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5.2 Pro Forma Balance Sheet

PLEASE NOTE: This book is currently in draft form; material is not final.

Learning Objectives

1. Analyze a Pro Forma Balance Sheet and its purpose.
2. Complete a Pro Forma Balance Sheet.

Similar to a pro forma income statement, the pro forma balance sheetA projected balance sheet. is a projection of a balance sheet. While the percentage-of-sales method could be used for the balance sheet as well, a more sophisticated and accurate approach would be to analyze each line of the balance sheet. A properly forecasted balance sheet uses best judgement to predict future sales and expenses. For example, our company may need to hold a certain amount of cash to meet basic expenses. Or a company at capacity might need to add assets to continue sales growth. A common size balance sheetA balance sheet with entries expressed as a percentage of total assets., which shows each balance sheet item as a percentage of total assets, may help guide us in making these decisions. This infomation enables an individually tailored and more accurately forecasted balance sheet.

Pet Product’s Forever Inc. has the following balance sheet. They know certain things about their next year which will play a role in determining the pro forma balance sheet.

Figure 5.4 Pet Products Forever Inc. Balance Sheet (Thousands) 2012

Figure 5.5 Pet Products Forever Inc. Common Size Balance Sheet (Thousands) 2012

Pet Products Forever has certain financial goals and knowledge about the upcoming year.

1. From our pro forma income statement, we expect net earnings of \$11 thousand on sales growth of 10%.
2. The company wants to hold at least \$20 thousand in cash.
3. The company’s debt (long-term and notes payable) will remain the same.
4. No new common stock will be issued (common stock will remain the same). \$4 thousand will be paid out in dividends to the shareholders.
5. Accounts receivable should scale with sales.
6. The company has determined that the current level of inventory is too low. They would like to hold \$13 thousand in inventory.
7. Accounts payable should scale with sales.

Given this information we construct the following balance sheet.

Figure 5.6 Pet Products Forever Inc. Pro Forma Balance Sheet First Pass (Thousands) 2013

Note that retained earnings has increased by our earnings less our divindends paid (\$11 thousand − \$4 thousand = \$7 thousand). Since accounts receivable and payable both scale with sales, and sales increased by 10%, each of these has increased by 10% as well.

After our first pass, our balance sheet doesn’t balance! If our total assets are larger than our total liabilities and equity, we need to raise money somehow, either by increasing financing (that is, borrowing more, reducing dividends, or issuing equity) or reducing assets. Smaller total assets means returning cash to our investors (by reducing debt or increasing dividend payout) or parking the cash on our balance sheet (in cash or other short term investments).

Since after the first pass the total assets are smaller, we can choose to increase cash held to balance the books.

Figure 5.7 Pet Products Forever Inc. Pro Forma Balance Sheet Second Pass (Thousands) 2013

Key Takeaways

Pro Forma balance sheets provide a look into a company’s future.

• They can be constructed using percentage changes from the previous year.
• It is more accurate to use last year’s balance sheet and past information to make realistic assumptions about the next year.

Exercises

1. Using the original Pet Products Forever balance sheet from 2012, construct a pro forma balance sheet using the following information:

1. Sales are projected to grow by 5%, causing net earnings of \$10 thousand.
2. The company wants to hold at least \$30 thousand in cash.
3. The firm’s long-term debt will decrease to \$10 thousand.
4. No new common stock will be issued, but \$3 thousand in dividends will be paid to shareholders.
5. Accounts receivable will scale with sales.
6. The company would like to hold \$10 in inventory.
7. The tax rate will remain the same.
8. The note payable will remain the same.
9. Accounts payable will scale with sales.