Proforma Analysis.docx
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Proforma Analysis.docx
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ProformaAnalysis
FORECASTINGFINANCIALSTATEMENTS:
PROFORMAANALYSIS
RogerClarkeandGrantMcQueen
August2001
ABSTRACT
Thisteachingnoteexplainswhyandhowmanagersprojectfinancialstatementsintothefuture.Thenoteisdesignedforanintroductiontocorporatefinanceclass.ThenotepreparesstudentsforeitheracasesuchasClarksonLumberorareal-wordprojectinwhichproformastatementsareneeded.Thisnoteexplainshowtobuildaproformabalancesheetandintentionallydoesnotincludeacompleteproformaincomestatementsothatthestudentswillhavetodemonstratesomeingenuitywhendoingthefollow-oncaseorproject.Thenoteisanicesupplementtoboththeadvanceandremedialcorporatefinancetextbooks.Themoreadvancedbooks(e.g.,Ross,Westerfield,andJaffe)typicallygiveshortshrifttothetopicofforecastingandthemoreremedialtextbooks(e.g.,BlockandHirt)typicallybuildtheforecastedstatementspresupposingthemanagerknowsproductionprojections(e.g.thetype,number,andpriceofunitstobebought,produced,andsold).
RogerClarkiswithAnalytic-TSAGlobalAssetManagementandanAdjunctProfessorintheMarriottSchoolatBrighamYoungUniversity.GrantMcQueenistheWilliamEdwardsProfessorofFinanceintheMarriottSchoolatBrighamYoungUniversity.TheauthorsthankcollegesatBYUandASUandtheresearchassistanceandstudentsfortheircontributions.SendcorrespondencetoGrantMcQueen,671TNRB,MarriottSchool,BrighamYoungUniversity,ProvoUT84602.email:
grant_mcqueen@byu.edu.
FORECASTINGFINANCIALSTATEMENTS:
PROFORMAANALYSIS
IINTRODUCTION
Forecastingafirm'sfinancialstatementscanhelpbothfinancialmanagersandgeneralmanagers.Proformastatementshelpthefinancialmanagerplanthefirm'sfinancialneeds. Withanestimateoffutureincomestatementandbalancesheetaccounts,amanagercantellhowmuchfinancingmightbeneeded,andwhenitmightbeneeded.Thus,oneintentofproformaanalysisistoforecastafirm'sfinancialstatementsundersomespecificconditions. Sincetotalassetsmustequalthesumoftotalliabilitiesandowner'sequity,anyimbalancewillrequiremanagementaction.Havingforecastedtheamountandtimingoftheimbalance,afinancialmanagercanarrangeforfinancing(suchasbankloansorstockofferings)orinvestment(suchasmarketablesecurities)longbeforetheneedbecomescritical.
Proformastatementshelpgeneralmanagersinoverallplanning(employmentandinventorylevels,forexample)andproblemsolving.Asforecastsaredeveloped,amanagercananalyzetheresultstoidentifypotentialtroublespotsandplanaccordingly.Findingproblemsandtryingoutsolutionsonpaper,monthsinadvance,ismuchpreferredtolearningabouttheproblemfirsthandinrealtime.Similarly,by“seeing”intothefuturewithproformastatements,amanagercananticipateopportunitiesandpreparetoexploitthemlongbeforethewindowofopportunitybeginstoclose.Inadditiontobeingaplanningtool,proformastatements,intandemwithactualresults,canbeusedtoevaluateperformanceandmakemidstreamcorrections.Varianceanalysis,acomparisonoftheplanwithactualperformance,helpsamanageranalyzefirmperformanceduringthebudgetperiod,gaugestrengthsandweaknesses,andmakeinterimadjustmentstotheplan.
Theaccuracyofproformastatementsislimitedbythevalidityoftheassumptionsusedincreatingthem.Oftenaseriesofstatementsisdevelopedbymakingdifferentassumptionsaboutsalesandabouttherelationshipbetweensalesandthebalancesheetaccounts.Thisiscalledasensitivityanalysis.Theresultingsetofstatementssuggeststhemostlikelyoutcomesforthefirmandarangeoffinancingneeds.Afterbuildingaproformabalancesheetbasedonexpectedsales,amanagercanthenusesensitivityanalysestoanswerquestionssuchashowthecompany'sfinancialneedswillchangeifsalesare10percentbelowtheirexpectedlevel,etc.
Proformabalancesheetsarecreatedbyforecastingtheindividualaccountbalancesatafuturedateandthenaggregatingthemintoafinancialstatementformat.Accountbalancesareforecastedbyidentifyingtheforcesthatinfluencethemandprojectinghowtheaccountswillbeinfluencedinthefuturebysuchforces.Sales,companypolicy,andrestrictivedebtcovenantsareoftensignificantforces.
Inthisteachingnote,ahypotheticalfirmisusedtoillustratetheproformaprocess.Threeyearsofhistoricaldata,1996to1998,aregivenforthehypotheticalfirm.Then,basedonthishistoricaldata,aproformabalancesheetfor1999isdevelopedbasedonsalesforecastfor1999alongwithcompanypoliciesandconstraints.
IISALESFORECAST
Thefirststepinpreparingproformafinancialstatementsistoforecastsales.Salesnormallyinfluencethecurrentassetandcurrentliabilityaccountbalances.Forexample:
assalesincrease,thefirmwillgenerallyneedtocarrymoreinventoryandwillhavealargeraccountsreceivablebalance.Retainedearningsarealsotiedtosalesthroughtheprofitmarginanddividendpayoutratio.Althoughdifficult,forecastingsalesisessential.Salestypicallydependontheindustry,theeconomy,theseason,andmanyotherfactors.
Industry:
Inagenericsense,thetwomainvariablesinsalesrevenueareunitpriceandvolume.Thesetwovariablesusuallyhaveareciprocalrelationship(i.e.,atypicaldemandcurve).Therefore,astatementthat,"unitdemandwillincreaseby20percentoverthenextfiveyears"neednotmeanthatsalesrevenues(unitpricetimesvolume)willincreasebythesameamountoverthattimeperiod.
Anindustrythatisrestructuringmaydramaticallyshiftmarketshareamongitsparticipants.Salesforecastersneedtoidentifyimportanttrendsandquantifytheirimpactonthecompany'sbusiness.
Economy:
Economicbusinesscycles(expansionsandrecessions)canhaveadramaticinfluenceonsomecompanies,exacerbatingtheforecastingproblem.Cyclicitynotonlyaffectsthelevelofsales,butalsomaychangetherelationshipbetweensalesandthebalancesheetaccounts.Industriesthatrequireagreatdealofcapitalinvestmenttendtoaddcapacityinlargechunks.Unitpricesriseandfalldependingonwhetherthereiscurrentlyashortageorsurplusofcapacityintheindustry.Thus,theproformatechniques(introducedbelow)mustbemodifiedforcyclicalindustries,particularlyifexperiencingadownturn.
Seasons:
Year-endproformabalancesheetscanprojecttheexternalfinancingneedsofacompanyunderspecificconditions;however,theyarestatic.Whensalesareseasonal,peakfinancingneedsmayexceedtheproformaprojectionbecausetheproformais"outofseason."Furthermore,historicalend-of-yearrelationshipsbetweensalesandbalancesheetaccountsmaydifferduringthepeak.Forexample,atoymanufacturer'saccountsreceivablemayaverage5percentofannualsaleseveryyearontheDecember31stannualreport.However,duringthesalespeakinAugustwhenretailersstockupforChristmas,accountsreceivablemightswellto30percentofsales.Furthermore,inSeptember,inventorymaypeakat25percentofsaleseventhoughinDecemberinventorymaybemuchsmaller.Theanalystmustdevelopmonthlyproformabalancesheetstobecomeawareofseasonalityinordertoarrangeforasufficientlineofcredit.
Table1showsthatsalesforthehypotheticalfirmhavegrownfrom$201(allnumbersareinthousands)in1996to$319in1998.Armedwiththisinformationandknowledgeabouttheindustryandeconomy,managementbelievesthatsaleswillincreaseto$350in1999.
IIITRIALPROFORMA
A.CurrentAssetsandCurrentLiabilities
Havingobtainedasalesforecast,thetrialproformabalancesheetcanbecreated.Accountsthattendtovarywithsalesaretypicallyforecastedfirst.Oftenthecurrentassetsandliabilities,suchasaccountsreceivable,inventory,andaccountspayable,willmovewithsales.Forexample,afirmmaymakearelativelyconstant40percentofsalesoncredit.Incontrast,otheraccounts,suchaslong-termdebtanddividendsmaybedrivenbyovertmanagementdecisions,notsales.Someaccountssuchasplantandequipmentmayhavearelationshiptosalesinthelongrun,butnotnecessarilyfromyeartoyear.Forexample,afirmcouldhaveexcesscapacityallowingsalestogrowwithoutinvestinginnewassets.Then,whentheplantandequipmentbecomecapacityconstrained,thesefixedassetsmaygrowatafasterratethansalessinceequipmentandfactoriestendtocomein“lumpy”amounts.Itmaybehardtobuy10percentofafactorywhensalesincreaseby10percent.
Threecommonwaystodescribethehistoricalrelationshipbetweensalesandthecurrentaccountsare:
percentofsales,ratios,andregressionanalysis. Forillustrativepurposes,inventoryandaccountspayablewillbeforecastedusingthepercentofsalesmethod,accountsreceivablesandnetincomewillbeforecastedusingratios,andcashwillbeforecastedusingregressionanalysis.
PercentageofSales:
Table1showsthelevelofsales,thecurrentaccounts,andnetincomefor1996through1998.Inventorywas13.5,12.8,and14.2percentofsalesfor1996,1997,and1998,respectively.Onaverage,inventoryhasbeen13.5percentofsales.Thus,giventhesalesforecastof$350,inventoryisforecastedtobe$47.3=0.135($350).Onaverageaccountspayablehasbeen8.7percentofsales;thus,accountspayableisestimatedtobe$30.5=0.087($350).
Ratios:
UsingtheaccountsreceivableandnetincomedatafromTable1,theaveragecollectionperiodandtheprofitmarginratioscanbecalculated.Assumingallsaleswereoncreditanda365dayyear,thefirmtook38,40,and43daystocollectthetypicalaccountin1996,
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