Pro forma income statements are financial projections that estimate future operating cash flow by considering potential sales revenue, expenses, taxes, and depreciation. The percent of sales method is a common technique used to prepare pro forma income statements. This method relies on the assumption that certain expenses are directly proportional to sales revenue.
Key Facts
- Purpose of the percent of sales method: The percent of sales method is used to forecast future operating cash flow by projecting potential sales revenue, expenses, taxes, and depreciation.
- Calculation process: The percent of sales method involves creating a common size income statement where each entry is expressed as a percentage of revenue. This allows for a better understanding of how expenses are related to the level of sales.
- Forecasting sales: To prepare a pro forma income statement using the percent of sales method, the first step is to forecast future sales by considering current sales and determining a growth rate. This growth rate is crucial for accurate projections.
- Expense calculations: After forecasting sales, each line of the income statement is considered. Some expenses may be held at current levels if they don’t scale with sales, while others are calculated as a percentage of the projected sales number. For example, raw materials used and labor costs typically increase as sales increase.
- Impact on net earnings: It’s important to note that not all expenses necessarily scale with sales. Some expenses, like depreciation and interest, may remain constant if they are not directly tied to sales. This can influence the bottom line of the pro forma income statement.
Process of the Percent of Sales Method
The percent of sales method involves the following steps:
Creating a Common Size Income Statement
The first step is to create a common size income statement, where each entry is expressed as a percentage of revenue. This helps identify expenses that are directly related to sales.
Forecasting Sales
The next step is to forecast future sales by considering current sales and determining a growth rate. This growth rate is crucial for accurate projections.
Expense Calculations
After forecasting sales, each line of the income statement is considered. Expenses that don’t scale with sales, such as depreciation and interest, are held at current levels. Other expenses, such as raw materials and labor costs, are calculated as a percentage of the projected sales number.
Impact on Net Earnings
It’s important to note that not all expenses scale with sales. This can influence the bottom line of the pro forma income statement.
Advantages of the Percent of Sales Method
- Simplicity: The percent of sales method is relatively easy to understand and implement.
- Transparency: It provides a clear view of how expenses are related to sales.
- Flexibility: The method allows for adjustments based on specific industry or company characteristics.
Limitations of the Percent of Sales Method
- Accuracy: The accuracy of the pro forma income statement depends on the reliability of the sales forecast.
- Assumptions: The method assumes that expenses are directly proportional to sales, which may not always be the case.
- Limitations: The method may not be suitable for companies with significant fixed costs or highly variable expenses.
Conclusion
The percent of sales method is a useful technique for preparing pro forma income statements. It provides a reasonable estimate of future operating cash flow by considering the relationship between expenses and sales. However, it’s important to recognize the limitations of the method and use it cautiously.
References
- The Percentage of Sales Method: Formula & Example
- Pro Forma Income Statement
- Percentage of Sales Method for Income Statements
FAQs
What is the purpose of a pro forma income statement?
A pro forma income statement is a financial projection that estimates future operating cash flow by considering potential sales revenue, expenses, taxes, and depreciation.
What is the percent of sales method?
The percent of sales method is a technique used to prepare pro forma income statements. It assumes that certain expenses are directly proportional to sales revenue.
How do I create a pro forma income statement using the percent of sales method?
To create a pro forma income statement using the percent of sales method, follow these steps:
1. Create a common size income statement.
2. Forecast sales.
3. Calculate expenses as a percentage of projected sales.
4. Consider non-operating items and make necessary adjustments.
What are the advantages of using the percent of sales method?
Advantages of using the percent of sales method include simplicity, transparency, and flexibility.
What are the limitations of using the percent of sales method?
Limitations of using the percent of sales method include accuracy (relies on sales forecast), assumptions (expenses are directly proportional to sales), and suitability (may not be appropriate for companies with significant fixed costs or highly variable expenses).
What is a common size income statement?
A common size income statement is an income statement where each entry is expressed as a percentage of revenue. This helps identify expenses that are directly related to sales.
How do I forecast sales for a pro forma income statement?
To forecast sales for a pro forma income statement, consider current sales, historical trends, industry outlook, and any planned changes that may impact sales.
What expenses are typically held at current levels in a pro forma income statement?
Expenses that are typically held at current levels in a pro forma income statement include depreciation and interest, which may not be directly tied to sales.