Slide 1Pro Forma Financial StatementsGeneric Forms: Income StatementGeneric Forms: Balance SheetGeneric Forms: BridgeGeneric Forms: BridgeBridgeThe Forecasting ProcessThe Process…The Process…The Process…The Process…The Process…A Circularity Rather Than A BridgeInteractions…ExampleThe PlugsThe Process…Challenge QuestionPRO FORMA FINANCIAL STATEMENTSForecasting the Future Financial Condition of the FirmPRO 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 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.GENERIC FORMS: INCOME STATEMENTSales (or revenue)Less Cost of Goods SoldEquals Gross Income (or Gross Earnings)Less Operating Expenses (SG&A, Depreciation, Marketing, R&D, etc.)Equals Operating IncomeLess Non-Operating Expenses (interest expense, “other” non-operating expenses/income)Equals EBTLess TaxesEquals Net Income (EAT, Profits)GENERIC FORMS: BALANCE SHEET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 + EquityGENERIC FORMS: BRIDGE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.GENERIC FORMS: BRIDGEOne important bridge is:Net Income – Dividends = Change in Retained EarningsAn income statement amount (less dividends) equals the change in a balance sheet amount.Another is:Interest Expense = Interest Rate  Interest Bearing DebtAn 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.BRIDGESales (or revenue)Less COGSEquals Gross Income Less Operating Exp Less DeprEquals EBITLess Interest ExpEquals EBTLess TaxesEquals Net Inc (EAT)Less DividendsChanges in Retained EAssetsCashAccts RecInventory Total Current AssetsGross PP&EAccumulated Depr.Net PP&ELand Total AssetsLiabilities + O EquityBank LoanAccts PayWages PayTaxes Pay Total Current LiabL-T DebtCommon StockRetained Earnings Total Liab + OEIncome Statement Balance SheetTHE 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.Policy or predetermined decisions“Other”Does this make any sense?THE PROCESS…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.THE PROCESS…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DividendsTHE PROCESS…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.THE PROCESS…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.**THE PROCESS…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.A CIRCULARITY RATHER THAN A BRIDGESales (or revenue)Less COGSEquals Gross Income Less Operating Exp Equals EBITLess Interest ExpEquals EBTLess TaxesEquals Net Inc (EAT)Less DividendsChanges in Retained EAssetsCashAccts RecInventory Total Current AssetsGross PP&EAccumulated Depr.Net PP&ELand Total AssetsLiabilities + Owner’s EBank LoanAccts PayWages PayTaxes Pay Total Current LiabL-T DebtCommon StockRetained Earnings Total Liab + OEINTERACTIONS…The income statement equation can be written:[EBIT – (Interest Bearing