Definition: The percentage of sales method is a type of financial statement analysis in which all accounts are expressed as a ratio of sales. In other words, financial statement line items such as cash, inventory, accounts receivable/payable, net income, and cost of goods sold, are each calculated as a percentage of revenue.
What Does Percentage of Sales Method Mean?
What is the defintion of percentage of sales method? Management and external users use this method to analyze the performance of the company and identify key indicators of improvement or signs the company might be in trouble over time. For instance, creditors might compare interest expense to sales to identify whether the company is able to service its debt. If interest expense rises in relation to sales each year, creditors might assume the company isn’t able to support its operations with current cash flows and need to take out extra loans. This is not a good sign, but keep in mind this method is a starting point for financial statement analysis.
Let’s look at an example.
Example
Management of XYZ Company meets on an annual basis to discuss the performance of the company and discuss the financial statement outlook. To do this, a special set of financial statements is prepared with percentages added to each line item. These percentages are calculated by dividing the line item into the sales figures. For instance, total sales for the year were $100,000 and total cost of goods sold was $58,000. Thus the cost of goods sold percent listed would be 58 percent.
Management uses these ratios to track trends. For example, if the CGS ratio increased to 65 percent next year, management would have to examine why their production costs are increasing relative to sales. This could happen because of a number of supply issues or environmental changes. Material prices or utility rates could have gone up uncontrollably during the year for example.
The goal for management is to ensure costs increase proportionately to revenues. With this information, management can look further into which costs are causing this relationship and implement effective cost cutting procedures. Management typically performs this analysis on each account to track the company’s financial progress year over year.
Summary Definition
Define Percentage of Sales Method: The percent of sales method is a ratio analysis tool used by management and investors to compare items on the financial statements from year to year as well as companies’ performance within industries.
