This is a very simple method used to prepare pro forma income statements and balance sheets. Each entry in the income statement and balance sheet is expressed as a percentage of sales, usually based on the figures from the previous year.
For example, to find cost of goods as a percentage of sales based on the figures in the previous year, company needs to take cost of goods in the previous year (which can be found in the income statement) and divide it by sales (which also found in the income statement for the previous financial period). The same way an interest expense could be obtained, which is by dividing interest expense of the last financial period (found in the income statement) by sales.
Than a sales forecast is developed for the next financial period and used as a base for establishing values for pro forma income statement and balance sheet. All that is required is to take the projected sales and apply the percentages established in the previous step to estimate figures for pro forma statements.
The shortcoming of this technique is that it assumes that all costs are variable. However, some of the costs are fixed. Therefore, when sales are increasing profit will be understated, as the company does not take into account the benefit of fixed costs in case of increasing sales. However, if sale are decreasing, than the profit will be overstated.
However, this shortcoming can be avoided if costs are divided into fixed and variable when preparing pro forma statements. This gives a more realistic representation of expected profitability of the company over the coming financing period.
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