How often do you produce a pro forma income statement…annually? Semi-annually? Never?
What is a pro forma income statement and why is it so important?
A pro forma income statement is a financial statement that uses both the actual and projected data (e.g. sales, margins, expenses) to estimate some future financial condition such as profits, cash flow or ending inventory levels for a defined period of time.
While financial statements constructed according to GAAP (generally accepted accounting practices) measure past performance, the pro forma income statement measures future net profits based upon historical data and other anticipated influences such as merchandise mix, competition and general economic conditions.
In its simplest terms, the pro forma income statement is a realistic look at the future profits of the company based upon anticipated sales, margins, expenses and marketing efforts. It is tantamount to being able to taste the soup without having to make it yet! Why is it so important? Because you can make changes to your business activities early enough in the year so as to improve the annual profits realized.
If you, the retailer, are willing to work six or seven days a week, risk your money buying hundreds of thousands of dollars of inventory and pay out mega dollars in expenses and payroll, then wouldn’t you want a peak at the future to see if you will earn a sizable, or any, profit at the end of the year?
The pro forma statement is merely a recipe for achieving a reasonable profit based upon the assumptions (sales, margins, expenses, etc.) you provide. This data will then give you a “picture” of the anticipated company’s profits. If you don’t like the answer, then change the assumptions. Be careful, however—you have to achieve that which you have assumed.
Ideally, retailers prepare pro forma statements in advance of the start of any given year or whenever an organization is considering a step that could have a significant financial impact. It is part of the budgeting process. Plainly put, if you want solid end of the year profits, then budget for it! As an aside, if you are seeking any form of financing or have already secured any term loans, banks will require pro forma statements as a part of their due diligence.
The process of constructing a pro forma income statement is relatively easy and straightforward.
- Begin by forecasting sales (e.g. annual sales for next year). Based upon last yea’rs sales, adjust the number up or down to reflect changing conditions, new products, anticipated advertising, etc. Keep notes on how or why you made adjustments to last year’s sales.
- Select your targeted maintained margin percent based upon last year’s numbers. As with sales, raise or lower the targeted margin percent to reflect market changes. Now, multiply the planned sales times the planned maintained margin percent to give you thee total gross margin dollars for the period in question.
- Next, list and forecast all fixed expenses (rents, insurance, et all). Total these and subtract from the total gross margin dollars. Note this resultant number (gross margins net of fixed expenses) must be large enough to support all variable expenses and profits.
- Now list and forecast all variable expenses (payroll, supplies, advertising, etc). Total these and subtract from the gross margins net of fixed expenses number. The resultant number is your projected profits or losses for the forecasted period in question.
- Finally, the moment of truth. If the final number forecasts a reasonable return on your sales then great! Usually, however, you will have to adjust your numbers up or down such that the final forecast will yield somewhere between 5% and 10% of sales. Remember the formula (sales times margin percent, minus fixed expenses, minus variable expenses = projected profit or loss).
Once the pro forma income statement is completed, break up the line item numbers into monthly portions, which in turn become the basis for the monthly sales and expense budgets.
The last important ingredient is to compare all projected numbers against actual numbers as they become available, and to make forecast adjustments if prudent. If you are not hitting your numbers, take corrective action and do so aggressively.
Retailers are in business to make a profit…a profit consistent with the work, risk and investment involved. Use pro forma income statements to help you reach your profit aspirations!