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