Hello. It's Dr. Bob Nolley, back with you, continuing our discussion of forecasting, talking about forecasting the income statement.
Our forecast starts with what we call a pro forma income statement. Pro forma financial statements are prepared in advance of a planned transaction or a merger and acquisition or a new capital investment. But it is also done before the next accounting period.
The pro forma income statement is the company's estimate of how it plans to convert its revenue into net income, the result after all the expenses have been accounted for. And it is calculated the bottom line net income.
As I mentioned in our last lesson, the starting point for a pro forma income statement is the sales forecast. After setting the gross sales forecast, there are adjustments for returns, refunds, discounts, and other non-standard items. And this brings us down to the gross sales and net sales.
The next item to be forecast is the cost of goods sold, or COGS, or CGS. This is the inventory costs of the goods that a business has sold. And it includes all the cost of purchase, conversion, and other cost incurred, like, freight and labor and allocated overhead if you're selling physical goods.
Next, an estimate needs to be made for selling and general administrative expenses, called SGA. These are costs associated with payroll and the major portion of non-production related costs. We also deduct depreciation and amortization on fixed assets, along with research and development costs.
After that there is a section for deducting financing cost, income tax expenses, and any other irregular items. This brings us to the bottom line net income. Let's take a look at an example.
Here is a pro forma income statement for Layla's Café. She has projected total revenue of $4 million dollars. Some of that is from wholesale, some from retail, and some from her catering business.
The next step she took was calculating the cost of goods sold, which comes to $2,250,000. This brings her to a gross margin of $1,750,000, which gives her a margin of over 43%. Then she deducts the operating expenses, her SGA. And the total expenses sum up to $460,000.
So her income before interest and taxes is $290,000. After interest and after taxes, the bottom line, or her net income, is $891,450.
To summarize, let's review the key concepts. The starting point for any financial forecast is the sales forecast. Once this forecast is set, expense items can be calculated and forecast. We've mentioned each item that's part of the income statement forecast. But we still have the outstanding question of how each item is forecast itself.
The answer is this. It is largely a ratio or comparison to the sales forecast that started the process, when each expense item is projected to be a percentage of sales, as it was in the previous period. When finalizing the forecast, these expense items are adjusted for managerial forecast changes in the external environment and in the market.
This is Dr. Bob Nolley. And I'll see you in the next lesson.