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FORECASTING FINANCIAL STATEMENTS: PROFORMA ANALYSIS
Roger Clarke and Grant McQueen
August 2001
ABSTRACT
This teaching note explains why and how managers project financial statements into the future. The note is
designed for an introduction to corporate finance class. The note prepares students for either a case such as
Clarkson Lumber or a real-word project in which proforma statements are needed. This note explains how
to build a proforma balance sheet and intentionally does not include a complete proforma income statement
so that the students will have to demonstrate some ingenuity when doing the follow-on case or project. The
note is a nice supplement to both the advance and remedial corporate finance text books. The more
advanced books (e.g., Ross, Westerfield, and Jaffe) typically give short shrift to the topic of forecasting and
the more remedial text books (e.g., Block and Hirt) typically build the forecasted statements presupposing
the manager knows production projections (e.g. the type, number, and price of units to be bought, produced,
and sold).
Roger Clark is with Analytic-TSA Global Asset Management and an Adjunct Professor in the Marriott
School at Brigham Young University. Grant McQueen is the William Edwards Professor of Finance in the
Marriott School at Brigham Young University. The authors thank colleges at BYU and ASU and the
research assistance and students for their contributions. Send correspondence to Grant McQueen, 671
TNRB, Marriott School, Brigham Young University, Provo UT 84602. email: grant_mcqueen@byu.edu.
FORECASTING FINANCIAL STATEMENTS: PROFORMA ANALYSIS
I INTRODUCTION
Forecasting a firm's financial statements can help both financial managers and general managers.
Proforma statements help the financial manager plan the firm's financial needs. With an estimate of future
income statement and balance sheet accounts, a manager can tell how much financing might be needed, and
when it might be needed. Thus, one intent of proforma analysis is to forecast a firm's financial statements
under some specific conditions. Since total assets must equal the sum of total liabilities and owner's equity,
any imbalance will require management action. Having forecasted the amount and timing of the imbalance,
a financial manager can arrange for financing (such as bank loans or stock offerings) or investment (such as
marketable securities) long before the need becomes critical.
Proforma statements help general managers in overall planning (employment and inventory levels,
for example) and problem solving. As forecasts are developed, a manager can analyze the results to identify
potential trouble spots and plan accordingly. Finding problems and trying out solutions on paper, months in
advance, is much preferred to learning about the problem first hand in real time. Similarly, by “seeing” into
the future with proforma statements, a manager can anticipate opportunities and prepare to exploit them long
before the window of opportunity begins to close. In addition to being a planning tool, proforma statements,
in tandem with actual results, can be used to evaluate performance and make midstream corrections.
Variance analysis, a comparison of the plan with actual performance, helps a manager analyze firm
performance during the budget period, gauge strengths and weaknesses, and make interim adjustments to the
plan.
The accuracy of proforma statements is limited by the validity of the assumptions used in creating
them. Often a series of statements is developed by making different assumptions about sales and about the
relationship between sales and the balance sheet accounts. This is called a sensitivity analysis. The resulting
set of statements suggests the most likely outcomes for the firm and a range of financing needs. After
building a proforma balance sheet based on expected sales, a manager can then use sensitivity analyses to
answer questions such as how the company's financial needs will change if sales are 10 percent below their
expected level, etc.
Proforma balance sheets are created by forecasting the individual account balances at a future date
and then aggregating them into a financial statement format. Account balances are forecasted by identifying
the forces that influence them and projecting how the accounts will be influenced in the future by such
forces. Sales, company policy, and restrictive debt covenants are often significant forces.1
In this teaching note, a hypothetical firm is used to illustrate the proforma process. Three years of
historical data, 1996 to 1998, are given for the hypothetical firm. Then, based on this historical data, a
proforma balance sheet for 1999 is developed based on sales forecast for 1999 along with company policies
and constraints.
1Before agreeing to a loan, lenders often require borrows to abide by restrictive covenants.
For example, a bank could
require that a business keep its debt to asset ratio below 45 percent, its current ratio above 1.3, and its dividend payout ratio below
25 percent. Breaking a covenant “triggers” a default and the lender’s right to call the loan. Although banks pull the “trigger,” they
seldom call the loan. Doing so often results in bankruptcy for the company, bad publicity for the bank, and costly legal bills.
However, the trigger forces the borrower to return to the bargaining table where the lender can demand a plan for corrective
action, a higher interest rate, more collateral and/or extra covenants.
II SALES FORECAST
The first step in preparing proforma financial statements is to forecast sales. Sales normally
influence the current asset and current liability account balances. For example: as sales increase, the firm
will generally need to carry more inventory and will have a larger accounts receivable balance. Retained
earnings are also tied to sales through the profit margin and dividend payout ratio. Although difficult,
forecasting sales is essential. Sales typically depend on the industry, the economy, the season, and many
other factors.
Industry: In a generic sense, the two main variables in sales revenue are unit price and volume.
These two variables usually have a reciprocal relationship (i.e., a typical demand curve). Therefore, a
statement that, "unit demand will increase by 20 percent over the next five years" need not mean that sales
revenues (unit price times volume) will increase by the same amount over that time period.
An industry that is restructuring may dramatically shift market share among its participants. Sales
forecasters need to identify important trends and quantify their impact on the company's business.
Economy: Economic business cycles (expansions and recessions) can have a dramatic influence on
some companies, exacerbating the forecasting problem. Cyclicity not only affects the level of sales, but also
may change the relationship between sales and the balance sheet accounts. Industries that require a great
deal of capital investment tend to add capacity in large chunks. Unit prices rise and fall depending on
whether there is currently a shortage or surplus of capacity in the industry. Thus, the proforma techniques
(introduced below) mus...