The percentage of sales method is a more complex financial planning model than the internal growth, sustainable growth, or external financing needs models. The percentage of sales method generates a set of pro forma or forecasted balance sheets and income statements for the firm. The analyst projects what will happen to the firm’s accounts over time, which supports an estimate of the firm’s external financing needs for a particular period. The first step of the percentage of sales method is implied by the method’s name. Using historical data, the analyst divides each balance sheet and income statement item by sales revenue. The resulting ratios are examined to see which accounts have maintained fairly constant relationships or trends with respect to sales. The second step of the percentage of sales method is to estimate future sales levels. This estimate can rely on market research studies or on an analysis of internal or sustainable growth rates. In the third step, the analyst can construct projected financial statements. This process begins by placing the sales forecast at the top of the income statement. To forecast the value of income statement items having a steady or predictable relationship to sales, the analyst assumes this relationship will continue. For items that do not have a consistent relationship to sales, other assumptions will be needed to forecast their values. For example, current credit market conditions may suggest holding interest expense constant or projecting it to grow at a predetermined rate; projected taxes will reflect the firm’s tax rate. Similarly, the analyst projects balance sheet accounts based upon their relationship with sales revenue. Accounts that lack consistent relationships to sales may be assumed to be held constant or to change in a manner consistent with recent trends and future market projections. The analyst estimates retained earnings by adding the forecasted addition to retained earnings to the existing retained earnings balance. The forecasted addition to retained earnings is the net income on the pro forma (projected) income statement less any dividends, that is: Projected retained earnings ¼ Existing retained earnings þ Projected net income Estimated dividend payment: The accounting identity requires that total assets equal total liabilities and equity; in the first pass, however, the percentage of sales method will rarely produce this equality. To balance the pro forma balance sheet, the analyst inserts a plug figure, so that: Total assets ¼ Total liabilities þ Stockholders0 equity þ Plug: The plug figure, sometimes labeled ‘‘external funds needed’’ or ‘‘external funds required,’’ typically represents an addition to or subtraction from notes payable to restore equality to the balance sheet equation. A positive plug figure suggests that additional short-term borrowing will be needed to finance the firm’s growth plans. (Of course, this need for funds also can be met by issuing long-term debt or equity.) A negative plug figure suggests that project operating results will generate excess cash which the firm can use to reduce its short-term or long-term borrowing or to repurchase stock.