Foundations of Financial Management: An Analysis (part 11)

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.

Friedrich August von Hayek

Financial Forecasting (Part C)

by

Charles Lamson

Pro Forma Balance Sheet

Now that we have developed a pro forma income statement and a cash budget (see last post), it is relatively simple to integrate all of these items into a pro forma balance sheet. Because the balance sheet represents cumulative changes in the corporation over time, we first examine the prior period's balance sheet and then translate these items through time to represent June 30th, 2021. The last balance sheet, dated December 31st 2020, is shown in Table 16.

Table 16

In constructing our pro forma balance sheet for June 30th, 2021, some of the accounts from the old balance sheet will remain unchanged, while others will take on new values, as indicated by the pro forma income statement and cash budget. The process is depicted in Figure 1.

 Figure 1 Development of a pro forma balance sheet

We present the new pro forma balance sheet as of June 30th, 2021, in Table 17.

Table 17

Explanation of Pro Forma Balance Sheet

Each item in Table 17 can be explained on the basis of a prior calculation or assumption. The explanations are presented below in Figure 2.  

Figure 2

Analysis of Pro Forma Statement

In comparing the pro forma balance sheet (Table 17) to the prior balance sheet (Table 16), we note that assets are up by $25,640.

The growth was financed by accounts payable, notes payable, and profit (as reflected by the increase in retained earnings). Though the company will enjoy a high degree of profitability, it must still look to bank financing of $5,884 (shown as notes payable in Table 17) to support the increase in assets. This represents the difference between the $25,640 buildup and assets, and the $1,232 increase in accounts payable as well as the $18,524 buildup in retained earnings.

Percent of Sales Method

An alternative to tracing cash and accounting flows to determine financial needs is to assume that accounts on the balance sheet will maintain a given percentage relationship to sales. We then indicate a change in the sales level and ascertain our related financing needs. This is known as the percent-of-sales method. For example, for the Thomas Corporation, introduced in Table 18, we show the following balance sheet accounts in dollars and their percent of sales, based on a sales volume of $200,000. 

Table 18

Cash of $5,000 represents 2.5% of sales of $200,000; receivables of $40,000 are 20% of sales; and so on. No percentages are computed for notes payable, common stock, and retained earnings because they are not assumed to maintain a direct relationship with sales volume. Note that any dollar increase in sales will necessitate a 60% increase in assets, As shown at the bottom Of Table 18. Of this 60%, 25% will be spontaneously or automatically finance through accounts payable and accrued expenses, leaving 35% to be financed by profit or additional outside sources of financing. We will assume the Thomas Corporation has an after-tax return of 6% on the sales dollar and 50% of profits are paid out as dividends.

If sales increase from $200,000 to $300,000, the $100,000 increase in sales will necessitate $35,000 (35 percent) in additional financing. Since we will earn 6 percent on total sales of $300,000, we will show a profit of $18,000. With a 50 percent dividend payout, $9,000 will remain for internal financing. This means $26,000 out of the $35,000 must be financed from outside sources. Our formula to determine the need for funds is:

Presumably the $26,000 can be financed at the bank or through some other appropriate source.

Using the percent-of-sales method is much easier than tracing through the various cash flows to arrive at the pro forma statements. Nevertheless, the output is much less meaningful and we do not get a month-to-month breakdown of the data. The percen-of-sales method is a broad-brush approach, while the development of pro forma statements is more exacting. Of course, whatever method we use, the results are only as meaningful or reliable as the assumptions about sales and production that went into the numbers. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., 96-99*

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