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5 Building Pro Forma Financial Statements Part 2

Study Note

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39 views8 pages

5 Building Pro Forma Financial Statements Part 2

Study Note

Uploaded by

sanu sayed
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Financial Modeling

Building Pro-Forma Financial Statements


General Guidelines

Professor Iordanis Karagiannidis

© 2010 Iordanis Karagiannidis


Before building the actual model
 Understand the expected uses of the model
 Most financial statement models are structurally similar
 However, they need to be customized for each application
 Collect historical and other data
 At least 3-5 years of financial statement history
 Including explanatory financial statement materials (footnotes)
 Historical data and forecasts on industry and competitors
 Market growth, pricing trends, GDP growth, interest rate trends etc.
 Understand the company’s plans and develop modeling
assumptions
 For example, is the company planning a major expansion?
 Develop assumptions for all items except the plug
 There is no one correct way of making assumptions

© 2010 Iordanis Karagiannidis


Forecasting IS and BS items
 Most items are sales driven (e.g. COGS)
 Can use historical stable relationship with sales
 for example if COGS was around 50% of sales the past 5 years we can
assume that the relationship is fairly stable
 Of course if our analysis indicates that this relationship is going to improve
or worsen in the future we can build this in
 Can use trends (use regression analysis)
 For example, if turnover ratio is improving every year for the past 5 year we
can assume it will continue to improve
 Can locate trends or stable relationships by looking at common-size income
statements
 Always try to confirm the relationships with industry and company data
to decide what numbers to use in the forecast
 Also need to develop financial policy assumptions
 For example, company management might have a plan for debt or equity, have a
target debt ratio in mind, need to hold cash for liquidity purposes etc.

© 2010 Iordanis Karagiannidis


Projecting sales and other revenues
 Sales forecast very important
 Sales = price x units
 Some firms report both, some report volume-related measures
(number of new stores etc.)
 Increase in market share?
 Increase in population?
 Should consider firm-specific and industry-specific factors
 Demand and price elasticity
 Competition
 Should consider economy-wide factors
 Inflation
 Exchange rates
 Summary: Need to understand economic and competitive
industry forces, strategy, quality of accounting and the drivers of
profitability and risk

© 2010 Iordanis Karagiannidis


Projecting operating expenses
 Fixed or Variable?
 Linear relationship to sales or not?
 Yes  use common-size statements
 No  need to figure out the relationship (maybe significant FC)
 Expense as a percentage of sales can change if:
 Expenses change, sales constant
 Sales change, expenses constant
 Both change in the same direction
 Both change in opposite direction
 Need to consider other factors too
 For example, competition and pricing in suppliers industry
 Company’s strategy and plans

© 2010 Iordanis Karagiannidis


Projecting operating assets and
liabilities on the balance sheet
 Need to determine the underlying operating activities that drive
them
 Growth for some asset items (inventory, PPE) leads future sales
growth
 Growth for some asset items (such as AR) may lag sales growth
 Certain operating liabilities will be determined by operating assets
(Inventory purchases will drive accounts payable)
 Certain operating liabilities will be determined by operating
expenses (accrued expenses)

© 2010 Iordanis Karagiannidis


Projecting financial assets
 Does the company want to maintain a particular capital structure?

 Do they want to hold short-term or long-term investments for


future financial purposes?
 Corporate acquisitions, debt retirement, share repurchasing

 Do they want to borrow long-term or short-term?

 How much do they want to pay out?

 Do they want to issue new stock?

© 2010 Iordanis Karagiannidis


References
 Financial Reporting, Financial Statement Analysis, and Valuation,
2011, Wahlen, Baginski and Bradshaw, 7e, South-Western
 Building Financial Models, 2004, John S. Tjia, Mc-Graw Hill.

© 2010 Iordanis Karagiannidis

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