Forecasting Income Statement – Line Items
What is “Forecasting Income Statement Line Items”?
Creating a pro forma income statement is one of the most important tasks in the financial modeling process. The analyst creates the income statement line by line, beginning with the revenue projection. But before this is possible, the analyst must make certain assumptions that will drive the pro forma statements. To start the building the model, take the following steps:
- Gather historical financial statements – typically for the past 3 to 5 years – to identify historical trends in financial performance.
- Create common size financial statements that standardize figures to a percentage of assets or percentage of sales.
- Base assumptions on these historical trends and percentage figures (for example, COGS as a percentage of sales).
- Use these assumptions to forecast the income statement line items.
We start with an assumption for growth, which an analyst projects by looking at historical growth and combining that with information about the current environment – the economy, the competitive landscape, new products, and other factors that could impact revenue. While historical trends and average percentages from common sized statements are the strongest basis for assumptions, it’s essential to consider elements of the current environment and adjust assumptions accordingly.
Forecasting begins with the income statement, and then continues to the balance sheet and cash flow statement. Once the forecasting is complete, the financial statements can be linked.
Key Learning Points
- As part of fundamental analysis and valuation, analysts must create a pro forma income statement that forecasts future sales and earnings
- The analyst’s assumptions about future business conditions drive the forecasts
- Projecting all line items for the first forecast year before copying them over to all forecast periods can help ensure that the model is completed carefully and accurately.
Building Out the Pro Forma Income Statement
Look to historical data, such as growth rates, when making assumptions
Your assumptions are the basis for forecasting income statement line items. Say for example that revenue has increased 10% annually over the past five years. It would be reasonable to assume in this case that revenue is likely to increase by 10% in the first forecast period, barring any additional factors that could have either a positive or negative impact. Therefore, if revenue was $100 in Year 0, you can forecast revenue of $110 in Year 1, the first forecast period.
Complete the Entire Forecast for Year 1 before Moving Forward
When creating the pro forma income statement, complete the entire Year 1 before carrying assumptions forward into future years. Looking at the Year 1 pro forma income statement will help assess the quality of your assumptions and suggest whether any changes need to be made.
Example – Forecasting Income Statement – Line Items
In the example below, we build a pro forma income statement by line item for the first projection period. The historical period is Period –1, with Period 0 being the first projection period. For Period 0, we see a growth rate of 10%.
Forecasting Revenue and Cost assumptions (to Gross profit)
In the example below, we assume revenue growth of 5% after Period 0.
Second, we calculate the operating profit for period -1, which is gross profit minus SG&A costs. Third, we calculate the net income, which is operating profit minus tax expense.
Finally, we copy each of these subtotals into period 0 (historical period) and also period 1 (first year of the forecast). This will be helpful for checking that the assumptions are translating into realistic and sensible sales and profit forecasts.
Forecasting All Other Periods
Having completed the above, we now will start forecasting Period 1 (i.e. first forecast period).
Looking at the assumptions at the top, we know that revenue growth is forecast to be 5% for the next two years. We must add a formula for Period 1, based on the revenue growth assumption of 5%. By taking the 110 in Period 0 and multiplying 110 by (1 + 0.05), which equals 115.5 we can get a revenue forecast for Period 1 based on our assumptions.
Next, we move on to forecast COGS. Again, we refer to the assumptions in the workout above and we see that COGS as a % of the revenue assumption for period 1 is 50%. So, to get the COGS forecast for Period 1 (forecast period), we multiply 50% by revenue of the previous year’s figure (historical period) of 110 to arrive at the COGS of (57.8). You can refer to the formula in the table for more detail.
Next is forecasting depreciation, which again refers to the assumptions in the workout above. The interesting point here is that the depreciation assumption for period 1 is 27.5% of the beginning net PP&E – which is the same thing as the net PP&E for the last year (historical period) that is found in the balance sheet (not shown here) and is 45.0. So, to forecast depreciation for Period 1, we multiply 27.5% by last year’s net PP&E of 45 to arrive at a depreciation forecast of (12.4) for Period 1.
Next, we find that the gross profit forecast for Period 1 is calculated by adding the forecasted revenue, COGS, and depreciation to arrive at the figure of 45.4.
We use the same process for SG&A costs – to obtain the SG&A forecasts for Period 1, we multiply this assumption by the forecast revenue (Period 1), which is 115.5, and obtain the figure of (11.6). Further, operating profit is calculated 33.8 by adding SG&A costs and gross profit.
The last line item is tax expense. We assume tax is 25% of operating profit for Period 1 (note that in this model there is no interest expense/income, so operating profit is equivalent to profit before tax_. Now, to get the tax expense forecast for Period 1, we simply multiply this assumption by operating profit forecast of 33.8 to get Period 1 tax expense of 8.5 . So, the net income forecast for Period 1 is 25.4. Tax must be deducted from operating profit to arrive at the forecasted net income.
Earnings per share is calculated as net income divided by the number of shares outstanding. We do this calculation for the first historical period first (Period -1) and then copy it through to Period 0. Then for Period 1, we calculate the EPS by taking the share outstandings assumption of 10 million shares for Period 1 (forecast period) and dividing forecast net income for Period 1 by the shares outstanding.
Conclusion
By sticking to the careful process and completing the first period fully before copying over, we can make sure the income statement forecasts are completed carefully and accurately.
Once familiar with this process, it is relatively easy to forecast the income statement. Sometimes the income statement layout will be altered to accommodate the details provided by a company – perhaps there will be an additional line of detail as R&D costs are broken out or more cost detail provided. However, the same principles remain in place for each income statement.
Additional Resources
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