Construct a pro forma income statement driven by sales
The idea
A sales-based pro forma model starts with a revenue forecast, often built from volume and price or from segment drivers, and then derives most other lines as ratios to sales. Cost of goods sold and variable selling expenses follow a margin or percentage of sales; fixed costs are modelled separately, since treating them as variable understates operating leverage. Some items need their own logic: depreciation follows capital expenditure and the asset base, interest follows the forecast debt and its rate, and taxes follow an effective rate. Working capital lines use turnover ratios, such as days of sales outstanding applied to daily sales to give receivables. The balance sheet is then made to balance with a plug, typically cash or a revolving credit line, and the model is checked by asking whether the implied margins and returns are plausible against history and peers.
A practice question
A sales-based pro forma model begins with:
- a forecast of revenue — correct
- a forecast of net incomeWhy not: Net income is the end point. It is derived from revenue after costs, interest and tax.
- a forecast of the share priceWhy not: A valuation output. The model produces the inputs a valuation needs, not the reverse.
The revenue forecast comes first, and most costs and working capital items are then modelled as ratios to it.
A harder one
Sales of 1,200 are forecast to grow 5%. Cost of goods sold is 60% of sales and SG&A is 18% of sales. Forecast operating profit is:
- 264.0Why not: Applies the 22% margin to this year's sales without the 5% growth.
- 504.0Why not: Stops at gross profit and leaves out SG&A of 18% of sales.
- 277.2 — correct
Sales = 1,200 x 1.05 = 1,260. Operating margin = 1 - 0.60 - 0.18 = 22%, so operating profit = 0.22 x 1,260 = 277.2.
The hardest tier
Sales of 2,000 grow 8%. Gross margin is 40%; SG&A is a fixed 300 plus 5% of sales; depreciation is 60; debt of 800 costs 5%; the tax rate is 25%. Forecast net income is:
- 249.0Why not: Treats all SG&A as variable at 20% of sales, which overstates the cost and loses operating leverage.
- 267.0 — correct
- 356.0Why not: Stops at pre-tax income and leaves out tax of 25%.
Sales = 2,160; gross profit = 864; SG&A = 300 + 108 = 408; EBIT = 864 - 408 - 60 = 396; interest = 40; pre-tax = 356; net income = 356 x 0.75 = 267.
In the app: 6 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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