Forecasting the Balance Sheet
|Course:||BUS202: Principles of Finance|
|Book:||Forecasting the Balance Sheet|
|Printed by:||Guest user|
|Date:||Saturday, December 2, 2023, 5:10 PM|
This section discusses the Pro Forma balance sheet. The question "why should the Pro Forma balance sheet be used in a business?" is relevant as the economy changes. Possible uses of the Pro Forma balance sheet include mergers and acquisitions, warranties, and negotiating a commercial lending relationship to support growth. A pro forma balance sheet summarizes the projected future status of a company after a planned transaction, based on the current financial statements. By the end of this section, you will be able to prepare a pro forma balance sheet.
A pro forma balance sheet summarizes the projected future status of a company after a planned transaction, based on the current financial statements.
Prepare pro form balance sheets when the situation requires
- The pro forma accounting is a statement of the company's financial activities while excluding "unusual and nonrecurring transactions" when stating how much money the company actually made.
- In business, pro forma financial statements are prepared in advance of a planned transaction, such as a merger, an acquisition, a new capital investment, or a change in capital structure such as incurrence of new debt or issuance of equity.
- Pro forma figures should be clearly labeled as such and the reason for any deviation from reported past figures clearly explained.
In business and legal transactions, a warranty is an assurance by one party to the other party that specific facts or conditions are true or will happen. The other party is permitted to rely on that assurance and seek some type of remedy if it is not true or followed.
- intangible assets
Intangible assets are defined as identifiable non-monetary assets that cannot be seen, touched, or physically measured. They are created through time and effort, and are identifiable as a separate asset.
- a merger, an acquisition
Mergers and acquisitions (abbreviated M&A) is an aspect of corporate strategy, corporate finance, and management dealing with the buying, selling, dividing, and combining of different companies and similar entities that can help an enterprise grow rapidly in its sector or location of origin, or a new field or new location, without creating a subsidiary, other child entity or using a joint venture.
- For example, when a transaction with a material effect on a company's financial condition is contemplated, the Finance Department will prepare, for management and board review, a business plan containing pro forma financial statements demonstrating the expected effect of the proposed transaction on the company's financial viability.
Pro Forma Financial Statements
In business, pro forma financial statements are prepared in advance of a planned transaction, such as a merger, an acquisition, a new capital investment, or a change in capital structure such as incurrence of new debt or issuance of equity. The pro forma models the anticipated results of the transaction, with particular emphasis on the projected cash flows, net revenues and (for taxable entities) taxes. Consequently, pro forma statements summarize the projected future status of a company, based on the current financial statements. For example, when a transaction with a material effect on a company's financial condition is contemplated, the Finance Department will prepare, for management and Board review, a business plan containing pro forma financial statements demonstrating the expected effect of the proposed transaction on the company's financial viability.
Pro Forma Balance Sheet
If applicable to the business, summary values for the following items should be included in the pro forma balance sheet :
Balance Sheet: Simple balance sheet including basic items
- Current assets
- Cash and cash equivalents
- Accounts receivable
- Prepaid expenses for future services that will be used within a year
- Non-current assets (Fixed assets)
- Property, plant and equipment
- Investment property, such as real estate held for investment purposes
- Intangible assets
- Financial assets (excluding investments accounted for using the equity method, accounts receivables, and cash and cash equivalents)
- Investments accounted for using the equity method
- Biological assets, which are living plants or animals. Bearer biological assets are plants or animals which bear agricultural produce for harvest, such as apple trees grown to produce apples and sheep raised to produce wool.
- Accounts payable
- Provisions for warranties or court decisions
- Financial liabilities (excluding provisions and accounts payable), such as promissory notes and corporate bonds
- Liabilities and assets for current tax
- Deferred tax liabilities and deferred tax assets
- Unearned revenue for services paid for by customers, but not yet provided
- The net assets shown by the balance sheet equals the third part of the balance sheet, which is known as the shareholders' equity. It comprises:
- Issued capital and reserves attributable to equity holders of the parent company (controlling interest)
- Non-controlling interest in equity
- Formally, shareholders' equity is part of the company's liabilities: they are funds "owing" to shareholders (after payment of all other liabilities). Usually, however, "liabilities" is used in the more restrictive sense of liabilities excluding shareholders' equity. The balance of assets and liabilities (including shareholders' equity) is not a coincidence. Records of the values of each account in the balance sheet are maintained using a system of accounting known as double-entry bookkeeping. In this sense, shareholders' equity by construction must equal assets minus liabilities, and are a residual.
- Regarding the items in equity section, the following disclosures are required:
- Numbers of shares authorized, issued and fully paid, and issued but not fully paid
- Par value of shares
- Reconciliation of shares outstanding at the beginning and the end of the period
- Description of rights, preferences, and restrictions of shares
- Treasury shares, including shares held by subsidiaries and associates
- Shares reserved for issuance under options and contracts
- A description of the nature and purpose of each reserve within owners' equity
Lenders and investors will require such statements to structure or confirm compliance with debt covenants such as debt service reserve coverage and debt to equity ratios. Similarly, when a new corporation is envisioned, its founders will prepare pro forma financial statements for the information of prospective investors. Pro forma figures should be clearly labeled as such and the reason for any deviation from reported past figures clearly explained.
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Balance sheet analysis is process of understanding the risk and profitability of a firm through analysis of reported financial information.
Analyze a company's balance sheet
- Balance sheet is a summary of the financial balances of a sole proprietorship, a business partnership, a corporation or other business organization. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year.
- Balance sheet analysis (or financial analysis) the process of understanding the risk and profitability of a firm (business, sub-business or project) through analysis of reported financial information, particularly annual and quarterly reports.
- Financial ratio analysis should be based on regrouped and adjusted financial statements. Two types of ratio analysis are performed: 3.1) Analysis of risk and 3.2) analysis of profitability.
- Balance sheet analysis consists of 1) reformulating reported Balance sheet, 2) analysis and adjustments of measurement errors, and 3) financial ratio analysis on the basis of reformulated and adjusted Balance sheet.
return on net operating assets
net financial debt
the net financial interest rate
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership, a corporation or other business organization. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A balance sheet is often described as a "snapshot of a company's financial condition". Of the four basic financial statements, the balance sheet is the only statement which applies to a single point in time of a business' calendar year.
A business operating entirely in cash can measure its profits by withdrawing the entire bank balance at the end of the period, plus any cash in hand. However, many businesses are not paid immediately; they build up inventories of goods and they acquire buildings and equipment. In other words: businesses have assets and so they cannot, even if they want to, immediately turn these into cash at the end of each period. Often, these businesses owe money to suppliers and to tax authorities, and the proprietors do not withdraw all their original capital and profits at the end of each period. In other words businesses also have liabilities.
Balance sheet: Classified balance sheet
Balance Sheet Analysis
Balance sheet analysis (or financial analysis) the process of understanding the risk and profitability of a firm (business, sub-business or project) through analysis of reported financial information, particularly annual and quarterly reports.
Balance sheet analysis consists of 1) reformulating reported Balance sheet, 2) analysis and adjustments of measurement errors, and 3) financial ratio analysis on the basis of reformulated and adjusted Balance sheet. The two first steps are often dropped in practice, meaning that financial ratios are just calculated on the basis of the reported numbers, perhaps with some adjustments. Financial statement analysis is the foundation for evaluating and pricing credit risk and for doing fundamental company valuation.
Financial ratio analysis should be based on regrouped and adjusted financial statements. Two types of ratio analysis are performed: 3.1) Analysis of risk and 3.2) analysis of profitability:
3.1) Analysis of risk typically aims at detecting the underlying credit risk of the firm. Risk analysis consists of liquidity and solvency analysis. Liquidity analysis aims at analyzing whether the firm has enough liquidity to meet its obligations when they should be paid. A usual technique to analyze illiquidity risk is to focus on ratios such as the current ratio and interest coverage. Cash flow analysis is also useful. Solvency analysis aims at analyzing whether the firm is financed so that it is able to recover from a losses or a period of losses.
3.2) Analysis of profitability refers to the analysis of return on capital, for example return on equity, ROE, defined as earnings divided by average equity. Return on equity, ROE, could be decomposed: ROE = RNOA + (RNOA - NFIR) * NFD/E
Purposes of Balance Sheet Analysis
"The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions". Financial statements should be understandable, relevant, reliable and comparable. Reported assets, liabilities, equity, income and expenses are directly related to an organization's financial position.
Financial statements are intended to be understandable by readers who have "a reasonable knowledge of business and economic activities and accounting and who are willing to study the information diligently". Financial statements may be used by users for different purposes:
- Owners and managers require financial statements to make important business decisions that affect its continued operations. Financial analysis is then performed on these statements to provide management with a more detailed understanding of the figures. These statements are also used as part of management's annual report to the stockholders.
- Employees also need these reports in making collective bargaining agreements (CBA) with the management, in the case of labor unions or for individuals in discussing their compensation, promotion and rankings.
- Prospective investors make use of financial statements to assess the viability of investing in a business. Financial analyses are often used by investors and are prepared by professionals (financial analysts), thus providing them with the basis for making investment decisions.
- Financial institutions (banks and other lending companies) use them to decide whether to grant a company with fresh working capital or extend debt securities(such as a long-term bank loan or debentures) to finance expansion and other significant expenditures.
- Government entities (tax authorities) need financial statements to ascertain the propriety and accuracy of taxes and other duties declared and paid by a company.
- Vendors who extend credit to a business require financial statements to assess the creditworthiness of the business.
- Media and the general public are also interested in financial statements for a variety of reasons.