Pro Forma Statements
| Site: | Saylor Academy |
| Course: | BUS601: Financial Management |
| Book: | Pro Forma Statements |
| Printed by: | Guest user |
| Date: | Friday, 4 April 2025, 1:15 AM |
Description
We reviewed the complexities of creating a strategic plan for the business. By definition, strategy is a forward-looking process that considers where the company wants to be and what it will take to get there. The same applies to preparing future financial forecasts or pro formas. This chapter covers the process for determining future financial performance. It is important to understand the use of common sizing and the percentage of sales methods.
If we could accurately predict the future, we could easily become wealthy by making many wise investments (and we're not just speaking of winning lottery numbers). Even imperfect information could guide our decisions and lead to a greater chance of success. As individuals, we constantly try to predict the future (for example: should I buy the phone plan with 500 or 1000 minutes?) and the accuracy of our predictions has financial consequences (paying for minutes we don't use, or running over).
One way companies try to envisage the future is through the use of pro forma statements. 'Pro forma' is Latin 'for the sake of form'. Accurately predicted pro forma statements can help a company plan for the future. How much will sales be next year? Profits? Pro formas (for short) can also be created for distinct scenarios to see which would be more profitable. If created properly, pro forma statements can be a type of financial crystal ball that help a company 'see' the future, although we should always remember that no prediction is likely to be 100% accurate.
Source: https://2012books.lardbucket.org/books/finance-for-managers/s05-pro-forma-statements.html
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Learning Objectives |
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A pro forma income statement is a projected income statement which shows predicted future operating cash flow. A pro forma income statement shows what potential sales revenue, expenses, taxes and depreciation might look like. Pro forma statements typically only forecast operating items on the income statement such as sales and EBIT, and not any items generated by financing or investing flows.
The simplest method used to prepare a pro forma income statement is to use the percent-of-sales method. In a nutshell, future sales are forecasted, and then expenses are calculated as a percentage of the new sales figure. Step 1: We create a common size income statement where each entry is expressed as a percentage of revenue.
Equation 5.1 Calculating percentage of sales
as a percent of sales = 
We should notice that many expenses are related to the level of sales, that is, they have similar entries in each year of the common size statement. For example, raw materials used and labor costs typically increase as sales increase. Step 2: We consider current (observed) sales and determine a forecasted growth rate to arrive at a projected revenue number. Step 3: We consider each line of the income statement and either hold it at current levels (if we don't think it scales with sales) or make the entry a percentage of our projected sales number. In the case of taxes, we use the appropriate tax rate.
Projecting the proper growth rate for sales is key to this analysis and, unfortunately, one of the most difficult things to do accurately. We can attempt to look at historical growth and adjust it using our beliefs about prospects, economic climate, etc. Sometimes companies have employees whose dedicated task is to constantly update sales projections.
To illustrate, Pet Products Forever Inc. has sales of $110, COGS of $51 and SG&A of $26.
What percent of sales are COGS and SG&A?
COGS / Sales = 51 / 110 = .464 or 46.4%
SG&A / Sales = 26 / 110 = .236 or 23.6%
new COGS = 46.4% of $121 = .464 × 121 = $56.1
new SG&A = 23.6% of $121 = .236 × 121 = $28.6
If we assume that depreciation and interest expense don't scale with sales, and our tax rate is 40%, then our pro forma statement might look like this:
Figure 5.3 Pet Products Forever Inc. Pro Forma Income Statement (Thousands)Why don't all expenses necessarily scale with sales? One expense we held constant was depreciation: our depreciation is tied to our fixed asset purchases; if we don't need to increase fixed assets to handle the increase of sales, then our depreciation will probably remain steady. If, however, all of our machines are at capacity and we have no more factory space, then sales growth might increase fixed assets, which might in turn increase depreciation! Likewise, if we need to borrow money to purchase those fixed assets, our interest expense might increase! Forecasting involves many such judgment calls, and each assumption we make can influence the bottom line.
Key Takeaways |
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Pro forma statements are a way to look into the future. The pro forma income statement projects future cash flow.
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Learning Objectives |
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Similar to a pro forma income statement, the pro forma balance sheet is a projection of a balance sheet. While the percentage-of-sales method could be used for the balance sheet as well, a more sophisticated and accurate approach would be to analyze each line of the balance sheet. A properly forecasted balance sheet uses best judgement to predict future sales and expenses. For example, our company may need to hold a certain amount of cash to meet basic expenses. Or a company at capacity might need to add assets to continue sales growth. A common size balance sheet, which shows each balance sheet item as a percentage of total assets, may help guide us in making these decisions. This information enables an individually tailored and more accurately forecasted balance sheet.
Pet Product's Forever Inc. has the following balance sheet. They know certain things about their next year which will play a role in determining the pro forma balance sheet.
Pet Products Forever has certain financial goals and knowledge about the upcoming year.
- From our pro forma income statement, we expect net earnings of $11 thousand on sales growth of 10%.
- The company wants to hold at least $20 thousand in cash.
- The company's debt (long-term and notes payable) will remain the same.
- No new common stock will be issued (common stock will remain the same). $4 thousand will be paid out in dividends to the shareholders.
- Accounts receivable should scale with sales.
- The company has determined that the current level of inventory is too low. They would like to hold $13 thousand in inventory.
- Accounts payable should scale with sales.
Given this information we construct the following balance sheet.
Figure 5.6 Pet Products Forever Inc. Pro Forma Balance Sheet First Pass (Thousands) 2013
Note that retained earnings has increased by our earnings less our dividends paid ($11 thousand − $4 thousand = $7 thousand). Since accounts receivable and payable both scale with sales, and sales increased by 10%, each of these has increased by 10% as well.
After our first pass, our balance sheet doesn't balance! If our total assets are larger than our total liabilities and equity, we need to raise money somehow, either by increasing financing (that is, borrowing more, reducing dividends, or issuing equity) or reducing assets. Smaller total assets means returning cash to our investors (by reducing debt or increasing dividend payout) or parking the cash on our balance sheet (in cash or other short term investments).
Since after the first pass the total assets are smaller, we can choose to increase cash held to balance the books.
Key Takeaways |
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Pro Forma balance sheets provide a look into a company's future.
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Learning Objective |
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Pro forma statements are to be tools to help a company plan for the future. They are only as good as the assumptions upon which they are constructed.
Our analysis has been straightforward and simple but it can get more complex. Companies can change many of the other variables found on their income statements and balance sheets. Companies determine their dividend policy (which influences retained earnings) and they can influence their level of debt (through their capital structure decisions which influences their interest expense) as well as their common stock.
Now we have constructed our pro forma statements. But how accurate are they? What's the probability that our pro forma will correctly depict our company's future? To answer this question, pro formas can be analyzed using scenario analysis, which we cover in more detail in chapter 13. Companies can analyze best, worst, and most likely case scenarios by creating sets of pro formas with different underlying assumptions. This might seem like a lot of work, but spreadsheets can make these calculations fairly easily.
Pet Products Forever estimates that their most likely case is an increase in sales of 10%. Their best case would be an increase of 20% and their worst case would be an increase of 2%. Remember that COGS are % of sales and SG&A are % of sales.
The best case results in net earnings of $13 thousand, while our worst outcome is $9.4 thousand. The company is still doing well, even under the worst case scenario. Not a bad result!
Key Takeaways |
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Learning Objectives |
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Pro forma statements are used to make many business decisions. Should we launch a new product line or open a new factory? Should we add another sales person or a worker in the plant? Pro formas use our best judgements to construct likely scenarios about the future. Accurately and appropriately used and constructed they can be helpful tools to improve our business.
When analyzing pro forma statements, it is important to understand how they were constructed, what the assumptions were and how to read them. Cash flows can be manipulated as well as assumptions. Economic and political conditions can change quickly which can strongly influence business outcomes. As with most predictions - take them with a grain of salt. No one can predict the future with 100% accuracy.
Ethical Considerations
Managers within a company may have different objectives. Someone in sales may want to have a low sales projection so they are guaranteed to 'hit their number' and earn their bonus. A retiring manager may want to maximize their current year compensation or the company’s share price to maximize their retirement benefit. When constructing pro forma statements managers may also have different opinions on the likelihood of the outcome of each scenario. While pro forma statements are projections, many business decisions are based upon them. Correct calculation and analysis is important.
Key Takeaways |
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