4.5 Preparing the Pro Forma Income Statement
LG 5 4.5 Preparing the Pro Forma Income Statement
percent-of-sales method
A simple method for developing a pro forma income statement is the percent-of-sales
A simple method for
method. It forecasts sales and then expresses the various income statement items as
developing the pro forma
percentages of projected sales. The percentages used are likely to be the percentages
income statement; it forecasts
of sales for those items in the previous year. By using dollar values taken from
sales and then expresses the various income statement items Vectra’s 2012 income statement (Table 4.12), we find that these percentages are as percentages of projected
Cost of goods sold
Operating expenses = $10,000 =
Interest expense = $1,000 =
Applying these percentages to the firm’s forecast sales of $135,000 (developed in Table 4.14), we get the 2013 pro forma income statement shown in Table 4.15. We have assumed that Vectra will pay $4,000 in common stock dividends, so the expected contribution to retained earnings is $6,327. This represents a consider- able increase over $3,650 in the preceding year (see Table 4.12).
CONSIDERING TYPES OF COSTS AND EXPENSES The technique that is used to prepare the pro forma income statement in Table
4.15 assumes that all the firm’s costs and expenses are variable. That is, for a given percentage increase in sales, the same percentage increase in cost of goods sold, operating expenses, and interest expense would result. For example, as Vectra’s sales increased by 35 percent, we assumed that its costs of goods sold also increased by 35 percent. On the basis of this assumption, the firm’s net profits before taxes also increased by 35 percent.
A Pro Forma Income Statement, Using the Percent-of-Sales Method, for Vectra
TA B L E 4 . 1 5 Manufacturing for the Year Ended
December 31, 2013
Sales revenue
Less: Cost of goods sold (0.80)
Gross profits
Less: Operating expenses (0.10)
Operating profits
Less: Interest expense (0.01)
Net profits before taxes
Less: Taxes (0.15 * $12,150)
Net profits after taxes
Less: Common stock dividends
To retained earnings
PART 2
Financial Tools
In more depth
Because this approach assumes that all costs are variable, it may understate the increase in profits that will occur when sales increase if some of the firm’s
To read about What costs are fixed. Similarly, if sales decline, the percentage-of-sales method may Costs Are Fixed? go to
overstate profits if some costs are fixed and do not fall when revenues decline. www.myfinancelab.com
Therefore, a pro forma income statement constructed using the percentage-of- sales method generally tends to understate profits when sales are increasing and overstate profits when sales are decreasing. The best way to adjust for the pres- ence of fixed costs when preparing a pro forma income statement is to break the firm’s historical costs and expenses into fixed and variable components. The potential returns as well as risks resulting from use of fixed (operating and finan- cial) costs to create “leverage” are discussed in Chapter 13. The key point to rec- ognize here is that fixed costs make a firm’s profits more variable than its revenues. That is, when both profits and sales are rising, profits tend to increase at a faster rate, but when profits and sales are in decline, the percentage drop in profits is often greater than the rate of decline in sales.
Parts
» The Prentice Hall Series in Finance
» 1 Merger Fundamentals 716 Major Causes of Business Failure 738
» The Financial Market Environment INTEGRATIVE CASE 1 Merit Enterprise Corp.
» LG 2 1.1 Finance and Business
» REVIEW QUESTIONS 1–7 What is the goal of the firm and, therefore, of all managers and
» LG 5 1.3 Managerial Finance Function
» PART 1 Introduction to Managerial Finance FINANCIAL MARKETS
» 2.3 Regulation of Financial Institutions and Markets
» 3.1 The Stockholders’ Report
» 3.8 A Complete Ratio Analysis
» LG 2 4.1 Analyzing the Firm’s Cash Flow
» 8 3 Coulson Industries has gathered the following data needed for the preparation of
» 4.5 Preparing the Pro Forma Income Statement
» 4.6 Preparing the Pro Forma Balance Sheet
» Evaluate the simplified approaches to pro forma financial statement
» 5.1 The Role of Time Value in Finance
» Explain yield to maturity (YTM), its calculation, and the procedure used
» LG 3 7.2 Common and Preferred Stock
» 7.4 Decision Making and Common Stock Value
» Explain the relationships among financial decisions, return, risk, and
» LG 4 8.3 Risk of a Portfolio
» 12 3 Consider two assets—Lo and Hi—with the characteristics described in the table below:
» LG 6 8.4 Risk and Return: The Capital Asset Pricing Model (CAPM)
» 15 3 In the preceding example for Benjamin Corporation, the risk-free rate, R F , was
» Explain the capital asset pricing model (CAPM), its relationship to the
» Calculate the weighted average cost of capital (WACC), and discuss
» 10.3 Net Present Value (NPV)
» 10.4 Internal Rate of Return (IRR)
» Discuss NPV and IRR in terms of conflicting rankings and the theoret-
» LG 2 11.1 Relevant Cash Flows
» LG 4 11.2 Finding the Initial Investment
» 11.3 Finding the Operating Cash Inflows
» 11.4 Finding the Terminal Cash Flow
» Determine the terminal cash flow associated with a proposed capital
» 12.3 International Risk Considerations
» LG 6 12.5 Capital Budgeting Refinements
» Explain the role of real options and the objective and procedures for
» LG 4 13.2 The Firm’s Capital Structure
» 19 3 We can plot coordinates on the EBIT–EPS graph by assuming specific EBIT
» 14.1 The Basics of Payout Policy ELEMENTS OF PAYOUT POLICY
» 14.2 The Mechanics of Payout Policy
» 14.4 Factors Affecting Dividend Policy
» Explain stock splits and the firm’s motivation for undertaking them.
» LG 5 15.4 Accounts Receivable Management
» LG 2 16.1 Spontaneous Liabilities
» LG 4 16.2 Unsecured Sources of Short-Term Loans
» LG 6 16.3 Secured Sources of Short-Term Loans
» Describe the various ways in which inventory can be used as short-term-
» 17.4 Stock Purchase Warrants
» LG 4 18.3 Analyzing and Negotiating Mergers
» Explain bankruptcy legislation and the procedures involved in reorgan-
» 19.1 The Multinational Company and Its Environment
» 3 3 Assume that the current exchange rate between the United States and the new
» 19.4 Long-Term Investment and Financing Decisions
» 19.6 Mergers and Joint Ventures
» Review recent trends in international mergers and joint ventures.
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