Pro Forma Financial Statements

1. Pro Forma Financial Statements Forecasting the Future Financial Condition of the Firm

2. 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 analysis and planning. • They are also vital for any valuation exercises one might do in investment analysis or M&A evaluation/planning. Remember, it’s future cash flow that indicates value. • Financial modeling skills such as these are also some of the most important skills you (especially those of you interested in finance or marketing) can develop.

3. Generic Forms: Income Statement Sales (or revenue) Less Cost of Goods Sold Equals Gross Income (or Gross Earnings) Less Operating Expenses (SG&A, Depreciation, Marketing, R&D, etc.) Equals Operating Income Less Non-Operating Expenses (interest expense, “other” non-operating expenses/income) Equals EBT Less Taxes Equals Net Income (EAT, Profits)

4. Generic Forms: Balance Sheet • Assets • Cash • Accounts Receivable • Prepaid Taxes • Inventory • Total Current Assets • Gross PP&E • Less Accumulated Depreciation • Net PP&E • Land • Total Assets • Liabilities + O’s Equity • Accounts Payable • Wages Payable • Taxes Payable • Bank Loan • Current Portion of L-T Debt • Total Current Liabilities • Deferred Tax Liabilities • Long-Term Debt • Common Stock • Retained Earnings • Total Liabilities + Equity

5. Generic Forms: Bridge • Clearly we can’t hope to get anywhere if we create separate forecasts of the different statements. • The income statement records activities of a given year and the balance sheets show the situation at the beginning of and the end of that year. • Furthermore the balance sheet must balance. • The two statements must therefore be intimately linked. There must be a “bridge” between them.

6. 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 the requirement that the balance sheet indeed balance, tie the statements together and impose (the only real) discipline on this process.

7. Bridge Income Statement Balance Sheet

8. 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. • Policy decisions • “Other”

9. The Process… • COGS will generally vary directly with sales. If not, it is likely that something has gone very wrong. • Examine the COGS/Sales ratio for the last few years. Multiply a forecast of this ratio times the forecast of sales to forecast 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? • SG&A or operating expenses for example.

10. The Process… • We then require estimates of the components of the income statement that don’t vary directly (and in a stable way) with sales so that we may complete it. • Other Expenses • Other Income • Depreciation • Taxes • Net Income • Dividends

11. The Process… • From the completed income statement, and the firm’s expected dividend, determine the change in retained earnings and transfer it to the balance sheet. • Now we have to fill out the rest of the balance sheet. • Some/many of the current assets and liabilities (accounts receivable, accounts payable, inventory, wages payable, etc.) can be expected to vary with sales in a predictable way. • Forecast these as we just described.

12. The Process… • The minimum cash balance is usually determined by a policy decision via some inventory (of liquidity) model. • Alternatively this account may be used as a “plug” variable or a combination of both – more later. • Changes in Gross PP&E are also the result of policy decisions and tied to sales growth. • Preferred and common stock (owners equity) are commonly held fixed (but for changes in RE) for initial planning purposes. • Often short-term (or long-term) debt is used as a residual to determine the required new financing (a plug to make it balance). • Don’t forget that this can’t be chosen in isolation.**

13. The Process… • The amount of interest bearing debt determines the amount of interest expense. • Interest expense effects net income, • Net income effects changes in retained earnings, • Changes in retained earnings, through the equality requirement for the balance sheet, effects the amount of interest bearing debt that is necessary. • The two statements are intimately connected.

14. A Circularity Rather Than A Bridge

15. Interactions… • The income statement equation can be written: [EBIT – (Interest Bearing Debt)(Interest Rate)](1-Tax Rate) - Dividends = Change in retained earnings • The balance sheet equation is: Total Assets = Current Liabilities + Interest Bearing Debt + Common Stock + Change in retained earnings • Interest bearing debt is the unknown in each equation. • Substitute the LHS of the income statement equation for the last term of the balance sheet equation to “solve the equations simultaneously” to find the level of interest bearing debt required for consistency. • This is made easy by spread sheets and should be easier to understand by looking at the following simplified example.

16. Example

17. The Plugs • Plug A: • IF(30,000+SUM(D20:D22)>I19+I21+I26+I28, (if) 30,000, (then) I19+I21+I26+I28 - SUM(D20:D22)) (else) • Plug B: • IF(30,000+SUM(D20:D22)>I19+I21+I26+I28, (30,000+SUM(D20:D22)) - I19+I21+I26+I28, 0)

18. 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 consistent with debt levels but “wrong”) and owner’s equity doesn’t jump around. • 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 action. • This method is not very useful for FAP and makes you think harder before you find FCF. • Why be sloppy when doing it right is so easy these days?