If a firm currently has excess capacity, then using the percent of sales method to forecast its fixed asset balance will likely result in an overestimate of the fixed asset balance and an inflated amount of discretionary financing needed.
True
False
The correct answer and explanation is:
Correct Answer: True
When a firm has excess capacity, it means the company is currently operating below its full productive potential. In other words, it has more fixed assets (such as equipment and buildings) than it needs to meet its current level of sales. This excess means that the firm can increase production or sales without needing to invest immediately in more fixed assets.
The percent of sales method is a common forecasting technique that assumes certain balance sheet and income statement items will increase in direct proportion to sales. This method works reasonably well for variable items like accounts receivable, inventory, and accounts payable. However, it can lead to inaccurate estimates for fixed assets when excess capacity is present.
If the percent of sales method is applied without adjusting for existing excess capacity, it will project an increase in fixed assets proportional to the sales increase. In reality, the firm may not need to invest in additional fixed assets to support this growth since current assets are underutilized. As a result, the method will overstate the required fixed assets.
This overstatement leads to another consequence: the amount of discretionary financing needed (DFN) will appear larger. DFN is the gap between forecasted total assets and the sum of forecasted liabilities and equity. If fixed assets are overestimated, total assets increase unnecessarily, widening the gap and inflating the projected financing needs.
Therefore, using the percent of sales method without considering excess capacity results in an overestimate of the fixed asset balance and an inflated amount of discretionary financing needed. For accurate forecasting, analysts should assess whether current fixed assets can support future sales and adjust projections accordingly.