Pro Forma Financial Statements

1. Pro Forma Financial Statements

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 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.

3. 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)

4. Generic Forms: Balance Sheet • Assets • Cash • Accounts Receivable • Inventory • Prepaid Taxes • Marketable Securities • Total Current Assets • Gross PP&E • Accumulated Depreciation • Net PP&E • Land • Total Assets • Liabilities + O’s 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

5. 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.

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 requiring the balance sheet to balance, tie the income statement directly to the balance sheet and vice versa.

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. • Then there is the rest.

9. The Process… • How would we describe and estimate the following: • COGS • Operating expenses • Depreciation & Amortization • Interest expense • Taxes

10. 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.

11. 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

12. 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.

13. 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.

14. 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.

15. A Circularity Rather Than A Bridge

16. 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.

17. Example

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 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?