growth rate, apply it to the most recent year's sales by multiplying sales by (1 plus the growth rate). The result is the forecast for the next year's sales.
Analyze historical gross profit margins much the same way you've analyzed sales, with the goal of obtaining an accurate proxy for projected gross profits. Calculate an historical average, time-weighted average and range of results. Take into account any price changes of raw materials that are included in cost of goods sold, as well as the company's inventory levels. Use an historical average gross profit margin as a baseline, and make small upward or downward adjustments based on factors that affect cost of goods sold.
Once you've forecast future sales using historical sales growth trends, and identified a reasonable gross profit margin, apply the gross profit margin to projected sales to obtain projected gross profits. For example, if you've forecast next year's sales to be $1 million with a gross profit margin of 35 percent, multiply 35 percent times $1 million, which results in projected gross profits of $350,000. You can make adjustments to gross profits by adjusting the gross profit margin, or by making adjustments in dollar amounts. For example, if you know that the subject company will incur one-time consulting fees related to cost of goods sold of $30,000, subtract the consulting fees of $30,000 from projected gross profits of $350,000, resulting in updated gross profits of $320,000.
Create a separate tab in the spreadsheet workbook in which to summarize your assumptions. When you create your projections, link the cells directly to the assumptions tab. This way, if your assumptions change, you will only need to update them once in the assumptions tab, as opposed to every relevant cell within the actual forecast tabs.
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