Investments & Securities Chapter 4 Developing pro forma statements is a fairly involved process.

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Financial Forecasting

Author’s Overview

Developing pro forma statements is a fairly involved process. However, the rewards to students are

high in terms of understanding the interaction of accounting data and financial forecasting. The

development of pro forma financial statements is an integrative exercise, so there is little reward for

a halfway approach. The use of an integrated Excel spreadsheet makes this process a little more

manageable. It should be emphasized than any student intending to start up a small business will be

required to prepare this type of statement for a bank loan or business plan. Often management

students see no reason to master this painstaking exercise, but, if they hope to become entrepreneurs,

it will be good for them to know it.

The percent-of-sales method, presented at the end of the chapter, is a second approach to financial

forecasting. It is easily understood and quickly mastered, but it has many weaknesses and does not

have the full validity of developing pro forma statements. Choosing whether and how to present the

percent-of-sales method is really a matter of instructor preference.

Chapter Concepts

LO2. The three financial statements for forecasting are the pro forma income statement, the cash

LO4. The various methods of forecasting enable the firm to determine the amount of new funds

4

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Annotated Outline and Strategy

I. Introduction

A. Financial planning helps managers arrange increased funding requirements to finance

additional assets needed to support changes in marketing strategies and growth.

E. Financial planning is necessary, not only for success, but for survival as well.

II. Constructing Pro Forma Statements: The most comprehensive means of financial

planning is through the development of pro forma financial statements, namely the pro forma

income statement, the cash budget, and the pro forma balance sheet.

PPT Development of Pro Forma Statements (Figure 4-1)

III. Pro Forma Income Statement: A projection of how much profit a firm will make over a

specific time period

1. Establish a sales projection

a. Forecast economic conditions

b. Survey sales personnel

PPT Projected Wheel and Caster Sales (Table 4-1)

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PPT Stock of Beginning Inventory (Table 4-2)

Finance in Action: Tesla’s Sales Forecasts: Where Marketing and Finance Come Together

PPT Production Requirements for Six Months (Table 4-3)

a. Determine units to be produced

+ Projected unit sales

b. Determine the cost of producing the units

(1) Unit cost = materials + labor + overhead

(2) Total costs = number of units to be produced  unit cost

PPT Unit Costs (Table 4-4)

PPT Total Production Costs (Table 4-5)

c. Compute cost of goods sold

(1) Estimate unit sales

(2) Cost of goods sold = unit sales × unit cost (FIFO or LIFO)

d. Compute gross profit

PPT Allocation of Manufacturing Cost and Determination of Gross Profits

(Table 4-6)

PPT Value of Ending Inventory (Table 4-7)

3. Compute other expenses

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a. General and administrative

4. Determine profit by completing the actual pro forma statement

+ Sales revenue

– Cost of goods sold

= Gross profit

PPT Income Statement (Table 4-8)

IV. Cash Budget: A summary of expected cash receipts and disbursements for a specific period

of time

1. Estimate cash sales and collection timing of credit sales

PPT Monthly Sales Pattern (Table 4-9)

PPT Monthly Cash Receipts (Table 4-10)

PPT Component Costs of Manufactured Goods (Table 4-11)

2. Forecast cash payments

a. Payments for materials purchased according to credit terms

b. Wages

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PPT Average Monthly Manufacturing Costs (Table 4-12)

PPT Summary of All Monthly Cash Payments (Table 4-13)

3. Determine monthly cash flow (receipts minus payments)

PPT Monthly Cash Flow (Table 4-14)

PPT Cash Budget with Borrowing and Repayment Provisions

(Table 4-15)

4. Construct cash budget

+ Total receipts (for each month, week, etc.)

Note: The beginning cash balance for each period of the cash budget is equal

to the cumulative cash balance of the previous period in the absence of

borrowing or investing of cash balances.

5. Determine cash excess or need for borrowing

+ Desired cumulative cash balance

V. Pro Forma Balance Sheet: An integrated projection of the firm’s financial position based

on its existing position, forecasted profitability (from pro forma income statement),

anticipated cash flows (cash budget), asset requirements, and required financing

1. Construction of pro forma balance sheet

a. Assets (source of information)

(1) Cash (cash budget)

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(4) Inventory (COGS computation for pro forma income

statement)

b. Liabilities and Stockholders’ Equity

(1) Accounts payable (cash budget worksheet)

(3) Long-term debt (previous balance sheet plus new issues)

(5) Retained earnings (previous balance sheet plus projected

addition from pro forma income statement)

Perspective 4-3: Use Figure 4-2 to reinforce the pattern used to arrive at the pro forma

balance sheet.

PPT Development of a Pro Forma Balance Sheet (Figure 4-2)

Perspective 4-4: Table 4-17 is the last piece in the puzzle in that it represents the actual pro

forma balance sheet. The amounts in the 10 accounts in the table can be clarified in the

explanations following the table in the text.

Finance in Action: Pro Forma Financial Statements: A Critical Tool For Entrepreneurs

VI. Percent-of-Sales Method: Shortcut, less exact alternative for determining financial needs

1. Assumes that balance sheet accounts maintain a given relationship to sales

Assets

PPT Balance Sheet and Percentage-of-Sales Table for Howard Corporation

2. Project asset levels on basis of forecasted sales (percent of sales of each asset 

forecasted sales)

3. Project spontaneous financing: Some financing is provided spontaneously when asset

5. Determine external financing = required new assets to support sales – spontaneous

financing – the change in retained earnings. The relationship is expressed as follows:

Where:

A/S = percentage relationship of variable assets to sales

S = change in sales

Required new funds = A

S(DS) – L

S (DS)– 2

PS (1–D)