© 2000 John Petroff
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© 2000 John Petroff |
H- Pro forma liabilities and equity
To be able to predict the financial results of a company it is necessary to construct a pro forma credit side of the balance sheet because several expense amounts are dependent on it: most specifically the interest expense amount.
The starting point is naturally the previous balance sheet. The capital budgeting (if available) or writings in the annual report on management's intentions for the coming year should give an indication of the new financing that will be necessary for next year. How this financing is broken down between retained earnings, new shares, bonds and short term financing can be in part deduced from the statement of cash flows. The final projection cannot be made until the profit for the coming year gives an indication of the size of retained earnings. But the proportions between the various financing sources can be set based on what the company has used in the past and what new marketing and production plans affect the optimum financial leverage the firm should have. This guides the overall size of current liabilities, long term debt and equity.
The next step is to refine the rough estimates. Long term debt can be reduced by the amount that mature next year, and incremented by the long term debt needed to finance new projects. In current liabilities, trade credit can be proportional to the projected needed purchases, accruals and other current obligations can increase proportionately to working capital, likewise for the bank credit. With the estimated average cost of capital of short term and long term debt from the previous year or from notes to financial statements (adjusted for anticipated changes in interest rates) the interest expense is calculated. After entering it in the pro forma income statement, and determining the profits for the year (as described in next chapter), the amount of retained earnings is projected based on projected dividend distribution.
With the amount of retained earnings, the final touches can be put to the forecast. The need to issue new share can be assessed from whether the increment in retained earnings is sufficient to complement the long term and short term debt sourcing, given the desirable level of financial leverage of the firm. If new shares need not be issued and it appears that there would be too much funds, cash can be increased and/or bank credit can be cut. If, on the contrary, funds appear to be short, cash can be cut and/or bank credit can be increased. After cash and bank credit seem in line with planned strategy and prior year patterns, the pro forma liabilities and equities are completed.
See review questions Q-12H.1 through Q-12H.3.
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