Chapter 3 Lecture (Part III)
In addition to forecasting cash flows, managers and investors are also interested in
forecasts of the firm’s financial statements. These projected financial statements are
called pro forma financial statements. They give both the management and investors an
insight into what the financial statements will look like in the future and a signal as to any
need to raise long-term funds.
The starting point in the creation of the pro forma financial statements is the construction
of the pro forma income statement (do you remember why?). Like the cash budget, it
also relies heavily on the sales forecast. Significant errors in the sales forecast will result
in errors in the income statement which, in turn, will cause errors on the pro forma
balance sheet.
Pro Forma Income Statement
There are two approaches to creating the pro forma income statement: the percentage of
sales method and what I will call the judgmental approach. The percentage of sales
approach is simplistic and prone to error (estimating financial statements is tricky enough
without compounding the error using an inferior technique). The percentage of sales
method assumes that all items on the income statement except interest expense and tax
expense vary in direct proportion to the change in sales. This is simply usually not true.
Some items will change with sales, but others will not. See the criticism of the
percentage of sales approach at the top of page 116 in your text. My illustration will
focus on the judgmental approach which allows the analyst to apply judgment to forecast
the level of those items that are not expected to vary with sales. My vehicle for
illustrating the creation of a pro forma income statement appears below:
Assume that sales for the BMX Corporation are expected to be $12 million in 2008 and
that sales in 2007 were $10 million. Further assume that cost of goods sold can be
divided into two parts: a part that varies with sales and a part that does not (i.e., cost of
goods sold has both fixed and variable components). Further assume that operating
expenses can also be divided a fixed portion and a variable portion. Further assume the
firm plans to increase its borrowing in 2008 which will increase interest expense on the
income statement.
The first step in the analysis is to determine the percentage increase in sales:
(2008 sales – 2007 sales)/2007 sales = percentage change in sales
($12 million - $10 million)/$10million - 1 = .2 or 20%
The second step in the analysis is to construct the 2008 proforma income statement
assuming those items that vary with sales will increase by the percentage change in sales
(20%) and that those items that don’t remain fixed. An example of this process is given
on the Excel worksheet below. Double click on the worksheet to access it, then scroll
up or down as needed. Notice the variable expenses are found by taking the 2007
expense and multiplying by 1 + the percentage change in sales (1.2). This increases those
expenses by 120%. A common error students make is to simply multiply the variable
expenses by the percentage change in sales. If we did that here, we would be multiplying
the variable expenses by 20%. In other words, we would not be increasing variable
expenses by 20%, we would be reducing them by 80%.
Notice the pro forma net income for 2008 is $600,000. You may wish to analyze the
effect using a strict percentage of sales approach would have had on pro forma net
income. Would net income be higher or lower as a result? You would be correct to
sense the potential for an exam question here. Finally $200,000 in dividends are
deducted from the $600,000 net income giving us a $400,000 addition to retained
earnings.
Sales
Less Cost of Goods Sold:
Fixed Cost
Variable Costs
Gross Profits
Less: Operating Costs
Fixed Cost
Variable Costs
Operating Profits
Less: Interest Expense
Net Profits Before Taxes
Less: Taxes (tax rate = 40%)
Net Profits After Taxes
Less: Common Stock Dividends
$10,000,000
$12,000,000
$3,000,000 Use Judgment
$5,000,000 $5,000,000 X 1.2
$2,000,000
$3,000,000
$6,000,000
$3,000,000
$500,000 Use Judgment
$1,000,000 $1,000,000 X 1.2
$500,000
$100,000 Use Judgment
$400,000
$160,000 $1,000,000 X .40
$240,000
$500,000
$1,200,000
$1,300,000
$300,000
$1,000,000
$400,000
$600,000
$200,000
The third step is to use the $400,000 pro forma additions to retained earnings in addition
to a number of other assumptions to compute the Pro Forma Balance Sheet. I will also
use the judgmental approach in this step. The 2007 historical balance sheet and the pro
forma balance sheet for BMX Corporation appear in the Excel worksheet below. To
access the worksheet, double click on it, then scroll up or down as needed to see view
the worksheets. I will make the following assumptions regarding the pro forma balance
sheet:
1. The firm wants to continue to maintain a minimum cash balance of $100,000
2. Marketable securities will increase to $75,000 in 2008.
3. Accounts receivable have historically been 36.5 days of sales. Since sales for
2008 are expected to be $12,000,000, accounts receivable will be
$12,000,000 x (36.5/365) = $1,200,000 (you could also do the following which is
algebraically identical: ($12,000,000/365) X 36.5).
4. Inventories have historically been 20% of cost of goods sold. Since cost of goods
sold for 2008 are expected to be $9,000,000, inventories will be $9,000,000 x .20
= $1,800,000.
5. Vectra will increase fixed assets by $750,000. Depreciation expense for 2008 is
estimated to be $200,000. Net fixed assets for 2008 will be:
Net fixed assets (2007) + additions to fixed assets – depreciation expense 2008
$5,000,000
+
$750,000
$200,000 = $5,550,000
6. Annual purchases (all on account) have historically averaged 60% of cost of
goods sold. The accounts payable balance, in turn, is typically 20% of purchases.
Accounts payable will therefore be $9,000,000 X .60 X .20 = $1,080,000
7. Taxes payable will be approximately one quarter of the tax expense shown on the
2008 pro forma income statement. Taxes payable will equal $400,000/4 =
$100,000.
8. Notes payable will increase to $1,000,000.
9. There will be no change in other current liabilities, long-term debt, or common
stock.
10. Retained earnings on the 2008 pro forma balance sheet will change by the
additions to retained earnings ($400,000) shown on the pro forma income
statement. Since the 2007 retained earnings was $1,000,000, the retained
earnings for 2008 are expected to be $1,000,000 + $400,000 = $1,400,000.
Marketable securities
Accounts Receivable
Inventories
Total Current Assets
Net Fixed Assets
Total Assets
$75,000
$1,200,000
$1,800,000
$3,175,000
$5,550,000
$8,725,000
Taxes Payable
Notes Payable
Other Current Liabilities
Total Current Liabilities
Long-term Debt
Common Stock
Retained Earnings
Total Liabilities and Equity
External Financing Required
Total After Financing
Notice the 2008 pro forma balance sheet did not initially balance: e.i., total assets
($8,725,000) did not equal the sum of total liabilities and equity ($8,332,500). In other
words, the firm’s need to fund assets of $8,725,000 in 2008 will not be met at anticipated
levels of debt and equity. This is the firm’s signal that it will have to raise funds by
issuing additional debt or equity in the amount of $392,500.
$100,0
$1,000,0
$500,0
$2,680,0
$1,000,0
$3,252,5
$1,400,0
$8,332,5
$392,5
$8,725,0