W e e k 1 – F o r e c a s t i n g F i n a n c i a l S t a t e m e n t s
P R O F O R M A S TAT E M E N T S
In finance, decisions are made looking into the future, that is, financial decisions are inherently forward looking (eg current asset values reflect future cash flows).
Pro forma financial analysis is the current state-of-the-art tool to forecast the future status of a company (or any asset), and is designed to help managers formulate expectations about the future based on information available now.
Pro form statements are commonly prepared ahead of a major planned transaction or events such as a corporate merger, acquisition or takeover, adoption of a new project (capital budgeting), or restructuring of debt or equity (capital structure).
Pro forma statements are typically used by:
Corporate managers, for project analysis, to forecast future financial needs, and to determine whether the firm’s anticipated performance is in line with the firm’s own general targets and investor expectations.
Sell side financial analysts, working as advisors for project financing, firm valuations pre-IPO and pre-SEO (seasoned equity offering, new equity issue by an already public company), and M&A.
Buy side financial analysts, to forecast future earnings, assess stock prices, and make buy/sell recommendations.
The value of a firm is determined by the size, timing and risk of its expected future free cash flows. We may find an estimation of the firm’s value by projecting the financial statements which in turn can be used to calculate expected future free cash flows.
S T E P S I N P R O F O R M A S TAT E M E N T S
Forecast future sales. Everything else will “trickle down” from sales.
Forecast future operating ratios, these are our primary assumptions for the model. These ratios form the basis for projections of many items in the statements.
Build the model, building the projected income statement and balance sheet.
Analyse the model for correctness, robustness checks, performance analysis, sensitivity analysis, scenario analysis, and risk analysis.
F O R E C A S T I N G S A L E S
There are three main ways to forecast the sales growth rate using historical data:
Compound/geometric growth rate, a rearrangement of the future value formula, and is predicted from two selected past sales values (ie salet+n and salet are past sales values that you select, though generally n will be between five and ten years):
= 1 + × Rearranges to:
= − 1
Arithmetic growth rate, taking the average of the growth rates of every period, n-periods back (where n is selected by you):
= ∑
Given the nature of compounding and simple growth rates (ie geometric and arithmetic growth rate), the arithmetic growth rate will always be larger than the geometric growth rate unless every period across n-periods has the same growth rate (in which case arithmetic and geometric growth rate calculations will net the same result).
