5.1 Pro Forma Income Statement

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.

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.