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 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, its 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 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)

GENERIC FORMS: BALANCE SHEET

Assets

Cash
Accounts Receivable
Inventory
Prepaid Taxes
Marketable Securities

Liabilities + Os Equity

Total Current Assets

Gross PP&E
Accumulated
Depreciation
Net PP&E
Land

Total Assets

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 cant 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.

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.

These

simple relations, plus requiring the

balance sheet to balance, tie the income
statement directly to the balance sheet
and vice versa.

BRIDGE
Income Statement
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
Change in Retained E

Balance Sheet
Assets
Cash
Accts Rec
Inventory
Prepaid Taxes
Total Current Assets
Gross PP&E
Accumulated Depr.
Net PP&E
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

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.

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 dont 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.
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.

THE PROCESS
The

cash balance is usually determined by

a policy decision via some inventory (of
liquidity) model.
Alternatively

plug.

this account may be used as a

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

dont forget that these cant 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 + Owners 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 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.

EXAMPLE

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 dont 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?