CHAPTER 3:

U N D E R S TA N D I N G T H E I N C O M E S TAT E M E N T
_Financial Analysis_
OUTLINE
1. Components of the income statement
2. Principles of revenue recognition
3. Princilples of expense recognition
4. Non-recuring and non-operating items
5. Earning per share (EPS)
COMPONENTS OF THE INCOME STATEMENT
• The income statement reports the revenues and expenses of the firm over a period of time.
• The income statement equation:

Net
Revenue Expense
Income

• Investors examine a firm’s income statement for valuation purposes while lenders examine
the income statement for information about the firm’s ability to make the promised interest
and principal payments on its debt.
 C O M P O N E N T S O F T H E I N C O M E S TAT E M E N T

• Revenues (sales, turnover): Amounts reported from the sale of goods and
services in the normal course of business.
• Net revenue: Revenue less adjustments for estimated returns and allowances
(e.g., for estimated returns or for amount unlikely to be collected).
• Expenses: Amounts incurred to generate revenue and include cost of goods
sold, operating expenses, interest and taxes. Expenses can be grouped by
nature or function.
• Gains and losses: assets inflows and outflows not directly related to the
ordinary activities of the business.
For example, a company sell surplus land, the cost of land is subtracted from the
sales price and the net result is reported as a gain or a loss.
 C O M P O N E N T S O F T H E I N C O M E S TAT E M E N T

• Gross profit: the amount that remains after the direct costs of producing a
product or service are subtracted from revenue.
• Operating profit: gross profit minus operating expense (selling, general
and administrative expenses)
• Net profit (net income, earning, bottom line): operating profit minus
interest expense and income taxes
• Minority owners’ interest: the pro-rata share of the subsidiary’s income
for the portion of the subsidiary that the firm does not own.
• Notes: In Vietnam interest expense is classified as operating expense and therefore
operating profit is equal to gross profit minus SG&A expense and interest expense.
A S I M P L I F I E D M U LT I P L E - S T E P I N C O M E S TAT E M E N T
A S I M P L I F I E D S I N G L E - S T E P I N C O M E S TAT E M E N T
EXAMPLE
IFRS VAS
Items 2004 Items 2004
Net sales 13,700 Net sales 203,862
Cost of goods sold (6,369) Cost of goods sold (127,947)
Gross profit 7331 Gross profit 75,915
Selling expenses (4,294) Financial revenue
2,630
General and administrative expenses (997) Financial expenses (18,558)
Research and development expenses (131) Interest expense
(15,377)
Other (expense) income (204) Financial income (15,928)
Operating income 1,705 Selling expense
Nonrecurring items (105) Administration expense (22,942)
Interest expense, net (73) Operating income 37,045
Income before provision for income taxes and minority 1,527 Other revenue
interests
Provision for income taxes (457) Other expense

Income before minority interests (1,070) Other income

Minority interests (189) Profit/loss in affiliates and joint venture
Share in net income of affiliates (564) Profit before tax 37,045
Net income 317 Corporate tax
Profit after tax 37,045
Minority interest

Net profit available to parent company’s 37,045

shareholders.
 PRINCIPLES OF REVENUE RECOGNITION

• Under the accrual method of accounting, revenue is recognized when earned

and expenses are recognized when incurred.
• The important point to remember is that accrual accounting does not
necessarily coincide with the receipt or payment of cash.
• Consequently, firms can manipulate net income by recognizing revenue
earlier or later, or by delaying or accelerating the recognition of expense.
PRINCIPLE OF REVENUE RECOGNITION
VAS, IASB The U.S securities and Exchange
Commission (SEC)
•Seller has transferred most of risks and •There is evidence of an arrangement
benefits associated with ownership of goods between the buyer and seller
to buyer •The product has been delivered or the
Điều kiện ghi nhận doanh thu (VAS)
•Seller has no longer had management right of service has been rendered
good management as owner or control right of •The price is determined or determinable
goods. •The seller is reasonably sure of collecting
•Revenue is recognized reliably money
•Seller has earned or will earn future
economic benefits
•Related expenses can be measured
•Completed work can be measured on the date
of establishing the balance sheet (for service)
 REVENUE RECOGNITION APPLICATIONS
1. Long term contract
Condition Methods
Cost and revenue can Percentage of completion method.
be reliably estimated Revenue, expense and profit are recognized as the work is performed.
The percentage of completion is measured by the total cost incurred to
date divided by the total expected cost of the project.

Cost and revenue can GAAP: Completed contract method (GAAP)

not be reliably Revenue, expense and profit are recognized only when the contract is
measured, or the complete. If a loss is expected, the loss must be recognized
project is short-term immediately.
IFRS: Revenue is recognized to the extent of contract costs; cost are
expensed when incurred and profit is recognized only at completion.
EXAMPLE 1
Assume that AAA Construction Corp. has a contract to build a ship for
$1,000 and a reliable estimate of the contract’s total cost is $800.
Project costs incurred by AAA are as follows:

Year 2005 2006 2007 Total

Cost incurred 400 300 100 800
(USD)

Determine AAA’s net income from this project for each year using the
percentage of completion and completed contract methods in
accordance with US GAAP.
 EXAMPLE 2
Using the data from the previous example, determine AAA’s net income
from this project each year in accordance with IFRS.
 REVENUE RECOGNITION APPLICATION
2. Installment sales: A firm finances a sales and payments are expected to
be received over an extended period
• If collectability is certain, revenue is recognized at the time of sale using
the normal revenue recognition criteria.
• If collectability cannot be reasonably estimated, the installment method
is used.
• If collectability is highly uncertain, the cost recovery method is used.
REVENUE RECOGNITION APPLICATION
Installment method: profit is recognized as cash is collected. Profit is
equal to the cash collected during the period multiplied by the total
expected profit as a percentage of sales.
Cost recovery method: Profit is recognized only when cash collected
exceeds costs incurred.
EXAMPLE 3

BBB Property Cor. Sells a piece of land for $1,200. The original cost of land
was $600. Collections received by BBB for sale are as follow:
Year 2005 2006 2007 Total
Collection 600 500 100 1200

Determine BBB’s profit under the installment and cost recovery methods.
Review Question
PRINCIPLES OF EXPENSE RECOGNITION

• Expenses are subtracted from revenue to calculate net income.

• Expenses are decreases in economic benefits during the accounting
period in the form of outflows or depletions of assets or incurrences of
liabilities that result in decreases in equity other than those relating to
distributions to equity participants.
• General principle of expense recognition is “matching principle”. A
company directly matches some expenses with associated revenue.
DEPRECIATION METHODS

• Straight-line method
• Accelerated method
• Units-of-production methods
 DEPRECIATION METHODS

Straight-line method recognizes an equal amount of depreciation expense each period:

𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑐𝑜𝑠𝑡 − 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒

𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 =
𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑙𝑖𝑓𝑒
DEPRECIATION METHODS
• Accelerated depreciation speed up the recognition of depreciation expense in a
systematic way to recognize more depreciation expense in the early years of the asset’s
life and less depreciation expense in the later years of its life.
Declining balance method applies a constant rate of depreciation of an asset’s
book value each year.
Double declining balance method applies two times the straight-line rate to the
declining balance.

𝐷𝐷𝑃 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

2
= 𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑐𝑜𝑠𝑡 − 𝑎𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑙𝑖𝑓𝑒
DEPRECIATION METHODS

• Units-of-production method is based on usage rather than time.

𝑢𝑛𝑖𝑡𝑠 − 𝑜𝑓 − 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑐𝑜𝑠𝑡 − 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒
= ×𝑜𝑢𝑡𝑝𝑢𝑡 𝑢𝑛𝑖𝑡𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑
𝑙𝑖𝑓𝑒 𝑖𝑛 𝑜𝑢𝑡𝑝𝑢𝑡 𝑢𝑛𝑖𝑡𝑠
EXAMPLE 4
A company purchased a machine at cost of 550,000$ with useful life of 5
years and salvage (residual) value of 50,000$. Calculate depreciation
expense according to A, straight line method ; B, double declining method
in the first two years and straight-line method in the remaining years.
 EXAMPLE 5

• Sackett Laboratories purchases chemical processing machinery for $550,000. The

equipment has an estimated useful life of five years and an estimated salvage value of
$50,000. The company expects to produce 20,000 units of output using this machinery,
with 6,000 units in each of the first two years, 3,000 units in the next two years, and
2,000 units in the fifth year. The company’s effective tax rate is 30%. Revenue are
$600,000 per year, and expenses other than depreciation are $300,000 in each year.
Calculate Sackett’s net income and net profit margin if the company depreciates the
machinery using (a) the straight-line method, (b) the DDB method, changing to the
straight-line method after 2 years, and (c) the units of production method.
AGE OF ASSETS
• Average age (in years) = accumulated depreciation/ annual depreciation expense

• Average depreciable life = ending gross investment/ annual depreciation expense

• Remaining useful life = (ending gross investment-accumulated

depreciation)/annual depreciation expense
 EXAMPLE 6
At the end of 2008, a company reported fixed assets’ gross investment of 3
million USD, accumulated depreciation of 2.5 million USD, annual depreciation
expense of 500,000 USD. Calculate average age of assets, average depreciable
life and remaining useful life? What should you comment ?
EXAMPLE 7
CCC purchases inventory items for resale. During 2006, CCC had the following
transactions:
Quarter Inventory Purchases
First quarter 2,000 units at $40 per unit
Second quarter 1,500 units at $41 per unit
Third quarter 2,200 units at $43 per unit
Fourth quarter 1,900 units at $45 per unit
Total 7,600 units at a total cost of $321,600
Inventory sales during the year were 5,600 units at 50$ per unit. CCC determines that
there were 2,000 remaining units of inventory and specifically identifies that 1,900
were purchased in the fourth quarter and 100 were purchased in the third quarter.
What are the revenue and expense associated with these transactions during 2006.
SOLUTION
Cost of good sold
From the first quarter 2,000 x 40 = 80,000
From the second quarter 1,500 x 41= 61,500
From the third quarter 2,100 x 43= 90,300
Total cost of good sold 231,800
Cost of goods remaining in inventory
From the third quarter 100 x 43= 4,300
From the fourth quarter 1,900 x 45= 85,500
Total ending inventory 89,800

• Cost of goods sold would be expensed against the revenue of 280,000$ so the gross
profit in 2006= 280,000-231,800=48,200
• The remaining inventory amount of 89,800 will be matched against revenue in a
future year when the inventory are sold.
 NON-RECURRING ITEMS
• A discontinued operation is one that management has decided to dispose
of, but either has not yet done so, or has disposed of in the current year after
the operation had generated income or losses.
Income/loss from discontinued operations is reported separately in the
income statement, net of tax, after income from continuing operations
Analytical implications: Discontinued operations do not affect net income
from continuing operations. However, they may provide information
about the future cash flows of the firm.
NON-RECURRING ITEMS

• Unusual or infrequent items: the events are either unusual in nature or

infrequent in occurrence but not both. Examples:
ü Gains or losses from the sale of assets or part of a business
ü Impairments, write-offs, write downs and restructuring costs
Unusual or infrequent items are included in income from continuing operations are
reported before tax.
Analytical implications: Even though unusual or infrequent items affect net income
from continuing operations, an analyst may want to review them to determine
whether they truly should be included when forecasting future firm earnings.
 NON-RECURRING ITEMS
• Extraordinary items are events or transactions that is both unusual and infrequent in
occurrence.
Examples: gains/losses from early retirement of debt, uninsured losses from natural disasters…(GAAP)
ü GAAP: Extraordinary items are reported separately in the income statement, net of tax, after income
from continuing operations.
ü IFRS, VAS do not allow extraordinary items to be separated from operating results in the income
statement.
Analytical implications: Judgment is required in determining whether a transaction or event is
extraordinary. Although extraordinary items do not affect income from continuing operations, an analyst
may want to review them to determine whether some portion should be included when forecasting
future income.
OTHER COMPREHENSIVE INCOME

Other comprehensive income includes transaction that are not included in

net income, such as:

1. Foreign currency translation gains and losses

2. Adjustments for minimum pension liability

3. Unrealized gains and losses from cash flow hedging derivatives.

4. Unrealized gains and losses from available-for-sale securities

E X A M P L E 8 : C A L C U L AT I N G C O M P R E H E N S I V E I N C O M E

• Calculate comprehensive income for Triple C Corporation using the

selected financial statement data found in the following table

Net income $1000

Dividends received from avalaible-for-sale securities 60
Unrealized loss from foreign currency translation (15)
Dividends paid (110)
Reacquire common stock (400)
Unrealized gain from cash flow hedge 30
Unrealized loss from available-for-sale securities (10)
Realized gain on sale of land 65
EARNINGS PER SHARE

1. Basic EPS
Weighted average number of common shares is the number of shares outstanding during
the year, weighted by the portion of the year they were outstanding.

𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 − 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠

𝐵𝑎𝑠𝑖𝑐 𝐸𝑃𝑆 =
𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
EXAMPLE 9
Johnson Company has net income of $10,000 and paid $1,000 cash dividends to
its preferred shareholders and 1,750 cash dividends to its common shareholders.
At the beginning of the year, there were 10,000 shares of common stock
outstanding. 2,000 new shares were issued on July 1. Assuming a simple capital
structure, what is Johnson's basic EPS?
EARNINGS PER SHARE
Effect of stock dividend and stock split:
• A stock dividend is the distribution of additional shares to each
shareholder in an amount proportional to their current number of shares.
• A stock split refers to the division of each “old” share into a specific
number of “new” (post-split) shares.
• Each shareholder’s proportional ownership in the company is unchanged
by either of these events. Each shareholder has more shares but the same
percentage of the total share outstanding.
EXAMPLE 10
During the past year, R&J Inc. had net income of $100,000, paid dividends of
$50,000 to its preferred stockholders, and paid $30,000 in dividends to its common
shareholders. R&J’s common stock account showed the following:
Time Event Number
01/01 Shares issued and outstanding at the 10,000
beginning of the year
01/04 Shares issued 4,000
01/07 10% stock dividend
01/09 Shares repurchased for the treasury 3,000

Compute weighted average number of common shares outstanding during the year,
and compute EPS.
EARNINGS PER SHARES

2. Diluted EPS
• Dilutive securities are stock options, warrants, convertible debt, or
convertible preferred stock that would decrease EPS if exercised or
converted to common stock.
• Antidilutive securities are stock options, warrants, convertible debts, or
convertible preferred stock that would increase EPS if exercised or
converted to common stock.
EARNINGS PER SHARE
EARNINGS PER SHARE
EPS with options and warrantsà if options and warrants are dilutive à use
treasury stock method
- Treasury stock method assumes that the hypothetical funds received by
the company from the exercise the options would be used to purchase
shares of the company’s common stock in the market at the average
market price
- The net increase in the number of shares outstanding is the number of
shares created by exercising the option less the number of shares
hypothetically repurchased with the proceeds of exercise
EXAMPLE 11

Last year, Hipotech company reported net income of 2,3 million USD and
average number of share outstanding of 800,000 shares. The company had
30,000 options with exercise price of 35$ and no other dilutive securities.
During the year, the average market price of the company’s stock was $55.
Calculate basic EPS and dilutive EPS of Hipotech.
EXAMPLE 12

On 31/12/2006, Bright-Warm Utility reported net income of 1,750,000$. The

company had average number of outstanding shares of 500,000 and 20,000 of
convertible preferred shares. Each preferred shares paid 10 USD dividend
and was convertible into 5 common shares. Calculate basic and dilutive EPS
of the company.
EXAMPLE 13

Oppnox company reported net income of 750,000 USD in 2005. The

company’ average number of outstanding shares was 690,000. The
company had 50,000 convertible bonds, coupon rate of 6%, convertible into
10,000 common shares. Tax rate was 30%. Calculate EPS and dilutive EPS
of Oppnox.
WHY IS FORECAS TING IMPORTANT?

• Mistakes are costly:

ü If you produce too much of a product, or a product that no one wants to

buy, you still must pay for materials, labor, and storage.
ü If you produce too little of a product, you will lose sales and possibly
market share.
FORECAS TING APPROACHES

• Experience

• Profitability

• Correlation

à Financial managers concentrate on three general approaches to financial

forecasting
EXPERIENCE

• Managers who have been in the business for a long time have developed a
sense for the patterns in sales, expenses, consumer demand factors, etc.

• Example: Editors who work for book publishers regularly read submitted
manuscripts and make judgments about whether their company should buy
the rights to publish the books.
PROBABILIT Y

• Past history often tells us a lot about what will happen in the future.

• Managers can use this information to estimate the future.

• Example: In the past, a 711 manager has found that she will lose 1% of
candy inventory to shoplifters. She can use this information to estimate
future losses and also to design better controls
CORRELATION
• Correlation is a measure of the relative movement of two variables relative
to each other.

• Example: If interest rates go up, a real estate agent knows that home sales
will tend to fall (because the higher cost of financing makes it harder for
buyers to qualify for mortgages).

• Example: Sales of umbrellas are higher in rainy seasons

PRO FORMA FINANCIAL S TATEMENT S
• Pro forma financial statements are forecasts of the firm’s future financial
statements based on a certain set of assumptions about sales trends and the
relationships between sales and various financial variables, and between other
financial statement variables relative to each other.
PRODUCING PRO FORMA
• Example Data for Marginal Product Inc.

ü Sales will increase from $5 million to $8 million.

ü Production is at full capacity (24 hrs. per day).
ü Dividend payout will be 70% of NI.
ü Spontaneous balance sheet accounts increase in a constant proportion to sales.
PRODUCING PRO FORMA
• Step 1:
• Determining Sales Growth: ($8-$5)/$5 =60%

Income Statement
Marginal Product Inc.
Current Projected
Note: The projected sales will be determined
Sales 5,000 8,000
after input from many different units or
COGS 4,133
EBIT 867 departments of the firm.
Int 200
EBT 667
Tax (.40) 266.8
NI 400.2
PRODUCING PRO FORMA
• Step 2:
• Calculate projected Net Income.
New COGS = Old COGS x 1.6 = 6,613
Income Statement
Marginal Product Inc. Note: There is no increase yet in the interest charges
Current Projected
since Marginal Product’s managers have not yet
Sales 5,000 8,000
COGS 4,133 6,613 decided how they will finance the growth.
EBIT 867 1,387
Int 200 200
EBT 667 1,187
Tax (.40) 266.8 474.8
NI 400.2 712
PRODUCING PRO FORMA
• Step 3: Forecast increase in assets (% of sales).
Balance Sheet (figures in 000,000s)
Marginal Product Inc.
Assets Current Projected Liabilities Current Projected
Current Assets 2.5 Account Payable 1.0
Net Fixed Assets 3.0 Accrued Expenses 0.5
Total 5.5 Notes Payable 0.0
Current Liabilities 1.5
Long-term Debt 2.0
Common Stock 0.5
Retained Earnings 1.5
Common Equity 2.0
Total 5.5
PRODUCING PRO FORMA
• Step 3: Forecast increase in assets (% of sales). If sales increase by 60%, so
too will any asset that remains a constant percent of sales.
Balance Sheet (figures in 000,000s)
Marginal Product Inc.
Assets Current Projected Liabilities Current Projected
Current Assets 2.5 4.0Account Payable 1.0
Net Fixed Assets 3.0 $2.5(1+0.60)
Accrued Expenses = $4.0 0.5
Total 5.5 Notes Payable 0.0
Current Liabilities 1.5
Long-term Debt 2.0
Common Stock 0.5
Retained Earnings 1.5
Common Equity 2.0
Total 5.5
PRODUCING PRO FORMA
• Step 3: Forecast increase in assets (% of sales).
Balance Sheet (figures in 000,000s)
Marginal Product Inc.
Assets Current Projected Liabilities Current Projected
Current Assets 2.5 4.0Account Payable 1.0
Net Fixed Assets 3.0 4.8Accrued Expenses 0.5
Total 5.5 8.8Notes$3.0(1+0.60)
Payable = $4.8 0.0
Current Liabilities 1.5
+$3.3 Long-term Debt 2.0
Common Stock 0.5
Retained Earnings 1.5
Common Equity 2.0
Total 5.5
PRODUCING PRO FORMA

• Step 4: Forecast increase in spontaneous liabilities

Balance Sheet (figures in 000,000s)
Marginal Product Inc.
Assets Current Projected Liabilities Current Projected
Current Assets 2.5 4.0Accounts Payable 1.0 1.6
Net Fixed Assets 3.0 4.8Accrued $1.0(1+0.60)
Expenses = $1.6 0.5
Total 5.5 8.8Notes Payable 0.0
Current Liabilities 1.5
Long-term Debt 2.0
Common Stock 0.5
Retained Earnings 1.5
Common Equity 2.0
Total 5.5
PRODUCING PRO FORMA
• Step 4: Forecast increase in spontaneous liabilities
Balance Sheet (figures in 000,000s)
Marginal Product Inc.
Assets Current Projected Liabilities Current Projected
Current Assets 2.5 4.0Accounts Payable 1.0 1.6
Net Fixed Assets 3.0 4.8Accrued Expenses 0.5 0.8
Total 5.5 8.8Notes Payable 0.0
$0.5(1+0.60) = $0.8
Current Liabilities 1.5
Long-term Debt 2.0
Common Stock 0.5
Retained Earnings 1.5
Common Equity 2.0
Total 5.5
PRODUCING PRO FORMA
• Step 5: Forecast increase in retained earnings.
Balance Sheet (figures in 000,000s)
Marginal Product Inc.
Assets Current Projected Liabilities Current Projected
Current Assets 2.5 4.0Accounts Payable 1.0 1.6
Net Fixed Assets 3.0 4.8Accrued Expenses 0.5 0.8
New Retained Earnings
Total 5.5 8.8Notes Payable 0.0
= Old Retained Earnings
+ AdditionsCurrent Liabilities
to Retained Earnings 1.5
= $1.5 + [NILong-term Debt payout)] 2.0
✖ (1 – dividend
= $1.5 + [0.712 ✖ (1 –Stock
Common 0.7)] 0.5
= $1.7 Retained Earnings 1.5 1.7
Common Equity 2.0
Total 5.5
 PRODUCING PRO FORMA
• Step 6: Hold other accounts constant to see how much additional funds will be needed.

Balance Sheet (figures in 000,000s)

Marginal Product Inc.
Assets Current Projected Liabilities Current Projected
Current Assets 2.5 4.0Accounts Payable 1.0 1.6
Net Fixed Assets 3.0 4.8Accrued Expenses 0.5 0.8
Total 5.5 8.8Notes Payable 0.0 0.0
Current Liabilities 1.5 2.4
Long-term Debt 2.0 2.0
Common Stock 0.5 0.5
Retained Earnings 1.5 1.7
Common Equity 2.0 2.2
Total 5.5 6.6
PRODUCING PRO FORMA
• Step 7: Additional funds needed (AFN) = projected assets minus projected claims.

Balance Sheet (figures in 000,000s)

Marginal Product Inc.
Assets Current Projected Liabilities Current Projected
Current Assets 2.5 4.0Accounts Payable 1.0 1.6
Net Fixed Assets 3.0 4.8Accrued Expenses 0.5 0.8
Total 5.5 8.8Notes Payables 0.0 0.0
Current Liabilities 1.5 2.4
AFN = $8.8 – 6.6 = $2.2m
Long-term Debt 2.0 2.0
Common Stock 0.5 0.5
Raise $2.2m using notes payable, Retained Earnings 1.5 1.7
and/or long-term debt, and/or common Common Equity 2.0 2.2
stock
Total 5.5 6.6
PRODUCING PRO FORMA - SUMMARY
1. Determine sales growth.

2. Calculate projected net income.

3. Project assets needed to support the new sales level.

4. Project increases in spontaneous asset and liability accounts.

5. Project addition to retained earnings.

6. Determine the difference between projected assets and projected liabilities & equity.
EXAMPLE 14
 EXAMPLE 15
• Fill in the missing values of the pro forma income statement for 2013. Sales will
increase by 25% and the dividend payouts will increase 40% to 55%. Variable
costs will be 5% points less than the original percentages of sales.

2012 2013
Sales 1000
Variable Costs 500
Fixed Costs 160
Net income 340
Dividends 136
 EXAMPLE 16
After completing the pro forma income statement, Mr.
Tine now realizes he should also complete a pro forma
balance sheet. Net sales in 2012 were $90,000 and his
forecasted sales for 2013 are $110,000. All of Sugar
Cane Alley’s current assets will remain the same
percentage of sales as they were in 2012. Mr. Tine
does not plan to buy or sell any equipment, so his
gross property and equipment amount will remain the
same as 2012. In the liabilities and equity section, only
accounts payable will remain the same percentage of
sales as in 2012. Except for retained earnings, the
other accounts are expected to remain the same value
as 2012. The following balances were taken from
Sugar Cane Alley’s end-of-2012 balance sheet:
a. Calculate the forecasted end-of-2013 values for each of the current asset accounts.
b. Depreciation expense for 2013 is estimated to be $2,000. Calculate the estimated total
assets for the end of 2013.
c. Forecast the accounts payable for the end of 2013.
d. What will total liabilities be at the end of 2013?
e. Assuming the forecasted net income for 2013 is $19,351 and cash dividends paid equal
$10,000, what total will be forecasted for the end- of-2013 total liabilities and equity?
f. Based on these calculations of the pro forma balance sheet, are additional funds
needed?
g. Net income for 2012 was $14,840. What was Sugar Cane Alley’s net profit margin for
2012? The forecasted net income for 2013 is $19,351. What is Sugar Cane Alley’s
forecasted 2013 net profit margin?