Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.
In this lesson you'll learn about pro-forma financial statements and how to estimate specific line items on the balance sheet, income statement, and statement of cash flows. We'll also discuss the difference between pro forma and GAAP.
Pro-Forma Financial Statements
Jack is a director of financial analysis for Juicy Hot Dogs (JHD), the largest hot dog chain in the U.S. His boss, the chief financial officer, Susan, privately shares with him that JHD may purchase the second largest hot dog chain, Doggie Dogs. If the acquisition were to be finalized, JHD would be the largest hot dog chain in the world!
Susan tells Jack she needs him to prepare pro-forma financial statements to determine the profitability of the purchase. Pro forma is a forecast or estimate of financial statements. She mentions that following GAAP is not required in preparing pro-forma statements. GAAP is an acronym for generally accepted accounting principles, which are common standards publicly traded companies must follow. GAAP is used to ensure investor confidence. Susan explains to Jack that while she wants the statements to be as accurate as possible, they are to be used internally to make an acquisition decision. Pro-forma statements are created when there's an anticipated change in the company's circumstances.
Jack travels to Doggie Dogs' headquarters to review their financials and create a pro-forma balance sheet, income statement, and statement of cash flows.
Pro-Forma Balance Sheet
Jack meets with a senior accountant who shows him the balance sheet first. A balance sheet is a financial statement that portrays a company's financial position. It's considered a snapshot in time since it's not a consolidation report of weeks, months, or quarters.
The components of a balance sheet are assets, liabilities, and equity. Assets are items the company owns, which include cash, buildings, semi-trucks, and investments. Liabilities are obligations owed to others, such as suppliers. Other liabilities include the loans on the semi-trucks and buildings.
The difference between assets and liabilities is equity. Equity represents shareholder ownership. Shareholders are investors who have purchased stock, or a percentage of the company.
Jack's job is to create a year-end pro-forma balance sheet. He asks the accountant several questions:
• Does Doggie Dogs have any outstanding contracts to purchase assets?
• Do they plan to sell any investments?
• What are their plans to pay off obligations by the end of the year?
• Estimate the last five years of stock purchases in the final quarter of the year.
The answers to these questions will assist Jack in completing a pro-forma balance sheet.
Pro-Forma Income Statement
An income statement shows a company's profitability by taking revenues minus expenses.
Revenues are sales. Revenue on pro-forma statements is calculated based on events such as a competitor going out of business, which will increase sales by 20%, or a new competitor coming on the market, which will decrease sales by 10%. Other factors can affect sales, including seasonality, marketing, customer service, and new product launches.
Expenses are the costs of doing business. Examples of Doggie Dogs' expenses include restaurant workers' wages, utilities, and their cost of goods sold (COGS). Costs of goods sold are the costs a business incurs to purchase the product they are selling. Doggie Dogs does not make hot dogs or buns, they purchase them from a supplier. Therefore, these two costs are listed as COGS. Other expenses include selling, general and administrative costs, utilities, and insurance.
It's important to note that expenses can be fixed or variable. Fixed expenses, such as automobile insurance, do not change based on sales. Whether Doggie Dogs sells $1 million or $100,000, their automobile insurance remains the same. On the other hand, variable expenses change with a change in sales. For example, utilities may increase substantially in the summer for Doggie Dogs since their sales increase due to picnics, family reunions, and vacations.
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Therefore, expenses on an income statement are calculated as a percentage of sales. Jack uses a five-year average of sales and expenses to calculate a base percentage. The five-year average of sales is $1,500,000 and variable expenses are $500,000; therefore variable expenses are 33% ($500,000/$1,500,000) of sales. If Doggie Dogs' sales are expected to increase to $1,750,000, it's safe to assume variable expenses will increase to $577,500 ($1,750,000 * 33%).
Pro-Forma Statement of Cash Flow
Next, Jack reviews Doggie Dogs' statement of cash flow. The statement of cash flow shows how a company uses cash, the inflows and outflows. The statement of cash flow has three main components: operating activities, investing activities, and financing activities.
Purchasing a building with cash is an example of an operating activity; the company has a cash outflow for the purchase. Selling equipment is another operating example. However, the sale is considered an inflow.
Investing activities work in the same manner. If a company purchases stock, they are paying money out and a cash outflow is recorded. If they sold the stock and made a profit, the cash is considered an inflow.
Financing activities includes a mortgage on a building with the monthly payments categorized as an outlay; whereas borrowing money from a financial institution would bring cash into the organization as a cash inflow.
Jack simply asks Doggie Dogs' senior accountant for information pertaining to the future cash inflows and outflows to create a pro-forma cash flow statement. A few weeks later, after Jack has created pro-forma financial statements for Doggie Dogs, he makes a recommendation to purchase the company.
Pro forma is a forecast of financial statements. While GAAP is required to create financial statements for publicly traded companies, pro-forma statements do not need to follow GAAP, as they are used internally or simply to estimate changes.
Pro-forma financial statements are created for balance sheets, income statements, and statement of cash flows.
A balance sheet shows a company's financial position by estimating assets, liabilities, and equity. A pro-forma balance sheet is generated by making assumptions for the purchase or sale of assets, acquiring or paying off liabilities, and stock ownership. An income statement depicts profit by subtracting expenses from revenue. Estimates are created by using a percentage of sales method. Lastly, a pro-forma statement of cash flow estimates the cash inflows and outflows of operating, financing, and investing activities.
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