PRO FORMA FINANCIALSTATEMENTS 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 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: INCOMESTATEMENT 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)
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 Total Current Assets Debt Gross PP&E Total Current Liabilities Accumulated Long-Term Debt 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 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.
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. Thesesimple relations, plus requiring the balance sheet to balance, tie the income statement directly to the balance sheet and vice versa.
BRIDGEIncome Statement Balance SheetSales (or revenue) Assets Liabilities + Owner’s ELess COGS Cash Bank LoanEquals Gross Income Accts Rec Accts PayLess Operating Exp Inventory Wages PayLess Depr Prepaid Taxes Taxes PayEquals EBIT Total Current Assets Total Current LiabLess Interest Exp Gross PP&E L-T DebtEquals EBT Accumulated Depr. Common StockLess Taxes Net PP&E Retained EarningsEquals Net Inc (EAT) Land Total Liab + OELess Dividends Total AssetsChange 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 the 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. 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.
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 BRIDGESales (or revenue) Assets Liabilities + Owner’s ELess COGS Cash Bank LoanEquals Gross Income Accts Rec Accts PayLess Operating Exp Inventory Wages PayLess Depr Total Current Assets Taxes PayEquals EBIT Gross PP&E Total Current LiabLess Interest Exp Accumulated Depr. L-T DebtEquals EBT Net PP&E Common StockLess Taxes Land Retained EarningsEquals Net Inc (EAT) Total Assets Total Liab + OELess DividendsChanges 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 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.
EXAMPLEIncome StatementNet Sales $240,000.00 Firm decides that $20,000 is a minimumCost 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 loanInterest Expense $8,000.00 "+E22*.10+4500" are assumed to be estimated via ratios.Earnings Before Tax $40,000.00Tax $16,000.00 "+E6*.4" Interest on existing LT Debt is $4,500Net Income $24,000.00Dividends 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 $82,000.00Net PP&E $150,000.00Other Assets $25,000.00Total Assets $342,000.00Accounts Payable $18,000.00Tax Accruals $9,000.00Bank 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 $5,000.00Long-Term Debt $45,000.00Common Stock $95,000.00Retained 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?