Pro Forma Financial Statements - PowerPoint Presentation

Slide1

Pro Forma Financial Statements

Forecasting the Future Financial Condition of the FirmSlide2

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.Slide3

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)Slide4

Generic Forms: Balance Sheet

Assets

Cash

Accounts Receivable

Prepaid Taxes

Inventory

Total Current Assets

Gross PP&ELess Accumulated DepreciationNet PP&ELandTotal 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 + EquitySlide5

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.Slide6

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.Slide7

Bridge

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

AssetsCashAccts RecInventory Total Current AssetsGross PP&EAccumulated Depr.Net PP&ELand Total AssetsLiabilities + O EquityBank LoanAccts PayWages PayTaxes Pay Total Current LiabL-T DebtCommon StockRetained Earnings Total Liab + OE

Income Statement

Balance SheetSlide8

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?Slide9

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.Slide10

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

DividendsSlide11

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.Slide12

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.**Slide13

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.Slide14

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 RecInventory Total Current AssetsGross PP&EAccumulated Depr.Net PP&ELand Total AssetsLiabilities + Owner’s EBank LoanAccts PayWages PayTaxes Pay Total Current LiabL-T DebtCommon StockRetained Earnings Total Liab + OESlide15

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 REInterest 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.Slide16

ExampleSlide17

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) Slide18

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

.Slide19

Challenge Question

Wasatch Case

Solution due from each group at beginning of next class.