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 M&A planning.

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)

Generic Forms: Balance Sheet Assets –Cash –Accounts Receivable –Inventory –Marketable Securities Total Current Assets –Gross PP&E –Accumulated Depreciation –Net PP&E –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

Generic Forms: Bridge Clearly we can’t 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.

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 Income StatementBalance Sheet

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) –D&A, Interest expense (won’t), Taxes (will be predictable from EBT) Require estimates of the components of expenses that don’t vary directly (and in a stable way) with sales to complete the income statement.

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 PP&E 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).

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.

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 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: 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

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 doesn’t sell new equity, without relying excessively on debt financing. –A firm with sales growth beyond its SGR that doesn’t sell new equity must borrow. If the period of growth is extended, obviously the use of debt will be excessive.

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.

Example Suppose a firm has an ROE of 15%, a retention ratio of 100%, and has established a target debt/equity ratio of This firm’s 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 This firm’s 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 firm’s 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.