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Pro Forma Financial Statements

Pro Forma Financial Statements. Dr Clive Vlieland-Boddy. What are they?. Projected or “future” financial statements.

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Pro Forma Financial Statements

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  1. Pro Forma Financial Statements Dr Clive Vlieland-Boddy

  2. What are they? • 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.

  3. Pro Forma Forecasting • Financial Statement Forecasting • The Pro Forma Income Statement • The Pro Forma Cash Flow Statement • The Pro Forma Balance Sheet • Projected Profitability and Price Ratios • Business plans should include pro-Forma financial statements

  4. Key Pro Forma Statements 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.

  5. Pro-forma Financial Statements • Sales revenue (revenue growth) • Operating expenses (mostly as a % of Sales • Asset requirements (asset turnover) • Debt and equity requirements (agreed capital structures) • Cost of financing (interest etc.) • Statement of cash flows (the resulting balance with agreed minimum liquidity levels)

  6. Income Statement - Format 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)

  7. Balance Sheet - Format • Assets • Cash at Bank • Accounts Receivable • Inventory • Marketable Securities • Total Current Assets • Gross PP&E • Less: Accumulated Dep’n • Net PP&E • Intangibles • Investments • Total Assets • Liabilities • Accounts Payable • Wages Payable • Taxes Payable • Current Portion – L-T Debt • Total Current Liabilities • Long-Term Debt • Deferred Tax • Equity • Common Stock • Retained Earnings • Total Liabilities + Equity

  8. Bridge between I/S & B/S Clearly we can’t 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 Sheet show the situation at the beginning of and at 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.

  9. The Bridge with I/S & B/S • 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, connect the Income Statement directly to the Balance Sheet and vice versa.

  10. Bridge to the Cash Statement • From the monthly cash flow created using a spread sheet, the end cash balance is obtained. • Also, the likely changes in Non Current Assets and working capital ( AR, AP and Inventories) will have been calculated.

  11. Pro Forma Financial Statements • Last we looked at forecasting Profits and Cash flow for the next 12 months using a spread sheet. • These gave us the monthly figures and totals for the year. • Having done the profit forecast and then the resulting cash flow forecast we can… • Establish the Pro forma Income Statement and then The Balance Sheet.

  12. Projections – The Process • Sales revenue (revenue growth) • COGS (% of Sales) • Operating expenses (Some as % of Sales) • Generates a Profit Forecast • Asset requirements (Some as % of Sales) • Debt and equity requirements (finance capital) • Cost of financing-(interest etc.)

  13. Returning to Common Sized Statements • The common size Income Statement shows all items as a % of Sales.

  14. Forecasting the Income Statement So projected sales are taken as 100% Sales Are taken as 100%

  15. 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.

  16. The Balance Sheet The Balance Sheet- Assets • Non Current assets do not always vary directly with sales. It will do so, only if the firm is operating at 100 percent capacity and fixed assets can be incrementally changed. • Current Assets normally vary directly with sales.

  17. The Balance Sheet The Balance Sheet - Liabilities and Equity • Only current liabilities are likely to vary directly with sales. The exception here is notes payables (short-term borrowings) that changes as the firm pays it down or makes an additional borrowing. • Long-term liabilities and equity accounts change as a direct result of managerial decisions like debt repayment, stock repurchase, issuing new debt or equity. They are not a % of sales!

  18. The Balance Sheet Liabilities and Equity (Continued) • Retained earnings will vary as sales changes but not directly. It is affected by the firm’s dividend payout policy.

  19. The Balance Sheet The Preliminary Pro-forma Balance Sheet • At this point the balance sheet will normally be unbalanced. A plug value is necessary to get the balance sheet to balance. • First, determine the retained earnings based on the firm’s dividend policy.

  20. The Balance Sheet The Preliminary Pro-forma Balance Sheet • Next, the plug figure will represent the external financing necessary to make the total assets equal total liabilities and equity. This calls for management to choose a financing option – choosing debt, equity or a combination – to raise the additional funds needed.

  21. The Balance Sheet The Management Decision • The first decision relates to the firm’s dividend policy. Should the firm alter its dividend policy to increase the amount of retained earning? • If external funding is still needed, should the firm issue new debt, or issue equity? Or, should it be a mix of both? • It is important to recognize that while financial planning models can identify the amount of external financing needed, the financing option is a managerial decision.

  22. The Pro Forma Income Statement

  23. The Pro Forma Cash Flow Statement

  24. The Pro Forma Balance Sheet

  25. Sensitivity Analysis

  26. Sensitivity • All forecasts need to be tested to see how they will be affected by possible forces. • Both the upside and down side as well as a mix of options should be tested. • This will normally result in a range or results.

  27. The What if analysis? • The best way to test any forecast is to apply tests to it to view how it would change given different assumptions.

  28. The What if test? • What if sales were higher or lower? • What if costs were higher or lower? • What if competitors discount? • What if inflation rises? • What if exchange rates change?

  29. What are the weaknesses ofsensitivity analysis? • Does not reflect diversification. • Says nothing about the likelihood of change in a variable, i.e. a steep sales line is not a problem if sales won’t fall. • Ignores relationships among variables.

  30. Why is sensitivity analysis useful? • Gives some idea of stand-alone risk. • Identifies dangerous variables. • Gives some breakeven information.

  31. Uncertainty Investment planning and benefit/cost analysis is fraught with uncertainties forecasts of future are highly uncertain applications often made to preliminary designs data is often unavailable Statistics has confidence intervals – economists need them, too.

  32. Test & Evaluate By sensitivity analysis you can: • See what variables are the most concerning. • Those that will create the most risk. • See what can be done to minimise that risk. • Ensure that the key areas are either protected or subject to high levels of control.

  33. Definition: “Base Case” Generally uses single values and our ‘best guesses’ Sensitivity Analysis acknowledges uncertainty exists Incorporate variables instead of constant assumptions If our ‘Net Benefits’ remain positive over a wide range of reasonable assumptions, then robust results. You should test all reasonable possibilities.

  34. How many variables? Choosing ‘variables’ instead of ‘constants’ for all parameters is likely to make model unsolvable Partial Sensitivity Analysis - change only one variable at a time. Do for the most ‘critical’ assumptions Can use this to find ‘break-evens’ Highlights the areas of high or low risk.

  35. Best and Worst-Case Analysis Analogous to “upper and lower bounds” used in estimation problems Does any combination of inputs reverse the sign of our answer? If so, are those inputs reasonable? E.g. using very conservative ests. Might want NB > 0, but know when NB < 0 Similar to ‘breakeven analysis’

  36. Example of Sensitivity

  37. Scenario Analysis

  38. Scenario Analysis Definition • A tool that helps you develop strategies for your company and a means to explore multiple outcomes to complex competitive situations, determine the implications, and set future strategies. • Is a process that uses decision logic and that generates scenarios based on changing variables or possible future events and assigns probabilities to each scenario.

  39. What is scenario analysis? • Examines several possible situations, usually worst case, most likely case, and best case. • Provides a range of possible outcomes. • A good scenario analysis will give the company a contingency plan that covers several different possibilities.

  40. How to Use Scenario Analysis • The scenario analysis tool works by looking at a future goal as if it has been obtained, and then works backward to the planning phase. • Scenario Analysis can also be used to help the company have a better understanding of possible future occurrences and how to take advantage of them.

  41. Are there any problems with scenario analysis? • Only considers a few possible out-comes. • Assumes that inputs are perfectly correlated--all “bad” values occur together and all “good” values occur together. • Focuses on stand-alone risk, although subjective adjustments can be made.

  42. Case Study • Toy Producers.

  43. Bye for now! Please ensure you Prepare for next session I’m ready forsome leisure time. 44

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