Pro Forma Financial Statements

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 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 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 SoldEquals Gross Income (or Gross Earnings)Less Operating ExpensesEquals Operating IncomeLess DepreciationEquals EBITLess Interest ExpenseEquals EBTLess TaxesEquals 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 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.

• 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 EarningsAn income statement amount less dividends equals a balance sheet amount.

• Another is:Interest Expense = Interest Rate Interest Bearing DebtAn 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

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

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

Income Statement Balance Sheet

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 estimated relations.

• Then there is the rest.

The Process…

• How would we describe and estimate the following:– COGS– Operating expenses– Depreciation & Amortization– Interest expense– Taxes

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.– Some 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: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.

ExampleIncome StatementNet Sales $240,000.00 Firm decides that $20,000 is a minimumCost 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 loanInterest Expense $8,000.00 "+E22*.10+4500" are assumed to be estimated via ratios.Earnings Before Tax $40,000.00Tax $16,000.00 "+E6*.4" Interest on existing LT Debt is $4,500Net Income $24,000.00Dividends 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 $82,000.00Net PP&E $150,000.00Other Assets $25,000.00Total Assets $342,000.00

Accounts Payable $18,000.00Tax Accruals $9,000.00Bank 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 $5,000.00Long-Term Debt $45,000.00Common Stock $95,000.00Retained Earnings $112,000.00 "100000+E10" Firm had $100,000 RE end of last period.Total Liabilities + Equity $342,000.00

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?

Teton Valley Case

Free Cash Flows

Existing Accounting Statements

Free Cash Flow

• For each future year you want to calculate:

• FCF = EBIT(1 – Tc) (no debt tax shields calculated)

+ Depr & Amort. (adjust for non-cash

expenses)

- Capital Expenditures (a cash flow not

part of EBIT)

- Changes in NWC (almost, to adjust for

accruals.)

Teton Valley Corporation• Sales growth at 10% for 5 years then 4% in

perpetuity.• CGS at 65% of sales.• SGA at $500,000 + 4.5% of sales.• Net Fixed assets grow at 5% per year for next 5 years.• Depreciation is 20% of beginning of year net fixed

assets.• NWC is $80,000, grows with sales.• FCFs grow at 4% in perpetuity after 2011.

Forecasting Earnings

TETON VALLEY CORPORATIONVALUATION

(See Valuation; LectureMod#19) 2007 2007 2008 2008

NET FIXED ASSETS GROW AT 5% $750,000(1.05) 787,500$ (C5 (1.05)) 826,875$ (From base of $750,000)

(1) SALES (10% growth from $5.5M) $5,500,000(1.1) 6,050,000$ C8 * 1.1 6,655,000$ (2) COST OF GOODS SOLD (0.65 of sales) (B8 * 0.65) 3,932,500$ (D8 * 0.65) 4,325,750$ (3) GROSS MARGIN (1 - 2) (B8 - B9) 2,117,500$ (D8 - D9) 2,329,250$ (4) GSA ($500,000 + 4.5% of sales) $500,000+B8*.045 772,250$ $500,000+D8*0.45 799,475$ (5) DEPRECIATION (20% of prev yr NFA) $750,000(.20) 150,000$ $787,500(.20) 157,500$ (6) EBIT (3 - 4 - 5) (B10 - B11 - B12) 1,195,250$ (D10 - D11 - D12) 1,372,275$ (7) INTEREST (DO NOT INCLUDE!) finance cost -$ finance cost -$ (8) EBT (just 6 - "assume its an all equity firm") B13 1,195,250$ D13 1,372,275$ (9) TAX (8 *Tc) B13 * 0.30 (358,575)$ D13 * 0.30 (411,683)$ (10) EAT (8*(1-Tc) or 8 - 9) B13 * 0.70 836,675$ D13 * 0.70 960,593$

The Pro Forma Exercise

• For a complete pro forma analysis we also need to forecast the balance sheet.

• Two issues for this example:1. The balance sheet is so simple it is a trivial

exercise.

2. We need to make some assumptions. About what?

Forecasting the Balance Sheet

• What did I assume?

• Are there any issues?

• Complete the forecast on the spreadsheet.

Balance Sheet 2007 2008Assets Liabilities Assets Liabilities

Current Assets 275000 Non-Int Bearing Liab 187000 Current Assets 302500 Non-Int Bearing Liab 205700Net Fixed Assets 787500 Interest Bearing Liab 395500 Net Fixed Assets 826875 Interest Bearing Liab 443675

Equity 480000 Equity 480000Total Assets 1062500 Total Liab+ Equity 1062500 Total Assets 1129375 Total Liab+ Equity 1129375

From Earnings To Free Cash Flow

(10) EBIT(1-Tc): (8*(1-Tc) or 8 - 9) B13 * 0.70 836,675$ D13 * 0.70 960,593$

(11) + DEPRECIATION (5) B12 150,000$ D12 157,500$

(12) OPERATING CASH FLOW (10 + 11) B17 + B19 986,675$ D17 + D19 1,118,093$

(13) - Change in Net W/C (grows at 10%) $80,000 * 0.10 8,000$ C23 *1.1 8,800$ (14) -CAPITAL EXPENDITURE B5 - 750k + B12 187,500$ D5 - C5 + D12 196,875$ (change in NFAs + depr = change in gross FA)(15) FREE CASH FLOW (FCF=12-13-14) B21 - B23 - B24 791,175$ D21 - D23 - D24 912,418$

FCF = EBIT(1-Tc) + Depr. - ∆NWC – Cap Ex.

So: 2007 2007 2008 2008

2007 2008 2009 2010 2011FCF: 791,175 912,418 1,046,141 1,193,610 1,356,219