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Principles of Finance

18.3 Pro Forma Financials

Principles of Finance18.3 Pro Forma Financials

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

Learning Outcomes

By the end of this section, you will be able to:

  • Define pro forma in the context of a financial forecast.
  • Describe the factors that impact the length of a financial forecast.
  • Explain the risks associated with a financial forecast.

In this section of the chapter, we will move beyond the sales forecast and look at the general nature, length, and timeline of forecasts and the risks associated with using them. We’ll look at why we use them, how long they generally are, what the key variables in a forecast are, and how we pair those variables with common-size analysis to develop the forecast.

Purpose of a Forecast

As mentioned earlier in the chapter, forecasts serve different purposes depending on who is using them. Our focus here, however, is the world of finance. In this realm, the key purpose of pro forma (future-looking) financial statements is to manage a firm’s cash flow and assess the overall value that the firm is generating through future sales growth. Growing just for the sake of growing doesn’t always yield favorable income for the firm. A larger top-line sales figure that results in lower net income doesn’t make sense in the grand scheme of things. The same is true of profitable sales that don’t generate enough cash flows at the right time. The firm may make a profit, but if it doesn’t manage the timing of its cash flows, it could be forced to shut down if it can’t cover the costs of payroll or keep the lights on. Forecasting helps assess both cash flow and the profitability of future growth. Managers can forecast cash flow using data from forecasted financial statements; this allows them to identify potential gaps in cash and plan ahead in order to either alter collection and payment policies or obtain funding to cover the gap in the timing of cash flows.

Length of a Forecast

Forecasts can generally be for any length of time. The length generally depends on the user’s needs. A one-year forecast, broken down by month, is quite typical. A firm will often go through a formal budgeting process near the end of its calendar or fiscal year to project financial plans and goals for the coming year. Once that is done, a rolling financial forecast is then done monthly to adjust as time moves on, more information becomes available, and circumstances change.

To be useful, the future forecast for financial planning purposes is almost always calculated as monthly increments rather than one total figure for the next 12 months. Breaking the data down by month allows finance managers to more clearly see fluctuations in cash flows in and out, identify potential gaps in cash flow, and plan ahead for their cash needs.

Forecasts can also be done for several years into the future. In fact, they commonly are. However, once the firm is looking out beyond 12 months, it gets difficult to forecast items with a great degree of accuracy. Often, forecasts beyond a year will be completed only to quarterly or even annual figures rather than monthly. Forecasts that far into the future are often strategic in nature, made more to communicate future plans for the firm than for more detailed decision-making and cash flow planning.

Common-Size Financials

As we saw earlier in the chapter, common-size analysis involves using historical financial statements as a basis for future forecasts. Financial statements provide a great starting point for analysis, as we can see the relationships between sales and costs on the income statement and the relationships between total assets and line items on the balance sheet.

For example, in Figure 18.6, we saw that for the past two years, cost of goods sold has been 50% of sales. Thus, in the first draft of a forecast for Clear Lake, it’s likely that managers would estimate cost of goods sold at 50% of their forecasted sales. We can begin to see why forecasting sales first is crucial and why doing so as accurately as possible is also important.

Select Variables to Use

A simple way to begin a full financial statement forecast might be to simply use the common-size statements and forecast every item using historical percentages. It’s a logical way to begin a very rough draft of the forecast. However, several variables should be taken into consideration. First, managers must address the cost of an account and determine if it’s a variable or fixed item. Variable costs tend to vary directly and proportionally with production or sales volume. Common examples include direct labor and direct materials. Fixed costs, on the other hand, do not change when production or sales volume increases or decreases within the relevant range. Granted, if production were to increase or decrease by a large amount, fixed costs would indeed change. However, in normal month-to-month changes, fixed costs often remain the same. Common examples of fixed costs include rent and managerial salaries.

So, if we were to approach our common-size income statement, for example, we would likely use the percentage of sales as a starting point to forecast variable items such as cost of goods sold. However, fixed costs may not be accurately forecast as a percentage of sales because they won’t actually change with sales. Thus, we would likely look at the history of the dollar values of fixed costs in order to forecast them.

Concepts In Practice

COVID-19 Makes Forecasting Difficult for Big 5 Sporting Goods

Big 5 Sporting Goods announced record earnings in the third quarter of 2020, attributing its huge success that quarter to the impact of people’s reactions to the COVID-19 pandemic. With so many people in quarantine still wanting to make healthy lifestyle choices, sporting goods stores were making record sales. Record-breaking sales, however, are not certain in the future. The impacts of the pandemic are extremely difficult to predict, making it a challenge for Big 5 Sporting Goods and other companies to assemble pro forma financial statements.

(sources: https://www.globenewswire.com/news-release/2020/10/27/2115470/0/en/Big-5-Sporting-Goods-Corporation-Announces-Record-Fiscal-2020-Third-Quarter-Results.html; https://finance.yahoo.com/news/investors-want-big-5-sporting-054658521.html; https://www.cpapracticeadvisor.com/accounting-audit/news/21206691/four-ways-covid19-will-impact-2021-financial-forecasting-and-planning)

Determine Potential Changes in Variables

So far, we have focused on using historical common-size statements to create a draft (not a final version) of the forecast. This is because the past isn’t always a perfect indicator of the future, and our finances don’t always follow a linear pattern. We use the past as a good starting point; then, we must assess what else we know to fine-tune and make adjustments to the forecast.

Many items impact the forecast, and they will vary from one organization to another. The key is to do research, gather data, and look around at the market, the economy, the competition, and any other factors that have the potential to impact the future sales, costs, and financial health of the company. Though certainly not an exhaustive list, here are a few examples of items that may impact Clear Lake Sporting Goods.

  • It has an old product line that was discontinued in early October, contributing to a 2% reduction in monthly sales that will likely continue into the new year until a new line begins arriving in stores.
  • It will be adding a new brand to its collection of fishing supplies in March. The manufacturer plans to begin running commercials in late February. Managers anticipate that this will increase Clear Lake’s monthly sales by about $500 in March, $1,000 in April, $1,400 in May, and $2,000 per month in June, July, and August.
  • The company has just finished updating its employee compensation package. It goes into effect in January of the new year and will result in an overall 4% increase in the cost of labor.
  • The landlord indicated that rent will increase by $50 per month starting July 1.
  • Some fixed assets will be fully depreciated by the end of March. Thus, depreciation expense will go down by $25 per month beginning in April.
  • There are rumors of new regulations that will impact the costs of importing some of the more difficult-to-obtain hunting supplies. Managers aren’t entirely sure of the full impact of the new legislation at this time, but they anticipate that it could increase cost of goods sold for the affected product line when the new legislation goes into effect in the last quarter. Their best estimate is that it could increase the overall cost of goods sold by up to 2%.

We will use all of this data later in the chapter when we are ready to compile a complete forecast for Clear Lake.

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