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Lecture 5 - Assignment

By Philip Lewis,2014-07-09 15:01
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Lecture 5 - Assignment ...

Lecture 05 Pro Forma Financial Statements

Financial statements deal with past decisions of firm. In this lecture we want to look at

    projecting operating performance and expected financial requirements with which to

    support future activities. Also, outside lenders need this kind of information for making

    lending decisions.

    We will concentrate on two statements, the pro forma balance sheet and income

    statement. The pro forma statements are projected financial statements that are based on

    a set of assumptions about a company’s performance and the funding requirements.

In developing pro forma statements it is important first to determine the critical and non-

    critical assumptions. Use industry projections, internal projections and judgment to

    determine the appropriate values of items.

Pro Forma Income Statement

The pro forma income statement represents a broad operational outlook for the firm or

    project. It is usually prepared first since the items there would then be used to construct

    the yearly balance sheet. Estimates and projections must be made about:

    ? Sales

    ? COGS

    ? Selling Expenses

    ? General and Administrative Expenses

    ? Interest Expenses (if borrowings are contemplated)

Pro Forma Balance Sheet

After the income statement is developed, the balance sheet can be developed using some

    of the information derived from the income statement. Here also, specific assumptions

    must be made about each account.

It is sometimes useful to associate balance sheet items with sales:

    ? Accounts Receivables = days AR x Average Daily Sales

    ? Inventory = COGS / Inventory Turn-over

    ? Accounts Payable = Days AP x Average Daily Purchases where average daily

    purchases = (COGS + Change in Inventory) / 365

    Capital expenditure items will come from the capital budget, so:

    ? Gross Fixed Assets (GFA) = GFA + Capital Expenditure (t-1)

    ? Accumulated Depreciation = Acc. Dep + Depreciation Expenses. (t-1)

Payments on debt can also be obtained from the capital budget.

    ? Long Term Debt (LTD) = LTD + New LTD Current Maturity LTD (t-1)

    ? Term Notes (TN) = TN + New TN Current maturity TN (t-1)

    ? Retained Earnings (RE) = RE + NI Dividends (past)

     + New Stock Issues. ? Common Stock = CS(past)

Example:

SWTC wants to start a new business that sells traditional craft and furniture. They have

    arranged commitments from local artisans to supply the furniture and art objects.

They have found a location for the store. The building will cost $250,000 to purchase. It

    will require an extra $45,000 to renovate.

The owners have $235,000 from their savings that they are planning to commit to the

    business. They will also get a $90,000 loan from a relative. The repayment on the loan

    is not expected to begin for five years. The owners estimate that they will need $130,000

    in inventory to start the business and will pay for the inventory with cash. They also

    estimate that they will need a minimum cash balance of $20,000 to conduct day-to-day

    operations and pay bills.

The owners believe that the purchase and renovations to the building, and the purchase of

    inventory will all be completed by June 30, 2004.

    The other assumptions are as follows:

    ? Sales are expected to be lower through 2004 because of SWTC’s newness and it

    takes time for any firm to establish market presence. Sales are expected to grow

    significantly in 2005 and 2006 with lower growth rates in 2007. Sales are

    expected to be $275,000 for the final six months of 2004, and $675,000, $800,000,

    and $900,000 during the three full years of operations (2005, 2006, and 2007).

    Sales are expected to level off at $900,000 after 2007.

    ? Based on agreements and orders, it is expected that cost of goods sold will

    average 63 percent of sales.

    ? General and administrative expenses are expected to be $70,000 for the six

    months in 2004, increase to $100,000 in 2005, and level off at $120,000 from

    2006 on. We assume that interest expenses are included in operational expenses.

    ? Selling expenses are expected at 12 percent of sales. However SWTC will

    undertake a marketing promotion program when the business opens that will cost

    $30,000 in 2004 only.

    ? SWTC will use 10-year straight line depreciation for the building.

    ? SWTC will have an effective tax rate of 34 percent.

    ? A significant portion of the business is expected to be on credit such that SWTC

    will carry about 48 days of accounts receivables. Based on the type of business

    they are entering, SWTC expects to turn their inventory over three times a year.

    ? Based on negotiations with their craftsmen, supplies, and other wholesale

    distributors, they estimate that they can count on about 28 days of accounts

    payable to help finance the business.

SWTC wants to go to a bank for a loan. They need to prepare projected financial

    statements for the company to show if the company can make profits to pay back any

    loans. It is also important to know precisely how much will be needed in loans from the

    bank to open the doors and to help finance the initial years of business.

    ? Prepare an opening day balance sheet and determine how much financing will be

    needed to open the doors for business in July of 2004.

    ? Prepare pro forma balance sheets and income statements for 2004, 2005, 2006,

    and 2007. Show if additional financing will be needed. If so, how much? Assume

    that borrowing needs will equal the difference between projected assets, and

    liabilities plus equity

Key Questions

How much will be needed to open the doors?

Pro Forma Balance Sheet as of 06/31/2004

Cash 20,000

    Accounts Receivables 0

    Inventory 130,000

Gross Fixed Assets 295,000

    Less Accumulated Depreciation 0

    Net Plant and Equipment 295,000

    Total Assets 445,000

Accounts Payables 0

    Notes Payables 90,000

    Equity 235,000

Total Liabilities and Equity 325,000

Financing Needed (445,000 -325,000) 120,000

Summary of Assumptions

COGS 63 % of Sales

    Days AR 48 Days

    Inventory Turnover 3 times

    Days AP 28 Days

    Selling Expenses 12 % of Sales

    Depreciation Straight Line

Tax Rate 34 %

Year 2004 2005 2006 2007+

    Sales Projections 275,000 675,000 800,000 900,000 G and A 70,000 100,000 120,000 120,000 Other Expenses 30,000 0 0 0

Pro Forma Income Statement 12/31/2004

Sales 275,000

    COGS (.63 of Sales) (173,250)

    Gross Margin 101,750

Selling (12 of Sales) (33,000)

    G and A (70,000)

    Depreciation (.10 x 295,000)/2 (14,750) Other (30,000)

    Total Operating Expenses (147,750)

EBT (46,000)

    Taxes 0

    NI (46,000)

Taxable Income (46,000)

Pro Forma Balance Sheet 12/31/2004

Cash 20,000

    AR (1507 x 48) 72,336

    Inventory (.63(275,000)) / (3/2) 115,500

Building 295,000

    Less Acc. Depreciation (14,750)

Total Assets 488,086

    AP ((173,250 -14,500) /182.5) x 28 24,356 Notes Payable 90,000

    Equity (235,000 46,000) 189,000

Total Liabilities + Equity 303,356

Financing Needs (488,086 303,356) 184,730

Total Liabilities and Equity with New financing 488,086

    Change in loan Needs (184,730 120,000) 64,730

Assignment:

    Please complete the income statements and balance sheets for 2005, 2006 and 2007.

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