financial

1. PRO FORMA FINANCIAL
STATEMENTS

2. 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.

3. 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 (Net Earnings, EAT, Profits)

4. GENERIC FORMS: BALANCE SHEET
 Assets  Liabilities + O’s Equity
 Cash  Bank Loan
 Accounts Receivable  Accounts Payable
 Inventory  Wages Payable
 Prepaid Taxes  Taxes Payable
 Marketable Securities  Current Portion – L-T
 Total Current Assets Debt
 Gross PP&E  Total Current Liabilities
 Accumulated  Long-Term Debt
Depreciation  Preferred Stock
 Net PP&E  Common Stock
 Land  Retained Earnings
 Total Assets  Total Liabilities + Equity

5. 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.

6. 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.
 Thesesimple relations, plus requiring the
balance sheet to balance, tie the income
statement directly to the balance sheet
and vice versa.

7. BRIDGE
Income Statement Balance Sheet
Sales (or revenue) Assets Liabilities + Owner’s E
Less COGS Cash Bank Loan
Equals Gross Income Accts Rec Accts Pay
Less Operating Exp Inventory Wages Pay
Less Depr Prepaid Taxes Taxes Pay
Equals EBIT Total Current Assets Total Current Liab
Less Interest Exp Gross PP&E L-T Debt
Equals EBT Accumulated Depr. Common Stock
Less Taxes Net PP&E Retained Earnings
Equals Net Inc (EAT) Land Total Liab + OE
Less Dividends Total Assets
Change in Retained E

8. 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.

9. THE PROCESS…
 How would we describe and estimate the
following:
 COGS
 Operating expenses
 Depreciation & Amortization
 Interest expense
 Taxes

10. 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.

11. 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

12. 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.

13. 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.

14. 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.

15. A CIRCULARITY RATHER THAN
A BRIDGE
Sales (or revenue) Assets Liabilities + Owner’s E
Less COGS Cash Bank Loan
Equals Gross Income Accts Rec Accts Pay
Less Operating Exp Inventory Wages Pay
Less Depr Total Current Assets Taxes Pay
Equals EBIT Gross PP&E Total Current Liab
Less Interest Exp Accumulated Depr. L-T Debt
Equals EBT Net PP&E Common Stock
Less Taxes Land Retained Earnings
Equals Net Inc (EAT) Total Assets Total Liab + OE
Less Dividends
Changes in Retained E

16. 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.

17. EXAMPLE
Income Statement
Net Sales $240,000.00 Firm decides that $20,000 is a minimum
Cost of Goods Sold $156,000.00 65% of sales cash balance that is acceptable.
GS&A Expenses $36,000.00 15% of sales All but cash account and bank loan
Interest Expense $8,000.00 "+E22*.10+4500" are assumed to be estimated via ratios.
Earnings Before Tax $40,000.00
Tax $16,000.00 "+E6*.4" Interest on existing LT Debt is $4,500
Net Income $24,000.00
Dividends Paid $12,000.00 "+E8*.5"
Additions to Retained Earnings $12,000.00 "+E8-E9"
Balance Sheet (end of period)
Cash $20,000.00 "=IF(20000+SUM(E14:E17)>E20+E21+SUM(E23:E27),20000,"
Accounts Receivable $65,000.00 "E20+E21+SUM(E23:E27)-SUM(E14:E17))"
Inventory $82,000.00
Net PP&E $150,000.00
Other Assets $25,000.00
Total Assets $342,000.00
Accounts Payable $18,000.00
Tax Accruals $9,000.00
Bank Loan $35,000.00 "=IF(20000+SUM(E14:E17)>E20+E21+SUM(E23:E27),"
Equipment Loan $23,000.00 "(20000+SUM(E14:E17))-(E20+E21+SUM(E23:E27)),0)"
Miscellaneous Accruals $5,000.00
Long-Term Debt $45,000.00
Common Stock $95,000.00
Retained Earnings $112,000.00 "100000+E10" Firm had $100,000 RE end of last period.
Total Liabilities + Equity $342,000.00

18. 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?