How to Calculate a Five-Year Pro Forma
When estimating future income, create both conservative and aggressive income forecasts.
John Foxx/Stockbyte/Getty Images
- 1 How to Write a Pro Forma
- 2 How to Calculate Pro Forma Projections
- 3 A Financial Plan Vs. a Pro-Forma Cash Flow Budget
- 4 How to Make a Projected Income Statement
A business’s pro forma is the forecast financial statements based on either anticipated future events or potentially changing business performance in upcoming periods. This is in contrast to regular financial statements that are financial summaries on a business’s past. Businesses use pro forma statements to assist in their planning activities, both short term and long term. Strategic planning typically covers three to five years into the future; and five-year pro forma can provide a fuller view into how a business might fare under various assumed future conditions. Many areas of a business’s operations, such as realizable sales or required capital investment, may change as time goes by. The more accurate a pro forma is calculated, the better prepared a business may be in responding to future needs for resource allocation.
Make Forecast Assumptions
1. Forecast future sales. Sales are the single most important element in making forecasts, because many other statement items, such as cost of goods sold and accounts receivable, have a constant relationship to sales. Investigate sales numbers from past years and determine the historical sales trend. Find out the average annual percentage change in sales. Then if necessary, adjust the past sales growth rate to account for anticipated market changes to arrive at the assumed annual sales growth rate for the upcoming five years.
2. Determine to-sales ratios. For statement items that are clearly proportional to sales, a business may forecast ratios based on the forecast sales numbers. To decide the percentage ratio of a particular statement item to sales, look into past financial statements for comparisons. Suppose that the costs-to-sales ratio for the past five years has remained at 60 percent; a business may assume that costs will continue to equal 60 percent of annual sales for the next five years, unless there is a justification for a different percentage, such as expected improvement in profit margin in the future.
3. Project additional growth rates. There are statement items that do not change as a result of changing sales, but are determined by company policies or events that a business cannot control. Forecasts of these items are based on their own projected growth rates. For example, based on the latest borrowing agreement, a business may expect that interest paid on borrowing will increase by a specific percentage each of the next five years from its current value. A business makes separate projections on the growth rates of statement items that are independent of sales based on their own merits. If a business has no plans for new capital investment in the next five years, there will be no forecast fixed-asset growth.
Calculate Pro Forma
1. Apply sales growth rate. Sales are the top-line figure in the income statement and the basis for projecting many other statement items when calculating a business’ pro forma. Use the sales number from the most recent income statement as the base value and multiply it by the assumed future growth rate. This results in the projected sales for the first year in the future. Apply the sales growth rate to projected sales in this year and arrive at the future sales for the future year in question until reaching the fifth year in the future. Suppose the base sales are $100,000 and the projected sales growth rate is 10 percent annually. Sales in the pro forma for each of the five years into the future are $110,000 ($100,000 x 1.1), $121,000 ($110,000 x 1.1), $133,100 ($121,000 x 1.1), $146,410 (133,100 x 1.1) and $161,051 ($146,410 x 1.1). Projected sales numbers are then used to forecast other related items in a pro forma.
2. Calculate sales-related items. For statement items that are proportional to sales, apply their to-sales ratios to sales numbers for the same year to arrive at the value of the statement items in the pro forma. For example, assume that cost of goods sold remains at 60 percent of sales for each of the future five years. Annual cost of goods sold in a five-year pro forma will be $66,000 ($110,000 x 60 percent), $72,600 ($121,000 x 60 percent), $79,860 ($133,100 x 60 percent), $87,846 ($146,410 x 60 percent) and $96,630.60 ($161,051 x 60 percent).
3. Compute all other items independent of sales. Similar to calculating sales using future sales growth rate, calculate sales-independent statement items by applying their own growth rate directly to the item’s base value. For example, suppose interest payments are $10,000 at the end of the most recent year and expected to grow at 5 percent for each of the future five years. Annual interest payments in a five-year pro forma are calculated as follows: $10,500 ($10,000 x 1.05), $11,025 ($10,500 x 1.05), $11,576.25 ($11,025 x 1.05), $12,155.06 ($11,576.25 x 1.05) and $12,762.82 ($12,155.06 x 1.05).
4. Analyze changing assumptions. A pro forma statement is sensitive to the assumptions about the future, and its accuracy will depend on how reasonable the assumptions are. To improve forecast quality, a business may wish to further analyze its assumptions about certain statement items and set up different scenarios for sensitivity analysis. For example, based on additional information, if sales likely grow at a different rate in the future, how it might affect related statement items such as profits. Assumption analysis provides better insight into the uncertainty and risk in a forecast pro forma statement.