Pro Forma Financial Statements Pro Forma Financial Statements
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Pro Forma Financial Statements Pro Forma Financial Statements

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    Pro Forma Financial Statements Pro Forma Financial Statements Pro Forma Financial Statements Pro Forma Financial Statements Presentation Transcript

    • Pro Forma Financial Statements
    • 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 financial status of the firm into the future. • 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 M&A planning. Remember, it’s 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.
    • 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 (EAT, Profits)
    • Generic Forms: Balance Sheet • Assets • Liabilities + O’s Equity – Cash – Bank Loan – Accounts Receivable – Accounts Payable – Inventory – Wages Payable – Prepaid Taxes – Taxes Payable – Marketable Securities – Current Portion – L-T Debt • Total Current Assets • Total Current Liabilities – Gross PP&E – Long-Term Debt – Accumulated Depreciation – Preferred Stock – Net PP&E – Common Stock – Land – Retained Earnings • Total Assets • Total Liabilities + Equity
    • Generic Forms: Bridge • Clearly we can’t hope to get anywhere if we treat these forecasts as being separate. • 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.
    • 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.
    • Bridge Income Statement Balance Sheet Sales (or revenue) Assets Liabilities + Owner’s E Less COGS Cash Bank Loan Equals Gross Income Accts Rec Accts Pay Less Operating Exp Inventory Wages Pay Less Depr Prepaid Taxes Taxes Pay Equals EBIT Total Current Assets Total Current Liab Less Interest Exp Gross PP&E L-T Debt Equals EBT Accumulated Depr. Common Stock Less Taxes Net PP&E Retained Earnings Equals Net Inc (EAT) Land Total Liab + OE Less Dividends Total Assets Changes in Retained E
    • 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 estimated relations. • Then there is the rest.
    • The Process… • How would we describe and estimate the following: – COGS – Operating expenses – Depreciation & Amortization – Interest expense – Taxes
    • 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.
    • The Process… • We then require estimates of the components of expenses that don’t vary directly (and in a stable way) with sales to complete the income statement. – Other Expenses – Other Income – Depreciation – Taxes – Net Income – Dividends
    • 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. – Some 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.
    • 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 PP&E 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 don’t forget that these can’t be chosen in isolation.
    • 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.
    • A Circularity Rather Than A Bridge Sales (or revenue) Assets Liabilities + Owner’s E Less COGS Cash Bank Loan Equals Gross Income Accts Rec Accts Pay Less Operating Exp Inventory Wages Pay Less Depr Total Current Assets Taxes Pay Equals EBIT Gross PP&E Total Current Liab Less Interest Exp Accumulated Depr. L-T Debt Equals EBT Net PP&E Common Stock Less Taxes Land Retained Earnings Equals Net Inc (EAT) Total Assets Total Liab + OE Less Dividends Changes in Retained E
    • Interactions… • The income statement equation can be written: [Rev – Operating Exp – Depr&Amort - (Int Bearing Debt)(Int Rate)](1- Tax Rate) - Dividends = Change in retained earnings • The balance sheet equation is: 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.
    • Example Income Statement Net Sales $240,000.00 Firm decides that $20,000 is a minimum Cost of Goods Sold $156,000.00 65% of sales cash balance that is acceptable. GS&A Expenses $36,000.00 15% of sales All but cash account and bank loan Interest Expense $8,000.00 "+E22*.10+4500" are assumed to be estimated via ratios. Earnings Before Tax $40,000.00 Tax $16,000.00 "+E6*.4" Interest on existing LT Debt is $4,500 Net Income $24,000.00 Dividends Paid $12,000.00 "+E8*.5" Additions to Retained Earnings $12,000.00 "+E8-E9" Balance Sheet (end of period) Cash $20,000.00 "=IF(20000+SUM(E14:E17)>E20+E21+SUM(E23:E27),20000," Accounts Receivable $65,000.00 "E20+E21+SUM(E23:E27)-SUM(E14:E17))" Inventory $82,000.00 Net PP&E $150,000.00 Other Assets $25,000.00 Total Assets $342,000.00 Accounts Payable $18,000.00 Tax Accruals $9,000.00 Bank Loan $35,000.00 "=IF(20000+SUM(E14:E17)>E20+E21+SUM(E23:E27)," Equipment Loan $23,000.00 "(20000+SUM(E14:E17))-(E20+E21+SUM(E23:E27)),0)" Miscellaneous Accruals $5,000.00 Long-Term Debt $45,000.00 Common Stock $95,000.00 Retained Earnings $112,000.00 "100000+E10" Firm had $100,000 RE end of last period. Total Liabilities + Equity $342,000.00
    • 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 don’t 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?
    • Teton Valley Case Free Cash Flows
    • Existing Accounting Statements
    • Free Cash Flow • For each future year you want to calculate: • FCF = EBIT(1 – Tc) (no debt tax shields calculated) + Depr & Amort. (adjust for non-cash expenses) - Capital Expenditures (a cash flow not part of EBIT) - Changes in NWC (almost, to adjust for accruals.)
    • Teton Valley Corporation • Sales growth at 10% for 5 years then 4% in perpetuity. • CGS at 65% of sales. • SGA at $500,000 + 4.5% of sales. • Net Fixed assets grow at 5% per year for next 5 years. • Depreciation is 20% of beginning of year net fixed assets. • NWC is $80,000, grows with sales. • FCFs grow at 4% in perpetuity after 2011.
    • Forecasting Earnings TETON VALLEY CORPORATION VALUATION (See Valuation; LectureMod#19) 2007 2007 2008 2008 NET FIXED ASSETS GROW AT 5% $750,000(1.05) $ 787,500 (C5 (1.05)) $ 826,875 (From base of $750,000) (1) SALES (10% growth from $5.5M) $5,500,000(1.1) $ 6,050,000 C8 * 1.1 $ 6,655,000 (2) COST OF GOODS SOLD (0.65 of sales) (B8 * 0.65) $ 3,932,500 (D8 * 0.65) $ 4,325,750 (3) GROSS MARGIN (1 - 2) (B8 - B9) $ 2,117,500 (D8 - D9) $ 2,329,250 (4) GSA ($500,000 + 4.5% of sales) $500,000+B8*.045 $ 772,250 $500,000+D8*0.45 $ 799,475 (5) DEPRECIATION (20% of prev yr NFA) $750,000(.20) $ 150,000 $787,500(.20) $ 157,500 (6) EBIT (3 - 4 - 5) (B10 - B11 - B12) $ 1,195,250 (D10 - D11 - D12) $ 1,372,275 (7) INTEREST (DO NOT INCLUDE!) finance cost $ - finance cost $ - (8) EBT (just 6 - "assume its an all equity firm") B13 $ 1,195,250 D13 $ 1,372,275 (9) TAX (8 *Tc) B13 * 0.30 $ (358,575) D13 * 0.30 $ (411,683) (10) EAT (8*(1-Tc) or 8 - 9) B13 * 0.70 $ 836,675 D13 * 0.70 $ 960,593
    • The Pro Forma Exercise • For a complete pro forma analysis we also need to forecast the balance sheet. • Two issues for this example: 1. The balance sheet is so simple it is a trivial exercise. 2. We need to make some assumptions. About what?
    • Forecasting the Balance Sheet Balance Sheet 2007 2008 Assets Liabilities Assets Liabilities Current Assets 275000 Non-Int Bearing Liab 187000 Current Assets 302500 Non-Int Bearing Liab 205700 Net Fixed Assets 787500 Interest Bearing Liab 395500 Net Fixed Assets 826875 Interest Bearing Liab 443675 Equity 480000 Equity 480000 Total Assets 1062500 Total Liab+ Equity 1062500 Total Assets 1129375 Total Liab+ Equity 1129375 • What did I assume? • Are there any issues? • Complete the forecast on the spreadsheet.
    • From Earnings To Free Cash Flow FCF = EBIT(1-Tc) + Depr. - ∆NWC – Cap Ex. So: 2007 2007 2008 2008 (10) EBIT(1-Tc): (8*(1-Tc) or 8 - 9) B13 * 0.70 $ 836,675 D13 * 0.70 $ 960,593 (11) + DEPRECIATION (5) B12 $ 150,000 D12 $ 157,500 (12) OPERATING CASH FLOW (10 + 11) B17 + B19 $ 986,675 D17 + D19 $ 1,118,093 (13) - Change in Net W/C (grows at 10%) $80,000 * 0.10 $ 8,000 C23 *1.1 $ 8,800 (14) -CAPITAL EXPENDITURE B5 - 750k + B12 $ 187,500 D5 - C5 + D12 $ 196,875 (change in NFAs + depr = change in gross FA) (15) FREE CASH FLOW (FCF=12-13-14) B21 - B23 - B24 $ 791,175 D21 - D23 - D24 $ 912,418 2007 2008 2009 2010 2011 FCF: 791,175 912,418 1,046,141 1,193,610 1,356,219