CF 2-1A – Pro Forma Statements and EFN – Corporate Finance

Let's take a look at problem 21A. This has us doing pro forma financial statements, just projected financial statements, a really useful skill to have, right, to be able to say, okay, next year, what happens if our sales are up by 10% or 20% or 15% or whatever? What will happen to the rest of our accounts? What will our financial statements look like then and what are the implications of it? So, let's go through for 1A. Liam Company's financial statements are shown below and there we have an income statement and a balance sheet and it says assuming sales are projected to increase by 20% and that all items on the income statement and balance sheet, so all items that we're seeing above will also increase by 20%. Not the greatest assumption, you know, some things will go up by more or less than sales, but this is a good starting point, right, just to learn what financial statements look like with this type of change. Okay, so if our sales are going to go up by 20%, how do we make them increase from 5,000 to a, you know, plus 20%? What does that look like? Well, 5,000, you're going to add 20%, so you're going to add 1,000 to that. The way you do that in terms of a calculator is you go 5,000 times 1.2, right, 120% is 1.2, they're going to be $6,000 next year if they increase by 20%. Costs if they're expected to move with sales, which is a pretty reasonable assumption for most companies, costs go up again by 1.2, they're going to be at 5,400. Sales minus costs and expenses gives us our income before tax, 6,000 minus 5,400 is 600 and you can see this is also a 20% increase from the year before. Taxes are 20% of that, they're going to be 120 and 600 minus 120 is 480. Okay, there we have it, everything has gone up by 20%. Let's look at our balance sheet now if everything goes up by 20%. Current assets going up by 20%, what does that look like? Well, they're going to go up to 1,200, that's 20% more than 1,000. The fixed assets are going to go up to 3,600 and again that's just 20% more, 3,000 times 1.2, so pretty straightforward what we're doing so far, I hope it is anyway. 1,200 plus 3,600 gives us 4,800, there we have it. Our current liability is going up by 20%, 500 plus 20%, well that's 600. Our long-term debt, 2,600 going up by 20%, so multiplied by 1.2 is 3,120 and 900 multiplied by 1.2 is 1,080. Adding this up, hopefully the assets equals liabilities plus equity, hopefully our balance sheet balances 600 plus 3,120 plus 1,080, that gives us 4,800. Yes, indeed, good feeling, our balance sheet does balance. Okay, so we've answered the first part, prepare pro forma statements, we did that. Now, again, how useful is this? How realistic is this? It's a good starting point for us, but in reality, we could be a lot more surgical about this, we could say, oh, our revenues are going to go up 20%, but maybe our costs are only going to go up 15%, because there's a lot of fixed costs or whatever, and we could make various estimates, but it's a useful skill to have. We get to the end and it says, part two here, to compute the amount of the dividend required to balance the statements if dividends are the plug variable. This is often confused by students, so in their beginning, if I get students to project financial statements, they often will plug their shareholder's equity to make a balance sheet balance, like they sort of go, okay, I know what assets are, and I know how they're going to change, I know how liabilities change, but equity, I'm just going to plug and make it work, and that's essentially what we've done, we plug the equity by plugging dividends. Let's think about how equity works, and this is something you need to know. Our beginning equity plus net income, I'm going to say equals just a subtotal minus dividends. Now, I don't need the subtotal, it's just going to help me discuss this, equals our ending equity. Our beginning equity was $900, we're expecting it to go up to 1080, so our beginning equity was $900, we add net income, our net income is 480, so 900 plus 480 gives us $1380. Now, if we did not pay a dividend, then our ending equity should be 1380, but our ending equity isn't 1380, it's 1080, so we must have paid a dividend, because we know our ending equity is 1080, that's known here. Our dividends are the plug variable, well, what's the plug that makes this work? We must have paid, under this scenario, a $300 dividend. Okay, so, to answer the question, it says, compute the amount of the dividend required to balance the statements, if dividends are the plug variable, well, 300 bucks, that would be the dividend. Now, let's look at part three, it says, do the pro forma statements in part one make sense of the dividend payout was 30%, so the company, and remains unchanged, so the company always pays a 30% dividend. Does this work? Well, what is a 30% dividend, it's 30% of net income, that's what we're talking about, so 480 times 30%, 480 times .3, that's 144 dividend, does that work, does that make our statement work? If we plugged in 144 here, would we match, no, we would have higher equity, and our balance sheet would no longer balance, so the question is, do they make sense, no, they don't make sense, if the dividend is only $144, then the pro forma is no longer work, so that's a problem. Out of curiosity, what is our dividend payout ratio at 300, well, it's a $300 dividend, on $480 in net income, 300 divided by 480, that gives us a payout ratio of 62.5%, way higher, double, more than double the 30% payout ratio, so what does this mean in practical matters, it means probably our financial statements are going to look a little bit different from this, because we probably won't pay out a 60% dividend, if we're going to be consistent and pay out a 30% dividend, it means we'll have more cash, more current assets with which to play, right, you can do something, invest in long-term assets, or you can, you know, do something else, but the bottom line is we'd likely have higher than $1,200 in current assets if we paid a smaller than 62% dividend, okay, that's it for Part A, 1, 2, and 3 there, let's move on to Part B, it has us looking at the sort of same set of statements, but doing different things here, slightly different, so it says instead of Part A, assume a 20% increase in sales, so actually that was the same, a dividend rate payout ratio of 40%, so not the 62% or the 30% that we had in the previous version, so just the different scenario here, costs, expenses, current assets, and current liabilities, and net fixed assets will vary directly with sales, okay, so as we're projecting a 20% increase in sales, all of our costs and expenses, current assets, current liabilities, and fixed assets are going to just go up by 20%, long-term debt, I can't cross that out, long-term debt and shareholder's equity don't vary directly with sales, okay, so it's a different task, we've been assigned here, same task, but they've given us different information, let's see if we can solve it, so we'll start with the income statement, and the income statement is identical, because sales, costs, and expenses, that's all that's on an income statement, all go up by 20%, exactly as they did in this previous version, so we're going to prepare the same income statement, so sales up by 20%, so 20% increase here, gives us $6,045,000 times 1.2, $5,400, $500 times 1.2 is $600, and the math work is going down, $100 times 1.2 is $120, and $480 is our number here, $480, okay, so we've done the income statement rather quickly, let's just remember what else goes up, current assets and current liabilities, current assets and current liabilities go up by 20%, so current assets goes to $1,200, current liabilities goes to $600 under this scenario, net fixed assets also goes up by 20%, so $3,000 goes up to $3,600, now this is important, we now know our total assets is $4,800, and something you should be doing immediately if you're pretty confident, and I am pretty confident in that total assets number, write it over here as well, because the balance sheet has to balance, and that's going to become a key to sort of help us solve this problem, that's a piece of the puzzle that you might miss, is that if you know your total assets, or you know your total liabilities and equity, you know the other, because the balance sheet's got to balance, so what are we left with, we don't know our debt, and we don't know our equity, except we have the tools to figure out the equity, because we know the dividend payout ratio is 40%, so let's figure out our equity, our equity starts at $900, we're going to use the same formula as above, let me just remind you what it is, beginning equity plus net income, we subtotal minus dividends to get ending equity, so beginning equity was $900, plus net income, add net income, and our net income is $480, $480, we subtotal, and $900 plus $480 is $1380, we deduct dividends, now we know our dividends, our dividend payout ratio is 40%, and our projected net income is $480, so $480 times 40% will give us our dividend amount, $480 times .4 is $192, that's our dividend, $192, so our ending equity is $1380 minus $192, $1380 minus $192, it's $1,188, okay, so our ending equity is $1,188, oops, put the comma in the wrong spot there, $1,188, so now I know, okay, I'm just missing one number, right, I know my total liabilities and equity is $4,800, I know my current liabilities are $600, I know my equity is $1,188, I just got to plug, my plug variable here is long-term debt, so let's figure it out, now the way we're going to get there is just go $4,800 minus $1,100 minus $600, so $4,800 minus $1,188 minus $600 to get that missing number, the missing number is $3012, so there we have it, this is harder to do, Part B was definitely harder to do, particularly if you've never done it before, but we did it, we need to have $3,000, roughly $3,000 in debt in order to make this thing work, $3,012, so prepare pro forma statements, done, compute external financing needed, that's just saying how much new debt do we need, well, we had $2,600, we're going to need $3,000, so $3,012 minus $2,600, we're going to need $412 of new debt, the external financing needed, the new debt needed is $412, just the additional borrowing, and so again, that's a problem for real businesses, right, they go, wow, if we, everything goes according to plan, I need to borrow $400, you know, in this case, let's pretend it's all in thousands, $400,000, you better make sure you've got a bank willing to lend you the $400,000, or your plan goes poof, up in smoke, so that's why EFN is really important, because you run out of money, and you're dead as a company, right, companies get in crunches if they are unable to borrow when they need to borrow, okay, I don't know what's just happened here, there we go, I was just going to click over to this screen to say if you made it to the end of the video, I hope you liked it, I hope it was helpful, and if it was helpful, and if you did like it, please don't be shy, hitting those buttons helps me out a whole heck of a lot, have a great day, thanks for watching, bye for now.