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 SoldEquals Gross Income (or Gross Earnings)Less Operating Expenses (SG&A, Depreciation, Marketing, R&D, etc.)Equals Operating IncomeLess Non-Operating Expenses (interest expense, “other” non-operating expenses/income)Equals EBTLess TaxesEquals Net Income (EAT, Profits)

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

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 EarningsAn income statement amount (less dividends) equals the change in a balance sheet amount.

Another is:Interest Expense = Interest Rate Interest Bearing DebtAn 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

Sales (or revenue)Less COGSEquals Gross Income Less Operating Exp Less DeprEquals EBITLess Interest ExpEquals EBTLess TaxesEquals Net Inc (EAT)Less DividendsChanges in Retained E

AssetsCashAccts RecInventory Total Current AssetsGross PP&EAccumulated Depr.Net PP&ELand Total Assets

Liabilities + O EquityBank LoanAccts PayWages PayTaxes Pay Total Current LiabL-T DebtCommon StockRetained Earnings Total Liab + OE

Income Statement Balance Sheet

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 ExpensesOther IncomeDepreciationTaxesNet IncomeDividends

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 BRIDGESales (or revenue)Less COGSEquals Gross Income Less Operating Exp Equals EBITLess Interest ExpEquals EBTLess TaxesEquals Net Inc (EAT)Less DividendsChanges in Retained E

AssetsCashAccts RecInventory Total Current AssetsGross PP&EAccumulated Depr.Net PP&ELand Total Assets

Liabilities + Owner’s EBank LoanAccts PayWages PayTaxes Pay Total Current LiabL-T DebtCommon StockRetained 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.

Income Statement (in $ Millions) 2012 Act Formula 2013 EstSales 175.00$ %sales 191.63$ 9.5% sales growth is assumed hereCOGS (70.00)$ 40%sales (76.65)$ Gross Profit 105.00$ 114.98$ SG&A Expenses (38.50)$ 22%sales (42.16)$ Depreciation (8.00)$ schedule (8.00)$

Operating Income 58.50$ 64.82$ Other Income -$ -$ Earnings before interest and taxes 58.50$ 64.82$ Interest income (expense) (5.51)$ (5.21)$ (Bank Loan + Long-term debt)*10%Pretax Income 52.99$ 59.61$ Taxes (18.02)$ 34%tax (20.27)$ Net Income 34.98$ 39.34$

Balance Sheets (in $ Millions) 2012 Act Formula 2013 Est 2012 Act Formula 2013 EstAssets Liabilities and Stockholder's EquityCurrent assets Current LiabilitiesCash 30.00$ plug - A Accounts Payable 17.26$ 36-days-sales 18.90$ Accounts receivable 13.42$ 28-days-sales 14.77$ Bank Loan (revolver) 3.00$ plug - BInventories 8.63$ 45-days-COGS 9.45$ Other current liabilities 6.00$ constant 6.00$ Other current assets 2.50$ constant 2.50$ Total current liabilities 26.26$ 24.90$ Total current assets 54.55$ 26.72$ Long-Term LiabilitiesLong-term Assets Long-term debt 52.07$ constant 52.07$ Equipment 80.00$ constant 80.00$ Other long-term liabilities -$ constant -$ Less accumulated depreciation (16.00)$ schedule (24.00)$ Total long-term liabilities 52.07$ 52.07$ Net property, plant, and equipment 64.00$ 56.00$ Total Liabilities 78.33$ 76.97$ Other long-term assets 15.00$ constant 15.00$ Stockholders Equity 55.22$ from? 94.56$ Total long-term assets 79.00$ 71.00$ Total Assets 133.55$ 97.72$ Total Liabilities and Stockholder's Equity 133.55$ 171.53$

Example

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.