Financial ratios are a good starting point for analyzing a company's financial condition.
The ratios are employed also extensively by outside creditors, investors, and government regulators.Financial analysis enables management to examine and compare alternative assumptions and expectations.
From empirical testing, it appears that financial ratios can be used to successfully predict certain events. However, they can identify potential problems, but they cannot solve them.
Pro Forma Financial Statements
In previous part of this chapter, we saw one analysis financial statement in order to identify a firm's strengths and weaknesses. Now part we shall concern with projected, or pro forma, financial statements with the effects of alternative strategies on these statements. These statements give the financial manager insight into the prospective future financial conditions and performance of the firm, using yet another tool for financial planning and control.
Pro forma, or projected, financial statements are developed to determine the firm's financial requirements, which are established in the financial plan. Financial plan must occur within the framework of the firm's overall mission, objectives and strategies.
The principal components of the financial plan are:
- an analysis of the firm's current financial conditions as indicated by an analysis of its most recent statements,
- a sales forecast,
- the capital budget,
- the cash budget,
- as of pro forma (or projected) financial statements, and
- the external financing plan.
In this chapter, we shall focus on the pro forma statements.
Several methods are used to develop pro forma, or forecast, financial statements. The percentage of sales methods is a simple but often practical way of forecasting financial statement variables. This method is based on two assumptions:
- that most balance sheet accounts are tied directly to sales,
- that the current levels of all assets are optimal for the current sales level.
I shall describe the method with hypothetical RPS Corporation, whose 31 December 1994 balance sheet and summary income statements are given in Table 5-8.
RPS operated its fixed assets at full capacity to support its 1994 sales of $500 million, and it had no unnecessary stocks of current assets. Its profit margin on sales was 4 percent, and it distributed 40 percent of its net income to shareholders as dividends. If RPS s sales increase to &750 million in 1995, what will be the condition of its pro forma 31 December 1995 balance sheet, and how much additional financing will the company require during 1995?
The sales forecast generally bases on sale over the past to ten years.
The first step in the percentage of sales forecast is to isolate those balance sheet items that vary directly with sales. Since RPS has been operating at full capacity, each asset item must increase if the higher level of sales is to be attained. Some assets, such as marketable securities, are not tied directly to operations and hence do not vary directly with sales.
If RPS s assets are to increase, its liabilities and equity must likewise rise - the balance sheet must balance. However, retained earnings will increase, but not in direct proportion the increase in sales. Notes payable, mortgage bonds, and common share will not rise spontaneously with sales.
We can construct a pro forma balance sheet for 31 December 1994, proceeding as outlined in the following paragraphs:
* Step 1. In Table 5-9, Column 1, we express those balance sheet items that vary directly with sales as percentage of 1993 sales. An item such as notes payable that does not automatically vary with sales is designated "not applicable" here.
* Step 2. We multiply these percentages (their fractions, really) by the 750 million projected 1994 sales to obtain the forecast amounts as of 31 December 1994. These amounts are shown in Column 2 of the table.
* Step 3. We simply insert figures for notes payable, mortgage bonds, and common shares from the 31 December 1993 balance sheet. At least one of these accounts will have to be changed later in the analysis. * Step 4. We add the estimated addition to retained earnings for 1994 to the 31 December 1994 balance sheet figure for retained earnings to obtain the 31 December 1994 projected retained earnings. Recall that RPS expects to earn 4 percent on 1994 sales of $750 million, or $30 million, and expects to pay 40 percent of this in dividends to shareholders; thus the dividend payout ratio is 40 percent, and dividends paid will be 0.4($35 million) = $12 million. Therefore, retained earnings for the year are projected to be $30 million - $12 million = $18 million. Adding this $18 million addition to the $48 million beginning retained earnings gives the $66 million projected retained earnings shown in Column 2.
* Step 5. We sum the asset accounts, obtaining a total projected assets figure of $518 million for 1994. We also sum the projected liabilities and equity items to obtain $396 million, the estimate of available funds. Since liabilities and equity must total $518 million, but only $396 million is projected, we have a shortfall of $121 million, which designate additional funds needed (AFN); it will presumable be raised by bank borrowing and/or issuing securities.
* Step 6. RPS can use short-term bank loans (notes payable), mortgage bonds, common shares, or a combination of these securities to make up the shortfall. However, RPS has a contractual agreement with bondholders to keep total debt at or below 50 percent of total assets and also to keep the current ratio at a level of 2.5 or greater. These provisions restrict the financing choice as follows: 1. Restriction on additional debt 2. Restriction on additional current liabilities 3. Common equity requirements
As we see, RPS needs a total of $121 million from external sources. Its existing debt contract limits new debt to $79 million, and only $9 million of that amount can be short-term debt. Thus RPS must plan sell additional common shares in the amount of $43 million to cover its financial requirements. Here is a summary of its projected nonspontaneous external financing:
RPS financial staff can now construct a set of projected, or pro forma, financial statements and then analyses the ratios implied therein. Part I and II of Table 5-10 give abbreviated versions of the financial projected balance sheet and income statement; Part III gives the statement of the balance in financial position; and Part IV gives a few key ratios. We somewhat simplified the forecasting process.