© 2000 John Petroff
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© 2000 John Petroff |
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E- Pro forma income statement: forecasting earnings
The most common method of preparing a pro forma income statement is the percent-of-sales method. It consists in applying the percentage each expense item represents relative to total sale revenues, taken from current year normalized income statement. The starting point is naturally the all important forecast of sales revenue for the coming year. One can easily find fault with the method because it fails to account for differences in expense patterns that may exist from year to year, some of which are listed in the next sub-section. Nevertheless, in stable industries and when many significant expenses cannot be forecasted with any accuracy, financial analyst find the method serves their purpose adequately.
2)- Forecasting revenues and costs separately:
To improve on the percent-of-sales method, the analyst must
look at least into each of the following relationships:
- pricing depends on technological
leadership, industry composition, product maturity and need for
a defensive strategy ;
- volume depends on promotional efforts, consumer demand and retaliation
by competitors;
- unit cost of goods sold are linked
to volume expansion and prevailing cost patterns of supplies;
- overhead expense saving depends of
quality of assets;
- salaries depend of personnel strategies
and and labor market projections;
- interest expense depends on financial
leverage and financial market yield predictions;
- research and development depends
on commitment to technological efforts.
Determining each of these management view points and translating them into dollar expense amounts requires a great deal of familiarity with a given company and industry. Yet, these are not the most difficult elements to estimate. The discretionary expenses discussed earlier cannot be normally predicted until the actual company result are known, and that can obviously occur only at the end of the year. An analyst intuition about them can improve after years of following the performance a company.
In all the projections, an analyst will have to make assumptions about management's holding to their plans or not, competitor retaliating or not, consumers staying with product or not, and so on. These assumptions will be formulated on the basis of familiarity with the company, accurate vision of the industry and ability to predict economic conditions. The results are bound to be full of errors. But, believing that error free projections can be made is incompatible with financial analysis. Each assumption requires a careful investigation of many aspects of company environment. It is only by understanding prior errors that predictions can be improved. Thus, the exercise of forecasting all revenues and expenses can be very useful, much more useful than even the number put in the bottom line.
3)- Forecast error
As for all other forecasts discussed in previous chapters, it is useful to build a historical evaluation of past forecasts. Measuring and explaining past forecast errors is the key to improvement in forecasting.
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See review questions Q-13E.1 through Q-13E.11.
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