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5.3 Assessment of Pro Forma Statements

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

Learning Objective

  1. Use pro forma statements to analyze a business.

Pro forma statements are to be tools to help a company plan for the future. They are only as good as the assumptions upon which they are constructed.

Our analysis has been straightforward and simple but it can get more complex. Companies can change many of the other variables found on their income statements and balance sheets. Companies determine their dividend policy (which influences retained earnings) and they can influence their level of debt (through their capital structure decisions which influences their interest expense) as well as their common stock.

Now we have constructed our pro forma statements. But how accurate are they? What’s the probabilty that our pro forma will correctly depict our company’s future? To answer this question, pro formas can be analyzed using scenario analysis, which we cover in more detail in chapter 13. Companies can analyze best, worst, and most likely case scenarios by creating sets of pro formas with different underlying assumptions. This might seem like a lot of work, but spreadsheets can make these calculations fairly easily.

Pet Products Forever estimates that their most likely case is increase in sales of 10%. Their best case would be an increase of 20% and their worst case would be an increase of 2%. Remember that COGS are % of sales and SG&A are % of sales.

Figure 5.8 Pet Products Forever Inc. Pro Forma Income Statements (Thousands) 2013

The best case results in net earnings of $13 thousand, while our worst outcome is $9.4 thousand. The company is still doing well, even under the worst case scenario. Not a bad result!

Key Takeaways

  • Understand the assumptions behind the pro forma statements.
  • Analyze the financial statements taking risk into account and look at a best, worst and most likely case scenario.

Exercises

  1. Why would we be interested in risk with regard to pro forma statements?

  2. Analyze the following pro forma statement using the percent of sales method under best case and worst case scenarios given below.

    Sales are $100,000, COGS is $43,000, SG&A is $22,000. Depreciation is $10,000 and tax rate is 40%.