Financial Modeling and Pro Forma Analysis PDF

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Summary

Understanding the goals of long-term financial planning, the percent sales method, forecasting for planned expansion and the value of expansion....

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Financial Modeling and Pro Forma Analysis What are the Goals of Long-Term Financial Planning?

-Establishing a financial model to forecast the financial statements and free cash flows of a firm allows the financial manager to: - Identify important linkages. -Analyze the impact of potential business plans. -Plan for future funding needs.

Forecasting Financial Statements: The Percent of Sales Method

-One common approach to forecasting is the percent of sales approach, where you assume that costs, working capital, and total assets will remain a fixed percent of sales as sales grow. -A pro forma income statement projects the firm’s earnings under a given set of hypothetical assumptions. -A pro forma balance sheet projects the firm’s assets, liabilities, and equity under the same assumptions used to construct the pro forma income statement. -Forecasting the balance sheet with the percent of sales method requires two passes: -The first pass reveals by how much equity and liabilities would fall short of the amount needed to finance the expected growth in assets. -In the second pass, the pro forma balance sheet shows the necessary financing from the planned sources and is in balance.

Forecasting a Planned Expansion

-An improvement over the percent of sales method is to forecast the firm’s working capital and capital investment, along with planned financing of those investments directly. -Such a financial model will have the correct timing of external financing and capital investment so that we can estimate the firm’s future free cash flows.

Growth and Firm Value -Two common concepts are internal growth rate and sustainable growth rate.

Financial Modeling and Pro Forma Analysis -The internal growth rate identifies the maximum rate at which the firm can grow without external financing:

-The sustainable growth rate identifies the maximum rate at which the firm can grow if it wants to keep its D/E ratio constant without any new equity financing:

-Neither the internal growth rate nor the sustainable growth rate indicates whether planned growth is good or bad. Only an NPV analysis can tell us whether the contemplated growth will increase or decrease the value of the firm.

Valuing the Expansion

-In addition to forecasting cash flows for a few years, we need to estimate the firm’s continuation value at the end of the forecast horizon. -One method of estimating the continuation value is to use a valuation multiple based on comparable firms. -Given the forecasted cash flows and an estimate of the cost of capital, the final step is to combine these inputs to estimate the value of the firm based on the business plan. We can compare this to the value of the firm without the new plan to determine whether to implement the plan.

THINGS to Think About What is the purpose of long-term forecasting? What are the advantages and disadvantages of the percent of sales method? What is gained by forecasting capital expenditures and external financing specifically? What can the sustainable growth rate tell a financial manager and what can it not tell? How can the financial manager use the long-term forecast to decide on adopting a new business plan?...