Pro Forma Financial Statements
Sales-based pro forma financial statements is the most commonly used type of pro forma financial statements. These kinds of statements are the result of assumptions and estimates developed by financial analysts and are used to forecast the future performance of a company. Creating a sales-based pro forma financial statement consists of a number of steps. The particular estimation method and the complexities of estimating the individual statement items is not covered here.
Typically, when using a pro forma financial statements approach, it is important to segment information and to create segmented forecasts when the company under consideration has clear business or geographical segments that differ from each other in different respects. Sensitivity analysis or scenario analysis must also be used to estimate a range of possible outcomes and their probabilities where appropriate.
Sales-based pro forma financial statement steps
The steps in developing a sales-based pro forma model are:
- Estimate revenue growth and future expected revenue (using market growth plus market share, trend growth rate, or growth relative to GDP growth).
- Estimate COGS (based on a percentage of sales, or on a more detailed method based on business strategy or competitive environment).
- Estimate SG&A (as either fixed, growing with revenue, or using some other estimation technique).
- Estimate financing costs (using interest rates, debt levels, and the effects of any large anticipated increases or decreases in capital expenditures or anticipated changes in financial structure).
- Estimate income tax expense and cash taxes (using historical effective rates and trends, segment information for different tax jurisdictions, and anticipated growth in high- and low-tax segments).
- Estimate cash taxes taking into account changes in deferred tax items
- Model the balance sheet based on items that flow from the income statement (working capital accounts).
- Use depreciation and capital expenditure (for maintenance and growth) to estimate capital expenditures and net PP&E for the balance sheet
- Use the completed pro forma income statement and balance sheet to construct a pro forma cash flow statement.
Summary
Clearly, estimation methods for each of the items can be simple or very complex. An analyst must always decide when additional or more complex analysis is needed and when additional complexity in the estimation method provides real benefits in terms of improved forecasts and value estimates.