Forecasting the Income Statement

1. Pro Forma Income Statement

Forecasting begins with developing a pro forma income statement. Pro forma financial statements are prepared in advance of a planned transaction, merger, acquisition, or new capital investment. They are also done before planning for the upcoming fiscal period.

The pro forma income statement is the company’s estimate of how it plans to convert its revenue into net income, which is the result after all expenses have been accounted for.

hint

Pro forma, Latin for “as a matter of form,” is a method of calculating financial results using projections or presumptions.

Let’s use Leyla, the owner of a cafe, to illustrate this.

EXAMPLE

term to know

Pro Forma Income Statement

A financial statement of the company’s estimate of how it plans to convert its revenue into net income.

1a. Revenue Forecast

As mentioned in a previous lesson, the starting point for a pro forma income statement is the sales/revenue forecast. After the total revenue forecast is set, there may be adjustments for returns, refunds, discounts, and other nonstandard items. These adjustments bring us from gross sales to net sales. In Leyla’s case, these will not be necessary.

EXAMPLE

hint

Total revenue is the sum of the forms of all of Leyla’s revenue streams.

1b. Cost of Goods Sold

The next item to be forecast is the cost of goods sold or COGS. This is the inventory cost of the goods that a business has sold. It includes all costs to purchase and convert inventory to sell. If a business sells physical goods, other costs like freight, labor, and allocated overhead may be incurred. Leyla has two line items in her cost of goods sold section: ingredients and packaging.

EXAMPLE

1c. Gross Margin

Once the cost of goods sold is calculated, Leyla can calculate her gross margin. Gross margin represents what is left of the revenues after all costs of goods have been subtracted. To determine gross margin as a percentage of revenue, divide gross margin by total revenue.

EXAMPLE

1d. Operating Expenses

Next, an estimate must be made for selling, general, and administrative expenses or SGA. These costs can include combined payroll costs and the major portion of non-production-related costs. We also deduct depreciation and amortization on fixed assets, along with research and development costs. Leyla’s cafe does not have any depreciation or amortization, but she does have expenses for sales, marketing distribution, and general and administrative items.

EXAMPLE

1e. Other Deductions

There is also a section for deducting financing costs, income tax expenses, and any other irregular items. Out of these, Leyla only has interest expenses.

EXAMPLE

1f. Taxes

Finally, taxes must be paid. In Leyla’s case, she is paying a 30% rate. She applies this rate and subtracts it from her earnings before taxes to yield her projected net income.

EXAMPLE

hint

Net income is total revenue less all costs, expenses, and taxes.

big idea

Each item that is part of the pro forma income statement forecast is largely determined by a ratio or comparison to the sales forecast that started the process. Each expense item is projected to be the same percentage of sales as it was in the previous period. When finalizing the forecast income statement, these expense items are adjusted for managerial forecast changes in the external environment and the market.

try it

John owns a surf shop, and he wants to project his income for the upcoming fiscal year. He projects that his total revenue for next year will be $460,000. He also assigns percentages to expenses based on last year’s actual results. These assigned percentages are based on John’s total revenue.

hint

The cost of goods sold is 34% of the total revenue of $460,000, or $156,400 ($460,000 × 0.34 = $156,400).

Use the assigned percentages provided on the pro forma income statement to estimate his net income.