Pro Forma Financial Statements

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Pro Forma Financial Statements
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Pro Forma Financial Statements

• Projected or future financial statements.
• Pro forma income statements, balance sheets, and
  the resulting cash flow statements are the
  building blocks of financial planning.
• They are also vital for any valuation exercises
  one might do in investment or MA planning.

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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 (EAT)

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Generic Forms Balance Sheet

• Assets
• Cash
• Accounts Receivable
• Inventory
• Marketable Securities
• Total Current Assets
• Gross PPE
• Accumulated Depreciation
• Net PPE
• Land
• Total Assets

• Liabilities 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

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Generic Forms Bridge

• Clearly we cant hope to get anywhere if we treat
  these forecasts as being separate. 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.
• One important bridge is
• Net Income less Dividends Change in Retained
  Earnings
• This simple relation and interest expense will
  tie them together.

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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 Changes in Retained E Assets Cash Accts Rec Inventory Total Current Assets Gross PPE Accumulated Depr Net PPE Land Total Assets Liabilities Owners E Bank Loan Accts Pay Wages Pay Taxes Pay Total Current Liab L-T Debt Common Stock Retained Earnings Total Liab OE
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Overview of the Process

• The most common way to proceed is to fill in the
  income statement first. The standard approach is
  called percent of sales forecasting.
• Because you first get the sales or sales growth
  forecast.
• Then, project variables having a stable relation
  to sales using forecasted sales and estimated
  ratios.
• COGS, Inventory, Operating expenses (may)
• DA, Interest expense (wont), Taxes (will be
  predictable from EBT)
• Require estimates of the components of expenses
  that dont vary directly (and in a stable way)
  with sales to complete the income statement.

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Overview of the Process

• From the completed income statement, determine
  the change in retained earnings, transfer it to
  the balance sheet.
• Some of the current assets and liabilities
  (accounts receivable, accounts payable,
  inventory, wages payable, etc.) can be expected
  to vary directly with sales.
• Cash is usually determined by a policy decision
  via some inventory (of liquidity) model.
• Gross PPE changes are usually the result of
  policy decisions as are changes in preferred or
  common stock or long-term debt.
• Often the bank loan or long-term debt is used as
  a residual to determine the required new
  financing (make it balance).

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Overview of the Process

• Interest expense comes from the amount of
  interest bearing (Long-term) 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.
• Thus these two statements are intimately
  connected.

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Circularity
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 PPE Accumulated Depr Net PPE Land Total Assets Liabilities Owners E Bank Loan Accts Pay Wages Pay Taxes Pay Total Current Liab L-T Debt Common Stock Retained Earnings Total Liab OE
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Interactions

• The income statement equation can be written
• Rev Operating Exp DeprAmort
• - (Int Bearing Debt)(Int Rate)(1- Tax Rate)
• - Dividends Change in retained earnings
• The balance sheet equation is
• 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.

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Example
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Sustainable Growth Rate

• Life cycle Growth, Maturity, Decline
• During the growth phase most firms will require
  large amounts of outside capital to sustain the
  growth as internal funds cannot keep up with the
  required added investment in NWC and fixed
  assets.
• In the middle phase, firms may find that
  internally generated cash is sufficient to fund
  required investments.
• In the declining phase, investment is very low
  and firms are generally looking for ways to
  return capital to owners or to invest in new
  directions.
• Sustainable growth rate is a concept used in
  understanding what growth rate can be sustained,
  if the firm doesnt sell new equity, without
  relying excessively on debt financing.
• A firm with sales growth beyond its SGR that
  doesnt sell new equity must borrow. If the
  period of growth is extended, obviously the use
  of debt will be excessive.

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SGR Equation

• SGR Profit Margin Asset Turnover
  Beginning Financial Leverage Retention
  Ratio
• This is ROE times the retention ratio except that
  we need to use the beginning of period equity
  level in calculating the financial leverage.

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Example

• Suppose a firm has an ROE of 15, a retention
  ratio of 100, and has established a target
  debt/equity ratio of 0.50. This firms SGR is
  15.
• For such a firm 1 of net income becomes an
  increase in equity of 1. This increase in
  equity can support an increase in debt of 0.50
  or a total growth in assets of 1.50.
• Suppose an identical firm has a payout ratio of
  0.50. This firms SGR is 7.5.
• For the second firm 1 in net income becomes
  0.50 in increased equity that can support 0.25
  in new debt or only 0.75 growth in assets.
• If this second firms sales grow at 15 (rather
  than 7.5) then unless it can improve its profit
  margin or asset turnover it will have to violate
  its D/E target. Eventually, this will become
  dangerous.