Updated for the 2026-2027 CFA® Level I curriculum.
A sales-based pro forma model forecasts a company's future income statement and cash flow using sales as the main driver. You project sales first, then scale most costs to that sales figure using historical ratios. CFA Level I tests whether you can build this model in the correct order and explain what the resulting numbers mean for the company.
Quick Answer
A sales-based pro forma model forecasts a company's income statement and cash flow using sales as a starting driver, with separate assumptions for assets, liabilities, financing, and other costs. You project sales growth first, then apply historical cost-to-sales ratios to estimate COGS, SG&A, and other expenses. The resulting pro forma net income becomes a cash flow forecast after adjusting for non-cash items and working capital changes. The exam tests the full sequence, not just one ratio.
Key Takeaways
Sales forecast is the starting point and primary driver of a sales-based pro forma model.
Most income statement line items are forecasted as a percentage of sales, using historical ratios as a baseline.
Fixed costs, like interest expense on existing debt, should not automatically scale with sales.
Pro forma net income is an intermediate step. Analysts convert it into a cash flow forecast.
The net income to cash flow adjustment adds back non-cash charges and subtracts increases in working capital.
Historical ratios distorted by one-time items need adjustment before you use them in the model.
What You Need to Know for CFA Level I
The LOS asks you to demonstrate how to build a sales-based pro forma model, not just define one.
You must forecast sales first, then derive cost, income, and cash flow items from that sales number.
You need to apply a historical percentage-of-sales ratio to the forecasted sales figure, not to the prior year's sales.
You must separate costs that scale with sales, like COGS and SG&A, from costs that typically stay fixed, like interest expense on existing debt.
You need to convert pro forma net income into a cash flow estimate by adjusting for depreciation and working capital changes.
This note does not cover inflation-adjusted forecasting or competitive-forces forecasting. Those belong to sibling notes.
What a Sales-Based Pro Forma Model Does
A sales-based pro forma model treats sales as the input that drives everything else. Once you have a sales forecast, you scale cost items to that forecast using ratios taken from historical financial statements. The model moves in one direction: sales forecast, then cost forecast, then net income forecast, then cash flow forecast.
This matters because most companies do not plan costs independently of revenue. COGS rises when sales rise. SG&A tends to grow with the business, though less tightly. Treating sales as the anchor keeps the forecast internally consistent instead of guessing each line item separately.
Building the Pro Forma Income Statement
Step 1: Forecast Sales
Start with a sales growth assumption. This might come from management guidance, industry growth rates, or a trend in historical sales. The sales forecast is the single most important number in the model because every other line item depends on it.
Step 2: Apply Historical Ratios to Forecast Costs
Calculate each cost item as a percentage of sales in the base year. Apply that same ratio to the forecasted sales figure, not to the base year sales figure. This step is where candidates lose points. The ratio is historical, but the sales number you multiply it by must be the forecast year's sales.
Step 3: Identify Costs That Should Stay Fixed
Not every cost scales with sales. Interest expense on existing debt depends on the debt balance and the interest rate, not on sales volume. Lease payments under a fixed contract behave the same way. Before you scale a cost item, ask whether it is driven by sales activity or by a separate contractual or financing obligation.
Step 4: Calculate Pro Forma Net Income
Subtract the forecasted costs, interest expense, and taxes from forecasted sales in order. The result is pro forma net income. At this point, you have completed the income statement forecast, but the model is not finished. Net income is not cash flow.
Converting Pro Forma Net Income to a Cash Flow Forecast
Net income includes non-cash charges and ignores changes in working capital. To forecast cash flow from operations, you adjust pro forma net income for both.
where:
: forecasted cash flow from operations in period t,
: forecasted pro forma net income in period t,
: forecasted depreciation and amortization in period t (non-cash, added back), and
: forecasted increase in working capital in period t (cash outflow, subtracted).
Key Adjustments from Net Income to Cash Flow
Depreciation and amortization reduce net income but do not use cash, so you add them back. Working capital tends to grow with sales, since higher sales usually require more inventory and receivables. An increase in working capital is a cash outflow, so it reduces the cash flow forecast even though it does not appear on the income statement.
Projecting the Balance Sheet and Funding Needs
Forecast operating receivables, inventory, and payables using suitable activity ratios or sales relationships. Define operating working capital to exclude cash and financing debt, then reconcile its change with the CFO adjustment.
Project net PPE from beginning net PPE plus capital expenditure minus depreciation and disposals. Project retained earnings from beginning retained earnings plus net income minus dividends. Use the cash-flow forecast to update cash, and check that assets equal liabilities plus equity. If the model requires additional borrowing, update interest expense and resolve the resulting funding relationship rather than scaling interest automatically with sales.
Interpreting the Model Output
A pro forma model is only useful if you can explain what the numbers mean. If net income grows faster than cash flow, working capital investment is likely absorbing part of the earnings growth. If fixed costs like interest expense stay flat while sales grow, margins should improve, since the fixed cost represents a shrinking percentage of revenue. Analysts use these patterns to judge whether a company's growth is translating into cash, not just accounting profit.
Working Example
Bridgeway Components Inc. reported the following for Year 0 (the base year):
Sales: $120 million
COGS: 62% of sales
SG&A: 15% of sales
Depreciation: 5% of sales
Interest expense: $2 million (fixed, tied to existing debt)
Tax rate: 25%
Working capital: 10% of sales
An analyst forecasts 10% sales growth for Year 1.
Step 1: Forecast sales
Step 2: Forecast costs using historical ratios applied to Year 1 sales
Step 3: Calculate EBIT and net income
Step 4: Convert net income to cash flow
Working capital in Year 0 was 12 million (10% of 120 million). Working capital in Year 1 is 13.2 million (10% of 132 million), so .
Step 5: Extend the example to a linked balance sheet.
Assume Year 0 cash is $10 million, receivables $6 million, inventory $8 million, net PPE $60 million, operating payables $2 million, debt $40 million, and equity $42 million. Base-year operating working capital is $12 million. Forecast capital expenditure of $8 million and dividends of $5 million, with debt unchanged.
Scale receivables, inventory, and payables by the 10% sales growth assumption. Year 1 operating working capital is $6.6 million plus $8.8 million less $2.2 million, or $13.2 million, consistent with the $1.2 million CFO adjustment.
Balance sheet item (millions of dollars) | Year 0 | Forecast Year 1 |
|---|---|---|
Cash | 10.00 | 18.72 |
Receivables | 6.00 | 6.60 |
Inventory | 8.00 | 8.80 |
Net PPE | 60.00 | 61.40 |
Total assets | 84.00 | 95.52 |
Operating payables | 2.00 | 2.20 |
Debt | 40.00 | 40.00 |
Equity | 42.00 | 53.32 |
Total liabilities and equity | 84.00 | 95.52 |
The forecast balances and cash stays positive under these assumptions. A different capex, dividend, or working-capital assumption can create an additional financing need.
Pro forma net income grows to $16.32 million, but cash flow from operations comes in at $21.72 million. Depreciation is a larger non-cash add-back than the working-capital cash investment, so cash flow exceeds net income this year. If sales growth accelerates in future years, the working capital drag would grow too, and the gap between net income and cash flow would narrow.
Common Exam Traps
Applying the cost ratio to the wrong sales figure
Candidates sometimes multiply the historical cost ratio by the base year's sales instead of the forecasted sales. The ratio is historical. The sales number it multiplies must be the forecast year.
Scaling a fixed cost as if it were variable
Interest expense on existing debt does not move with sales. Scaling it up with revenue overstates how costs will behave and produces an inflated or understated net income.
Stopping at pro forma net income
Demonstrating a company model requires consistent projected relationships; this example links earnings, cash flow, and the balance sheet. A candidate who calculates net income correctly but never adjusts for depreciation and working capital has only completed half the model.
Reversing the depreciation adjustment
Depreciation is a non-cash expense that reduces net income but gets added back when calculating cash flow. Subtracting it again, instead of adding it back, understates cash flow.
Ignoring distorted historical ratios
If the base year included a one-time gain, lawsuit settlement, or impairment, the historical cost ratio will not represent normal operations. Using it without adjustment carries the distortion into every forecast year.
Practice Question
An analyst is building a sales-based pro forma model for Harmon Tools Inc. In Year 0, sales were $80 million, COGS was $55% of sales, SG&A was 12% of sales, and depreciation was 4% of sales. Year 1 sales are forecasted at $92 million. Interest expense is fixed at $3 million, and the tax rate is 30%. What is Harmon's forecasted net income for Year 1?
$16.58 million
$18.68 million
$22.54 million
Correct Answer: A
Option B: This result comes from forgetting to subtract interest expense before calculating tax. Taxing EBIT directly instead of EBT produces $18.68 million, which overstates net income.
Option C: This result comes from applying the cost ratios to Year 0 sales ($80 million) instead of the forecasted Year 1 sales ($92 million). This understates costs and overstates net income.
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FAQs About Sales-Based Pro Forma Financial Statement Model
What is the difference between a sales-based pro forma model and a full three-statement model?
A sales-based pro forma model focuses on forecasting the income statement and cash flow using sales as the driver. A full three-statement model also links the balance sheet, including debt schedules and equity rollforwards, and funding assumptions. A sales-based company model can also link all three statements; its defining feature is the use of sales-related drivers, not the omission of a balance sheet.
Why do analysts forecast costs as a percentage of sales instead of a fixed dollar amount?
Most operating costs, like COGS and SG&A, move with business activity. A percentage-of-sales approach keeps the forecast consistent with how the company's cost structure has actually behaved historically.
Should every cost item scale with sales in a pro forma model?
No. Costs tied to financing or fixed contracts, like interest expense on existing debt, should stay fixed unless you have a separate reason to expect them to change.
How does the sales-based pro forma model connect to cash flow forecasting?
Pro forma net income is the starting point. You add back non-cash charges like depreciation and subtract increases in working capital to arrive at a cash flow forecast.
What happens if historical ratios include a one-time or unusual item?
Using an unadjusted ratio carries the distortion into every forecast year. Analysts typically remove one-time items from the base year before calculating the ratio used in the model.