1. P RO F ORMA F INANCIAL S TATEMENTS Forecasting the Future Financial Condition of the Firm

2. P RO F ORMA F INANCIAL S TATEMENTS 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.

3. G ENERIC F ORMS : I NCOME S TATEMENT 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/income) Equals EBT Less Taxes Equals Net Income (EAT, Profits)

4. G ENERIC F ORMS : B ALANCE S HEET 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

5. G ENERIC F ORMS : B RIDGE 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.

6. G ENERIC F ORMS : B RIDGE One important bridge is: Net Income – Dividends = Change in Retained Earnings An income statement amount (less dividends) equals the change in a balance sheet amount. Another is: Interest Expense = Interest Rate  Interest Bearing Debt An 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.

7. B RIDGE 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 + O Equity Bank Loan Accts Pay Wages Pay Taxes Pay Total Current Liab L-T Debt Common Stock Retained Earnings Total Liab + OE Income StatementBalance Sheet

8. T HE F ORECASTING P ROCESS 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?

9. T HE P ROCESS … 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.

10. T HE P ROCESS … 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 Expenses Other Income Depreciation Taxes Net Income Dividends

11. T HE P ROCESS … 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.

12. T HE P ROCESS … 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.**

13. T HE P ROCESS … 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.

14. A C IRCULARITY R ATHER T HAN A B RIDGE Sales (or revenue) Less COGS Equals Gross Income Less Operating Exp 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

15. I NTERACTIONS … 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.

16. Example

17. 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)

18. T HE P ROCESS … 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.

19. C HALLENGE Q UESTION Wasatch Case Solution due from each group at beginning of next class.