Understanding Pro Forma Financial Statements
Projected or future financial statements, such as pro forma income statements and balance sheets, are essential for financial planning, valuations, and investment analysis. These statements represent expected results of actions and policies on a firm's financial status. To bridge income statements and balance sheets, key relationships like net income to dividends and interest expense to interest-bearing debt are crucial. Developing financial modeling skills is vital for those interested in finance or marketing.
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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.
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 or income) Equals EBT Less Taxes Equals Net Income (EAT, Profits)
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
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.
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.
BRIDGE Income Statement Balance Sheet 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 Change in Retained E Assets Cash Accts Rec Inventory Prepaid Taxes 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
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.
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.
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
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.
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.
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.
A CIRCULARITY RATHER THAN A 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 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: [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.
EXAMPLE Income Statement Net Sales Cost of Goods Sold GS&A Expenses Interest Expense Earnings Before Tax Tax Net Income Dividends Paid Additions to Retained Earnings $240,000.00 $156,000.00 65% of sales $36,000.00 15% of sales $8,000.00 "+E22*.10+4500" $40,000.00 $16,000.00 "+E6*.4" $24,000.00 $12,000.00 "+E8*.5" $12,000.00 "+E8-E9" Firm decides that $20,000 is a minimum cash balance that is acceptable. All but cash account and bank loan are assumed to be estimated via ratios. Interest on existing LT Debt is $4,500 Balance Sheet (end of period) Cash Accounts Receivable Inventory Net PP&E Other Assets Total Assets $20,000.00 "=IF(20000+SUM(E14:E17)>E20+E21+SUM(E23:E27),20000," $65,000.00 "E20+E21+SUM(E23:E27)-SUM(E14:E17))" $82,000.00 $150,000.00 $25,000.00 $342,000.00 Accounts Payable Tax Accruals Bank Loan Equipment Loan Miscellaneous Accruals Long-Term Debt Common Stock Retained Earnings Total Liabilities + Equity $18,000.00 $9,000.00 $35,000.00 "=IF(20000+SUM(E14:E17)>E20+E21+SUM(E23:E27)," $23,000.00 "(20000+SUM(E14:E17))-(E20+E21+SUM(E23:E27)),0)" $5,000.00 $45,000.00 $95,000.00 $112,000.00 "100000+E10" $342,000.00 Firm had $100,000 RE end of last period.
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?
