Pro forma modeling is where accounting meets forecasting. A clean model starts with sales, layers in costs proportional to that sales line, then explains every deviation from history with an explicit business reason.
A sales-based model starts with revenue. You can forecast that revenue top-down (from the economy and the industry), bottom-up (from units, stores or segments) or with a hybrid of the two. You forecast revenue first because costs, working capital and the capex schedule all key off it. Get sales wrong and every downstream line is wrong by construction.
- Revenue. Decompose into volume (units) and price. Volume ties to industry size times market share. Price ties to product mix and inflation pass-through.
- COGS. Forecast cost of goods sold as a percentage of revenue, or build from input costs (commodities, labor, freight) when margins are volatile.
- SG&A. Split selling, general and administrative expense into fixed (rent, base salaries) and variable (sales commissions, marketing tied to revenue).
- D&A. Tie depreciation and amortization to the capital expenditure (capex) schedule. Existing property, plant and equipment (PP&E) depreciates on its remaining life; new capex depreciates on policy life.
Common mistakes
- Forecasting margins instead of revenue first. Setting a target operating margin and backing into revenue or costs is reverse-engineering. Trap: assuming "operating margin holds at 12%" without justifying that costs grow slower than revenue.
- Applying one inflation rate to both revenue and COGS. Margin moves from the gap between output and input inflation. Trap: assuming +5% inflation everywhere produces zero margin change.
- Ignoring buyer or supplier concentration when modeling pricing. A company with retailer concentration above 50% cannot sustainably raise prices faster than its retailers tolerate. Trap: modeling price increases above inflation when buyer power is high.
Bottom line
- Sales-based pro forma flow: forecast revenue first, then COGS, SG&A, D&A, interest, taxes, working capital, capex, financing (revenue first, financing last)
- Working capital comes from days: AR = revenue × DSO / 365, inventory and AP = COGS × days / 365. Capex drives next year's D&A, and cash is the plug that balances the model
- Nominal revenue growth = , so model volume and price separately rather than adding a single combined rate
- Five Porter forces (rivalry, new entrants, substitutes, buyer power, supplier power) drive sustainable pricing and cost pass-through
Exam shortcut
When the stem describes a behavioral pattern and asks for the bias, match the cue word: narrow ranges = overconfidence, sticky to prior = anchoring, supporting evidence only = confirmation, recent-trend extrapolation = representativeness. For Porter's questions, remember that buyer power and rivalry compress prices, while supplier power compresses margin via costs. For terminal value, always sanity-check that the perpetuity growth rate sits at or below long-run nominal GDP.
The full lesson (about 4,067 words, 27 min read) adds 9 worked examples, all 8 common mistakes, a self-check, free in the app.
Learning objectives
- introduction to financial statement modeling
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