1. business and industrial

PRO FORMA FINANCIAL STATEMENTS
Forecasting the Future Financial Condition of the
Firm
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 is future cash
flow that determines 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.

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)
GENERIC FORMS: BALANCE SHEET

Assets




Cash
Accounts Receivable
Prepaid Taxes
Inventory



Liabilities + O’s Equity





Gross PP&E


Total Current Assets

Less Accumulated
Depreciation
Net PP&E
Land

Total Assets
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
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.
GENERIC FORMS: BRIDGE
 One important bridge is:
Net Income – Dividends = Change in Retained Earnings
An income statement amount (less dividends) equals the
change in a balance sheet amount.
 Another is:
Interest Expense = Interest Rate  Interest Bearing Debt
An income statement amount equals a balance sheet amount
times a market price.
 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.
BRIDGE
Income Statement
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
Balance Sheet
Assets
Cash
Accts Rec
Inventory
Total Current Assets
Gross PP&E
Accumulated Depr.
Net PP&E
Land
Total Assets
Liabilities + O Equity
Bank Loan
Accts Pay
Wages Pay
Taxes Pay
Total Current Liab
L-T Debt
Common Stock
Retained Earnings
Total Liab + OE
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 or predetermined decisions
 “Other”
 Does this make any sense?

THE PROCESS…
 COGS
will commonly 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 more broadly “operating expenses”)
for example.
THE PROCESS…
 We
then require estimates of the
components of the income statement that
don’t vary in a stable way with sales so
that we may complete this statement.






Other Expenses
Other Income
Depreciation
Taxes
Net Income
Dividends
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.
THE PROCESS…
 The
minimum (required) 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.**
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.
A CIRCULARITY RATHER THAN A
BRIDGE
Sales (or revenue)
Less COGS
Equals Gross Income
Less Operating Exp
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 PP&E
Accumulated Depr.
Net PP&E
Land
Total Assets
Liabilities + Owner’s E
Bank Loan
Accts Pay
Wages Pay
Taxes Pay
Total Current Liab
L-T Debt
Common Stock
Retained Earnings
Total Liab + OE
INTERACTIONS…

The income statement equation can be written:
[EBIT – (Interest Bearing Debt)(Interest Rate)](1-Tax Rate)
- Dividends = Change in RE




The balance sheet equation is:
Total Assets = Current Liabilities + Interest Bearing Debt +
Common Stock + “Old RE” + Change in RE
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 spreadsheets and should be easier to
understand by looking at the following simplified example.
Example
Income Statement (in $ Millions)
Sales
COGS
Gross Profit
SG&A Expenses
Depreciation
Operating Income
Other Income
Earnings before interest and taxes
Interest income (expense)
Pretax Income
Taxes
Net Income
Balance Sheets (in $ Millions)
Assets
Current assets
Cash
Accounts receivable
Inventories
Other current assets
Total current assets
Long-term Assets
Equipment
Less accumulated depreciation
Net property, plant, and equipment
Other long-term assets
Total long-term assets
Total Assets
2012 Act
$ 175.00
$ (70.00)
$ 105.00
$ (38.50)
$ (8.00)
$
$
$
$
$
$
$
Formula
%sales
40%sales
22%sales
schedule
58.50
58.50
(5.51)
52.99
(18.02) 34%tax
34.98
2012 Act Formula
2013 Est
$ 191.63
$ (76.65)
$ 114.98
$ (42.16)
$ (8.00)
$ 64.82
$
$ 64.82
$ (5.21)
$ 59.61
$ (20.27)
$ 39.34
(Bank Loan + Long-term debt)*10%
2013 Est
$ 30.00 plug - A
$ 13.42 28-days-sales $
$ 8.63 45-days-COGS $
$ 2.50 constant
$
$ 54.55
$
$ 80.00 constant
$ (16.00) schedule
$ 64.00
$ 15.00 constant
$ 79.00
$ 133.55
9.5% sales growth is assumed here
14.77
9.45
2.50
26.72
$ 80.00
$ (24.00)
$ 56.00
$ 15.00
$ 71.00
$ 97.72
2012 Act Formula
Liabilities and Stockholder's Equity
Current Liabilities
Accounts Payable
Bank Loan (revolver)
Other current liabilities
Total current liabilities
Long-Term Liabilities
Long-term debt
Other long-term liabilities
Total long-term liabilities
Total Liabilities
Stockholders Equity
2013 Est
$ 17.26 36-days-sales $ 18.90
$ 3.00 plug - B
$ 6.00 constant
$ 6.00
$ 26.26
$ 24.90
$
$
$
$
$
52.07 constant
constant
52.07
78.33
55.22 from?
Total Liabilities and Stockholder's Equity $ 133.55
$
$
$
$
$
52.07
52.07
76.97
94.56
$ 171.53
The Plugs
• Plug A:
– IF(15.75+SUM(D20:D22)+D29)>I19+I21+I26+I28, (if)
15.75,
(then)
I19+I21+I26+I28 – (SUM(D20:D22)+D29)) (else)
• Plug B:
– IF(15.75+SUM(D20:D22)+D29)>I19+I21+I26+I28,
(15.75+SUM(D20:D22)+D29) - I19+I21+I26+I28,
0)
THE PROCESS…

Many will not go to all the trouble and simply use
one balance sheet account as a plug (often “cash”) to
make the balance sheet balance.
In this way you don’t change the interest bearing debt
directly (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?
 Other methods forecast the SCF along with the I/S
and B/S and enact the reconciliation more directly.

CHALLENGE QUESTION

Wasatch Case

Solution due from each group at beginning of next
class.