Pro forma statements are often used for budgeting, forecasting, or evaluating the financial impact of potential decisions, such as mergers, acquisitions, or new investments. These forms help businesses visualize the potential outcomes of different scenarios by projecting future financial performance. Pro forma statements provide a more flexible view of financial data, allowing companies to plan and make informed decisions.

This blog outlines all the details with respect to Pro forma statements.

Overview of Pro Forma Statement

A pro forma statement typically includes projections for the income statement, balance sheet, and cash flow statement, helping businesses forecast future performance and plan accordingly. The key components of a pro forma statement are:

  • Pro Forma Income Statement: This reflects projected revenue, expenses, and profits, often based on anticipated sales growth, cost changes, or market conditions. It is used to estimate the company’s potential profitability over a certain period.
  • Pro Forma Balance Sheet: This shows a projected snapshot of the company’s assets, liabilities, and equity, helping businesses understand how changes in operations or financing might affect their financial position.
  • Pro Forma Cash Flow Statement: This outlines expected cash inflows and outflows, providing a forecast of liquidity and helping businesses ensure they have enough cash to cover operating costs, debt obligations, and investment opportunities.

Now that we have covered the basics of a pro forma statement let’s look at the Percent-of-Sales Method, which is used to project future financial performance based on estimated sales. 

For more information on Pro Forma Statements, you can read the article published by Harvard Business School.

Percent-of-Sales Method for Pro Forma Statement

The Percent-of-Sales Method is a straightforward approach for creating pro forma financial statements. This method assumes that certain costs and expenses will fluctuate in direct proportion to sales, making it an effective tool for forecasting future financial performance. The process involves estimating future sales, projecting costs and expenses as a percentage of those sales, and calculating key financial metrics such as gross profit, net profit, and retained earnings.

Here’s how you can use the Percent-of-Sales Method to prepare a pro forma statement:

1. Estimate Future Sales by Projecting Revenue

The first step is to estimate future sales based on historical data, market trends, or growth assumptions. This can be done by applying a growth rate to current sales or by analyzing industry trends. The general formula for projecting sales is:

Projected Sales = Current Sales × (1 + Growth Rate)

For example, if the current sales are $1,000,000 and you expect a 10% growth rate, your projected sales would be:

Projected Sales = $1,000,000 × (1 + 0.10) = $1,100,000

This projected sales figure is the foundation for the next steps in the pro forma statement.

2. List and Calculate Costs and Expenses as a Percentage of Projected Sales

Once the future sales figure is estimated, the next step is to list and calculate the costs and expenses that are typically tied to sales. These expenses are often expressed as a percentage of sales based on historical trends or industry averages. Common costs and expenses include:

  • Cost of Goods Sold (COGS): This is the direct cost of producing goods sold, including raw materials, direct labor, and manufacturing overhead. For example, if COGS typically accounts for 60% of sales, the projected COGS would be:

    Projected COGS = Projected Sales × COGS Percentage
    Projected COGS = $1,100,000 × 60% = $660,000


  • Selling, General, and Administrative Expenses (SG&A): These are expenses not directly tied to production, such as marketing, administrative salaries, and rent. If SG&A typically accounts for 20% of sales, the projected SG&A would be:  

    Projected SG&A = Projected Sales × SG&A Percentage
    Projected SG&A = $1,100,000 × 20% = $220,000


3. Determine Gross Profits by Subtracting Costs from Projected Sales

To calculate gross profit, subtract COGS from the projected sales. Gross profit represents the earnings from core business activities, excluding operating expenses like SG&A.

Gross Profit = Projected Sales – Projected COGS

For example:

Gross Profit = $1,100,000 – $660,000 = $440,000

This figure shows the profit after covering the direct costs of production, but before accounting for operating expenses and taxes.

4. Compute Net Profits After Taxes by Deducting Estimated Tax Expenses

Once you have the gross profit, the next step is to calculate net profit by subtracting the estimated tax expenses. Taxes are typically based on a set tax rate and can be deducted from gross profit.

Tax Expense = Gross Profit × Tax Rate

For example, if the tax rate is 30% and the gross profit is $440,000:

Tax Expense = $440,000 × 30% = $132,000

Now, subtract the tax expense from the gross profit to determine net profit:

Net Profit = Gross Profit – Tax Expense
Net Profit = $440,000 – $132,000 = $308,000

‍5. Include Deductions of Interest Expenses and Cash Dividends from Net Profits

Finally, after determining the net profit, subtract any interest expenses (on loans or debt) and cash dividends (paid to shareholders) to arrive at the final retained earnings. These deductions reduce the amount of profit that the company keeps for reinvestment or other uses.

  • Interest Expenses: These are the costs associated with borrowing, such as interest payments on loans.
  • Cash Dividends: These are payments made to shareholders, reducing the company’s retained earnings.

For example:

  • If interest expenses are $20,000 and dividends are $50,000, you would calculate retained earnings as follows:

    Retained Earnings = Net Profit – Interest Expenses – Dividends
    Retained Earnings = $308,000 – $20,000 – $50,000 = $238,000


    This amount represents the portion of the net profit that the company retains for future growth and reinvestment.


Commenda can help streamline the creation of pro forma statements using the Percent-of-Sales Method by providing expert guidance on estimating future sales, accurately calculating costs and expenses as percentages, and ensuring that all necessary deductions are made.

Fixed and Variable Cost Method for Pro Forma Statements 

The Fixed and Variable Cost Method is a key approach for preparing pro forma statements. This method breaks down costs into two categories: fixed costs and variable costs, allowing businesses to project their financial performance more accurately. Fixed costs remain constant regardless of sales or production volume, while variable costs change proportionally with sales or production levels. By categorizing costs and projecting future sales, this method helps businesses forecast gross profits, operating profits, and net profits.

1. Identify and Categorize Expenses into Fixed and Variable Components

  • Fixed Costs: These costs remain constant over time and do not vary with the level of production or sales. Fixed costs are typically associated with long-term commitments or operational overheads. Examples include:
    • Rent for office space or production facilities
    • Salaries of permanent employees
    • Depreciation of assets
    • Insurance premiums
    • Property taxes
  • Variable Costs: These costs fluctuate depending on the level of production or sales. Variable costs increase as production or sales rise, and decrease when production or sales fall. Examples include:
    • Raw materials for manufacturing
    • Direct labor (if based on production volume)
    • Shipping and packaging costs
    • Sales commissions
    • Utilities tied to production (e.g., electricity used in manufacturing)

By categorizing all expenses into these two groups, companies can better understand their cost structure and how changes in sales will impact their overall expenses.

2. Project Expenses Based on Fixed and Variable Cost Assumptions

Once fixed and variable costs have been identified, businesses can project future expenses based on assumptions regarding sales growth or changes in production levels.

  • Fixed Costs: These remain constant regardless of sales, so they are projected to stay the same over time (unless there is a significant change, like a rent increase or new insurance policy). For instance, if the fixed costs for rent, salaries, and insurance total $200,000 annually, these expenses will remain unchanged in future projections unless there is a change in the underlying factors.
  • Variable Costs: These need to be projected based on estimated changes in sales or production. If the company expects a 10% increase in sales, variable costs tied to production (like raw materials or direct labor) will also increase by that same percentage. For example, if variable costs currently total $500,000 and sales are projected to grow by 10%, the new variable costs would be:

    Projected Variable Costs = Current Variable Costs × (1 + Projected Growth Rate)
    Projected Variable Costs = $500,000 × 1.10 = $550,000


The total projected expenses can then be calculated by summing the fixed and variable costs.

3. Calculate Gross Profits by Subtracting Projected Expenses from Sales

Once sales and expenses have been projected, gross profit can be calculated. Gross profit represents the difference between projected sales and the cost of goods sold (COGS), which includes variable costs directly tied to production or service delivery.

The formula for gross profit is:

Gross Profit = Projected Sales – Projected COGS (Variable Costs)

For example:

  • Projected Sales: $1,000,000
  • Projected Variable Costs (COGS): $550,000

Gross Profit = $1,000,000 – $550,000 = $450,000

This is the amount the company earns from its core business activities before accounting for fixed costs, operating expenses, interest, and taxes.

4. Determine Operating Profits Before Tax Deductions

To calculate operating profit (EBIT), which is the profit from core business activities before considering taxes and interest, subtract the fixed costs and other operating expenses from the gross profit.

The formula for operating profit (EBIT) is:

Operating Profit (EBIT) = Gross Profit – Fixed Costs – Operating Expenses

For example, if fixed costs are $200,000 and operating expenses (like marketing, administrative costs, etc.) are $100,000, the operating profit would be:

Operating Profit (EBIT) = $450,000 – $200,000 – $100,000 = $150,000

This value represents the company’s earnings before taxes (EBT) and interest, reflecting profitability from day-to-day operations.

5. Compute Net Profits After Accounting for Taxes and Deduct Interest and Dividends to Estimate Retained Earnings

The final step is to calculate net profit, which accounts for interest expenses, taxes, and dividends. This is important for estimating how much profit will be retained in the business for reinvestment and growth.

  • Interest Expenses: Subtract any interest payments on loans or debt.
    EBT = Operating Profit – Interest Expenses
    For example, if interest expenses are $20,000, the Earnings Before Tax (EBT) would be:
    EBT = $150,000 – $20,000 = $130,000
    Taxes: Deduct tax expenses based on the applicable tax rate.
    Tax Expense = EBT × Tax Rate
    Assuming a tax rate of 30%, the tax expense would be:
    Tax Expense = $130,000 × 30% = $39,000
    Subtract the tax expense to get net profit:  
    Net Profit = EBT – Tax Expense
    Net Profit = $130,000 – $39,000 = $91,000
  • Dividends: Subtract dividends paid to shareholders, if applicable.
    If the company pays out $30,000 in dividends, the retained earnings would be:
    Retained Earnings = Net Profit – Dividends
    Retained Earnings = $91,000 – $30,000 = $61,000

Now that we have understood the details of the Fixed and Variable Cost Method, let’s compare both these methods to better understand their strengths and suitability for different financial forecasting needs.

Comparison of Methods

Choosing the right method for pro forma statements is crucial for accurately estimating future financial outcomes. Let’s compare the Fixed and Variable Cost Method with other approaches to evaluate their effectiveness.

 Accuracy of Each Method in Estimating Future Financial Outcomes

  • Fixed and Variable Cost Method: This method is effective for businesses with predictable cost structures. It clearly shows how sales or production impacts costs and profits. However, it assumes variable costs will remain proportional to sales growth, which may not always hold true, especially during market fluctuations.
  • Percent-of-Sales Method: This method is simpler and works well when sales directly influence most expenses. However, it can be less accurate if fixed costs or certain expenses don’t scale with sales, and may overlook changing business conditions.
  • Other Methods (e.g., Historical Growth or Bottom-Up): These methods offer more detail and may be highly accurate, but they require more time and data. The Historical Growth Method relies on past performance, which may not always predict future conditions.

Impact of Fixed Versus Variable Costs on Profit Projections

  • Fixed Costs: Provide stability since they remain constant regardless of sales, ensuring predictable expenses. However, they can pose challenges during downturns or when sales are low, as they still need to be covered.
  • Variable Costs:  Offer flexibility, allowing businesses to scale their costs according to demand, but it can also lead to more volatile profit projections. When sales increase, variable costs rise, impacting profit margins, but during slower periods, these costs decrease, which can help mitigate losses. 
  • Impact on Profit Projections: Businesses with high fixed costs need steady sales to cover those costs, while businesses with high variable costs experience more predictable fluctuations in profits. The Fixed and Variable Cost Method highlights these dynamics, making it useful for understanding how different cost structures impact profitability.

Whether you’re using the Fixed and Variable Cost Method for detailed projections or the Percent-of-Sales Method for simpler estimates, Commenda can help ensure that you apply the most accurate method for your financial goals. 

Conclusion

In conclusion, selecting the right method for preparing pro forma statements is essential for accurate financial forecasting and decision-making. Whether you choose the Fixed and Variable Cost Method or the Percent-of-Sales Method, understanding the impact of different cost structures on your projections is key. Let Commenda guide you in making informed decisions for your business’s future growth and success.

Trust Commenda to streamline and help you create a pro forma income statement and ensure full compliance. Schedule a free demo with Commenda today to get started and stay on track with your tax obligations!