Preparing Pro Forma Statements using the Percentage-of-sales method

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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Operating leverage

Operating leverage is the relationship between sales and revenue (Price*Quantity of units sold) and operating profit (which is also called EBIT (earnings before interest and taxes)). It is a measure of how the potential use of fixed costs can enlarge the effect that change in sales volume has on operating profit (EBIT).

We can represent the calculation of operating leverage as follows:

Sales (P * Q)

Less: Fixed operating costs (FC)

Less: Variable operating costs (VC*Q)

= EBIT

Or

EBIT = (P*Q)-FC-(VC*Q)

This simplifies into:

EBIT = Q * (P-VC) – FC

When do firms have operating leverage?

If a firm has fixed costs, it has operating leverage. Because fixed cost (FC) is unchanged, an increase in sales revenue (P*Q) results in a proportionally bigger increase in EBIT (earnings before interest and taxes, which is also called operating profit). However, decrease in sales revenue (P*Q) will result in a proportionally bigger decrease in EBIT.

Increase in operating leverage increases business risk, which is a chance that the business will not be able to cover its operating costs.

How to calculate the degree of operating leverage (DOL) of the firm?

To calculate degree of operating leverage, which is just a way to measure operating leverage of the firm, we can use the following formula:

DOL =% change in EBIT/% change in sales

Therefore, if the degree of operating leverage is greater than 1, than operating leverage exists (which is the case as long as the company has fixed operating costs).

Businesses can increase their operating leverage by substituting variable costs for fixed costs, where possible. For example, salaries to sales personnel could be fixed instead of variable of units sold. Of course, many other variables need to be taken into account to make such a decision, such as consideration of how such changes would affect motivation levels of sales personnel.

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Net Profit Margin Ratio

Net profit margin ratio (NPMR) is one of the profitability ratios and measures how much of each sales dollar is remaining after all costs are deducted. In other words it measures how successful the firm is in terms of its earnings on sales.

Net profit margin ratio (NPMR) = Net Profit/Sales

For example, if ABC has a net profit of $300,000 and sales of $3,000,000. The NPMR is calculated as follows.

= 300,000/3,000,000

= 0.1 or 10%

Test yourself


Dillon Corporation has a net profit of $500,000 and sales of $3,500,000.

Required: Find the Net profit margin ratio (NPMR)

Solution:

The calculation of Net profit margin ratio (NPMR) of Dillon Corporation will be as follows:

= 500,000/3,500,000

= 0.14 or 14%

The higher the Net profit margin ratio (NPMR), the better it is for the company’s health.

Operating Profit Margin Ratio

Operating profit margin ratio (OPMR) is a profitability ratio. It measures how much of each sales dollar remains after all costs, after interest, tax and preferred stock dividends are deducted. In other words it measures how efficiently a business manages its operations or how efficiently the firm manages its income statement (keeping a healthy balance between sales and costs).

Operating profit margin ratio (OPMR) = Operating Profit/Sales

Example


For example, if ABC Company has operating profit of $500,000 and sales of $3,000,000 then Operating profit margin ratio (OPMR) is calculated as follows:

= 500,000/3,000,000

= 0.167 or 16.7%

Test yourself


Dillon Corporation has operating profits of $600,000 and sales of $3,500,000.

Required: Find the Operating profit margin ratio (OPMR)

Solution:

The calculation of Operating profit margin ratio (OPMR) of Dillon Corporation will be as follows: OPMR = 600,000/3,500,000 OPMR = 0.17 or 17%

The higher the Operating profit margin ratio (OPMR) the better it is for the business.

 

Gross Profit Margin Ratio

Gross profit margin ratio (GPMR) is one of profitability ratios. It measures how much of each sales dollar remains after costs of goods are deducted. In other words it measures the relative costs of goods sold.

Gross profit margin ratio (GPMR) = Gross Profit/Sales

EXAMPLE:

For example, if ABC has a gross profit of $1,000,000 and sales of $3,000,000, then the Gross profit margin ratio (GPMR) is calculated as follows:

= 1,000,000/3,000,000 = 0.3333 or 33%

Test yourself


Dillon Corporation has a gross profit of $1,200,000 and sales of $3,500,000.

Required: Find the Gross profit margin ratio (GPMR)

Solution:

The calculation of  Gross profit margin ratio (GPMR) of Dillon Corporation will be as follows: = 1,200,000/3,500,000 = 0.34 or 34%

Conclusion:

The higher the Gross profit margin ratio (GPMR) the lower the relative cost of goods sold. Therefore, the higher the  Gross profit margin ratio (GPMR), the better.

Average Collection Period

The average collection period is one of the activity ratios which measures the relationship between accounts receivable and average credit sales per day. Activity ratios help businesses to measure how efficiently various accounts are converted into sales or cash. Other activity ratios include average payment period, total asset turnover and inventory turnover analysis.

It calculates how efficiently accounts receivable are collected. It indicates the quality of debtors of the business (how promptly debtors pay their bills as they come due). It is also referred to as the average age of accounts receivable, debtors collection period ratio or a collection ratio.

The formula to calculate the average collection period ratio is as follows:

Average Collection Period = Accounts receivable/Average sales per day

The figure for accounts receivable is obtained from the balance sheet and the figure for sales is obtained from the income statement. Sales must be further adjusted to credit sales, by excluding cash sales. Further, credit sales must be divided by the number of days per year to finally obtain average sales per day (average credit sales per day).

Average sales per day = Credit sales/365

Example calculation


Assume Heroic Company has accounts receivable of $750,000 and credit sales of $4,050,000. Heroic Company has credit terms of 30 days. Assume 365 days year.

The average collection period of Heroic Company is calculated as follows:

Average sales per day = Credit sales/365

= $4,050,000/365

= $11,095.89

Average collection period = $750,000/$11,095.89=67.6 days = 68 days.

It takes on average 68 days to collect the accounts receivable. However, the credit terms of Heroic Company is 30 days. This means that company’s customers have 30 days to settle their accounts.

In light of this information, it is evident that collection of accounts receivable and/or process of granting the credit to customers is inadequately managed. The performance and processes of credit and collection departments should be investigated to draw further conclusions.

Things to note about this ratio


Results are only relevant when compared to a company’s credit terms.

The average collection period ratio therefore allows business to gain a better understanding of the cash inflows to be anticipated. Understanding of cash inflows are vital for successful operation of the business.

It also allows to identify trends in the collection of the accounts receivable. This can bring to management’s attention important variables that must be investigated to ensure successful operation of the business. For example, if the average collection period of the business increased from 30 to 68 days over 1 year, a further investigation will be required to understand such a large increase in this ratio.

Furthermore, to obtain a better understanding, one should compare the average collection period ratio to industry averages, to the ratio of leading firms in the industry and to the firms own historical results.

 

Inventory Turnover Analysis

Inventory turnover analysis measure the liquidity of a firm’s inventory. It measures how many times the company turns over (sells, uses or replaces) its inventory during a period, such as the financial period.

It is calculated by dividing cost of goods sold by inventory. The formula is as follows.

Inventory Turnover = Cost of goods sold/Inventory

The results can be conveniently used to calculate the average age of inventory (also called average number of days sales in inventory or inventory turnover days) with the following formula:

Average age of inventory = 365/Inventory Turnover

Example of inventory turnover analysis


Assume Gold Co. has cost of goods sold of $1,850,000 and inventory of $680,000. Assume there are 365 days in the year. The inventory turnover analysis and average age of inventory analysis for the Gold Company is conducted as follows:

Inventory turnover analysis:

$1,850,000/$680,000=2.7

This indicates the business turns over its inventory 2.7 times per year.

Average age of inventory:

365/2.7=135.2

Things to note about inventory turnover analysis


The results are only meaningful when used in comparison. It can be compared to industry averages, to the firm’s past inventory ratios and to ratios of competitors.

Industry averages differ significantly between industries for this ratio. This ratio is positive (higher than zero) as long as the firm has any inventory. Generally, a high ratio is considered to be a good indicator.

However, the norm would differ significantly between industries. If the ratio is too high when compared to the norm within the industry, it may mean the company keeps too little inventory and, therefore, may lose some sales. On the other hand, a low ratio may indicate excess inventory and inferior sales. Excess inventory is usually considered to be undesirable as inventory is an investment without return, holding inventory implies costs and prices of goods to be sold may start decreasing.

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