Pro Forma Financial Statements

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Pro Forma Financial Statements
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Pro Forma Financial Statements

• Projected or future financial statements.
• The idea is to write down a sequence of financial
  statements that represent expectations of what
  the results of actions and policies will be on
  the future financial status of the firm.
• Pro forma income statements, balance sheets, and
  the resulting statements of cash flow are the
  building blocks of financial planning.
• They are also vital for any valuation exercises
  one might do in investment analysis or MA
  planning. Remember, its future cash flow that
  determines value.
• Financial modeling skills such as these are also
  one of the most important skills (for those of
  you interested in finance or marketing) to
  develop.

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Generic Forms Income Statement

• Sales (or Revenue)
• Less Cost of Goods Sold
• Equals Gross Income (or Gross Earnings)
• Less Operating Expenses
• Equals Operating Income
• Less Depreciation
• Equals EBIT
• Less Interest Expense
• Equals EBT
• Less Taxes
• Equals Net Income (Net Earnings, EAT, Profits)

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Generic Forms Balance Sheet

• Assets
• Cash
• Accounts Receivable
• Inventory
• Prepaid Taxes
• Marketable Securities
• Total Current Assets
• Gross PPE
• Accumulated Depreciation
• Net PPE
• Land
• Total Assets

• Liabilities Os Equity
• Bank Loan
• Accounts Payable
• Wages Payable
• Taxes Payable
• Current Portion L-T Debt
• Total Current Liabilities
• Long-Term Debt
• Preferred Stock
• Common Stock
• Retained Earnings
• Total Liabilities Equity

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Generic Forms Bridge

• Clearly we cant hope to get anywhere if we
  develop separate forecasts of the different
  statements.
• The income statement records the effect of a
  given year while the balance sheets show the
  situation at the beginning of and after that
  year.
• Furthermore the balance sheet must balance.
• The two statements must therefore be intimately
  linked. There must be a bridge between them.

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Generic Forms Bridge

• One important bridge is
• Net Income Dividends Change in Retained
  Earnings
• An income statement amount less dividends equals
  a balance sheet amount.
• Another is
• Interest Expense Interest Rate ? Interest
  Bearing Debt
• An income statement amount equals a balance
  sheet amount times a cost figure.
• These simple relations, plus requiring the
  balance sheet to balance, tie the income
  statement directly to the balance sheet and vice
  versa.

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Bridge
Income Statement
Balance Sheet
Sales (or revenue) Less COGS Equals Gross Income Less Operating Exp Less Depr Equals EBIT Less Interest Exp Equals EBT Less Taxes Equals Net Inc (EAT) Less Dividends Change in Retained E Assets Cash Accts Rec Inventory Prepaid Taxes Total Current Assets Gross PPE Accumulated Depr. Net PPE Land Total Assets Liabilities Owners E Bank Loan Accts Pay Wages Pay Taxes Pay Total Current Liab L-T Debt Common Stock Retained Earnings Total Liab OE
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The Forecasting Process

• The most common way to proceed is to fill in the
  income statement first. The standard approach is
  called percent of sales forecasting.
• Why? You first get the sales (or sales growth)
  forecast.
• Then, you project variables having a stable
  relation to sales using forecasted sales and the
  estimated relations.
• Then there is the rest.

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The Process

• How would we describe and estimate the following
• COGS
• Operating expenses
• Depreciation Amortization
• Interest expense
• Taxes

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The Process

• COGS will generally vary directly with sales. If
  not, it is likely that something has gone (or is
  going) very wrong.
• Calculate the COGS/Sales ratio for the last few
  years. Multiply a forecast for this ratio times
  the forecast for sales to find a forecast for
  COGS.
• How do we forecast the COGS/Sales ratio?
• Note that there may also be a fixed component for
  some of these relations. How do you adjust?
• Operating expenses is a good example.

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The Process

• We then require estimates of the components of
  expenses that dont vary directly (and in a
  stable way) with sales to complete the income
  statement.
• Other Expenses
• Other Income
• Depreciation
• Taxes
• Net Income
• Dividends

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The Process

• From the completed income statement, determine
  the change in retained earnings, transfer it to
  the balance sheet.
• Now we have to fill out the rest of the balance
  sheet.
• Many of the current assets and liabilities
  (accounts receivable, accounts payable,
  inventory, wages payable, etc.) can be expected
  to vary directly with sales.
• Forecast these as we just described.

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The Process

• The cash balance is usually determined by a
  policy decision via some inventory (of liquidity)
  model.
• Alternatively this account may be used as a
  plug.
• Changes in Gross PPE are also the result of
  policy decisions as are changes in preferred or
  common stock.
• Often short-term (bank loan or line of credit) or
  long-term debt is used as a residual to determine
  the required new financing (a plug to make it
  balance).
• But dont forget that these cant be chosen in
  isolation.

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The Process

• Interest expense comes from the amount of
  interest bearing debt.
• Interest expense effects net income,
• Which effects changes in retained earnings,
• Which, through the equality requirement for the
  balance sheet, effects the amount of interest
  bearing debt that is necessary.
• The two statements are intimately connected.

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A Circularity Rather Than A Bridge
Sales (or revenue) Less COGS Equals Gross Income Less Operating Exp Less Depr Equals EBIT Less Interest Exp Equals EBT Less Taxes Equals Net Inc (EAT) Less Dividends Changes in Retained E Assets Cash Accts Rec Inventory Total Current Assets Gross PPE Accumulated Depr. Net PPE Land Total Assets Liabilities Owners E Bank Loan Accts Pay Wages Pay Taxes Pay Total Current Liab L-T Debt Common Stock Retained Earnings Total Liab OE
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Interactions

• The income statement equation can be written
• Rev Operating Exp DeprAmort
• - (Int Bearing Debt)(Int Rate)(1- Tax Rate)
• - Dividends Change in retained earnings
• The balance sheet equation is written
• Total Assets Accts Pay Wages Pay Taxes Pay
  
• Int Bearing Debt Common Stock Change in
  retained earnings
• Interest bearing debt is the unknown in each
  equation.
• If we just substitute the LHS of the income
  statement equation for the last term of the
  balance sheet equation we can solve them
  simultaneously to find the external debt
  financing required.
• This is made easy by spread sheets and should be
  easier to understand by looking at the following
  example.

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Example
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The Process

• Many will not go to all the trouble and simply
  use one balance sheet account as a residual
  account (often cash) that makes the balance
  sheet balance.
• In this way you dont change the interest bearing
  debt directly (so interest expense is fixed but
  wrong) and equity changes only through retained
  earnings.
• This allows you to see what you have to do with
  financing to keep things on track. If cash gets
  big or very negative you can plan on having to
  take actions.
• This method is not very useful for FAP and makes
  you think about what is going on before you do
  any valuation.
• Why be sloppy when doing it right is now so easy?