Cash Flow and Financial Models

Pro-Forma Financial Statements

Created by David Moore, PhD

Key Concepts

  1. Free Cash Flow
  2. Pro-forma Financial Statements
    • Percentage of Sales Approach
  3. External Financing and Growth

Free Cash Flow

Cash flow that an enterprise produces that is "free" to be used to service the securities (debt and equity) that a firm issues to finance its operations

$FCFF=EBIT*(1-T_C)+Depreciation-Investment$

  • Investment
    • Change in net working capital
    • CAPEX

Financial Models

Project future financial status of company

  • Used in planning (short or long-term)
  • Influenced by decisions in:
    • Capital Budgeting
    • Capital Structure
    • Payout (dividend) Policy
    • Net Working Capital

The Ingredients

Percentage of Sales Approach

  • Sales Forecast
  • Pro-forma Statements
  • Asset Requirements
  • Financial Requirements
  • Plug Variable
  • Economic Assumptions

Income Statement

  • Most items vary with Sales
  • Depreciation and interest expense are often exceptions
  • Dividends are a management decision not directly varying with Sales

Balance Sheet

  • Assets vary with Sales (Standard Assumption)
  • Accounts payable varies with Sales
  • Any financing is a capital structure decision (notes payable,long-term debt)
  • Retained earnings depends on dividend decision

External Financing Needed (EFN)

The amount needed to balance

  • Can be seen directly on pro-forma by taking A-(L+E)
  • Alternatively:
    $EFN=\frac{Assets}{Sales}x \Delta Sales - \frac{Spontaneous Liabilities}{Sales}x\Delta Sales$
    $- Profit Margin x Proj. Sales x (1-d)$

  • d=dividend payout

Growth

Investment and Return are required for growth

$Internal Growth Rate=\frac{ROA x b}{1-ROA x b}$

$Sustainable Growth Rate=\frac{ROE x b}{1-ROE x b}$

$b=retention ratio=\frac{Additions To RE}{Net Income}$

Pro Forma Financial Statement Example

SIC

Video Walkthrough

Key Learning Outcomes

  • Free cash flows
  • Pro-forma financial statement
  • Growth