This is “Pro Forma Income Statement”, section 5.1 from the book Finance for Managers (v. 0.1).
This book is licensed under a Creative Commons by-nc-sa 3.0 license. See the license for more details, but that basically means you can share this book as long as you credit the author (but see below), don't make money from it, and do make it available to everyone else under the same terms.
This content was accessible as of December 29, 2012, and it was downloaded then by Andy Schmitz in an effort to preserve the availability of this book.
Normally, the author and publisher would be credited here. However, the publisher has asked for the customary Creative Commons attribution to the original publisher, authors, title, and book URI to be removed. Additionally, per the publisher's request, their name has been removed in some passages. More information is available on this project's attribution page.
For more information on the source of this book, or why it is available for free, please see the project's home page. You can browse or download additional books there. You may also download a PDF copy of this book (2 MB) or just this chapter (141 KB), suitable for printing or most e-readers, or a .zip file containing this book's HTML files (for use in a web browser offline).
PLEASE NOTE: This book is currently in draft form; material is not final.
A pro forma income statementA projected income statement. is a projected income statement which shows predicted future operating cash flow. A pro forma income statement shows what potential sales revenue, expenses, taxes and depreciation might look like. Pro forma statements typically only forecast operating items on the income statement such as sales and EBIT, and not any items generated by financing or investing flows.
The simplest method used to prepare a pro forma income statement is to use the percent-of-sales methodFuture sales are forecasted, and then expenses are calculated as a percentage of the new sales figure.. In a nutshell, future sales are forecasted, and then expenses are calculated as a percentage of the new sales figure. Step 1: We create a common size income statementA income statement with all entries expressed as a percentage of revenues. where each entry is expressed as a percentage of revenue.
Equation 5.1 Calculating percentage of sales
We should notice that many expenses are related to the level of sales, that is, they have similar entries in each year of the common size statement. For example, raw materials used and labor costs typically increase as sales increase. Step 2: We consider current (observed) sales and determine a forecasted growth rate to arrive at a projected revenue number. Step 3: We consider each line of the income statement and either hold it at current levels (if we don’t think it scales with sales) or make the entry a percentage of our projected sales number. In the case of taxes, we use the appropriate tax rate.
Projecting the proper growth rate for sales is key to this analysis and, unfortunately, one of the most difficult things to do accurately. We can attempt to look at historical growth and adjust it using our beliefs about prospects, economic climate, etc. Sometimes companies have employees whose dedicated task is to constantly update sales projections.
To illustrate, Pet Products Forever Inc. has sales of $110, COGS of $51 and SG&A of $26. See Pet Products Forever, Inc. Income Statement.
Figure 5.1 Pet Products Forever Inc. Income Statement (Thousands)
What percent of sales are COGS and SG&A?
COGS / Sales = 51 / 110 = .464 or 46.4%
SG&A / Sales = 26 / 110 = .236 or 23.6%
Figure 5.2 Pet Products Forever Inc. Common Size Income Statement (Thousands)
If Pet Products Forever Inc.’s sales increase by 10% to $121, then how much will future COGS and SG&A expenses be?
new COGS = 46.4% of $121 = .464 × 121 = $56.1
new SG&A = 23.6% of $121 = .236 × 121 = $28.6
If we assume that depreciation and interest expense don’t scale with sales, and our tax rate is 40%, then our pro forma statement might look like this:
Figure 5.3 Pet Products Forever Inc. Pro Forma Income Statement (Thousands)
Note that our net earnings have increased by more than the 10% of our sales growth! This is because we assumed that some of our expenses (in this case, depreciation and interest) didn’t scale with sales.
Why don’t all expenses necessarily scale with sales? One expense we held constant was depreciation: our depreciation is tied to our fixed asset purchases; if we don’t need to increase fixed assets to handle the increase of sales, then our depreciation will probably remain steady. If, however, all of our machines are at capacity and we have no more factory space, then sales growth might increase fixed assets, which might in turn increase depreciation! Likewise, if we need to borrow money to purchase those fixed assets, our interest expense might increase! Forecasting involves many such judgment calls, and each assumption we make can influence the bottom line.
Pro forma statements are a way to look into the future. The pro forma income statement projects future cash flow.