126 PART 1 Introduction to Managerial Finance
LG6 3.7 Evaluation of Pro Forma Statements
It is difficult to forecast the many variables involved in preparing pro forma state-
ments. As a result, investors, lenders, and managers frequently use the techniques
presented in this chapter to make rough estimates of pro forma financial state-
ments. However, it is important to recognize the basic weaknesses of these sim-
plified approaches. The weaknesses lie in two assumptions: (1) that the firm’s
past financial condition is an accurate indicator of its future, and (2) that certain
variables (such as cash, accounts receivable, and inventories) can be forced to
take on certain “desired” values. These assumptions cannot be justified solely on
the basis of their ability to simplify the calculations involved. However, despite
their weaknesses, the simplified approaches to pro forma statement preparation
are likely to remain popular because of their relative simplicity. Eventually, the
use of computers to streamline financial planning will become the norm.
However pro forma statements are prepared, analysts must understand how
to use them to make financial decisions. Both financial managers and lenders can
use pro forma statements to analyze the firm’s inflows and outflows of cash, as
well as its liquidity, activity, debt, profitability, and market value. Various ratios
can be calculated from the pro forma income statement and balance sheet to eval-
uate performance. Cash inflows and outflows can be evaluated by preparing a
pro forma statement of cash flows. After analyzing the pro forma statements, the
financial manager can take steps to adjust planned operations to achieve short-
term financial goals. For example, if projected profits on the pro forma income
statement are too low, a variety of pricing and/or cost-cutting actions might be
initiated. If the projected level of accounts receivable on the pro forma balance
sheet is too high, changes in credit or collection policy may be called for. Pro
forma statements are therefore of great importance in solidifying the firm’s finan-
cial plans for the coming year.Review Questions
3–18 What are the two key weaknesses of the simplified approaches to prepar-
ing pro forma statements?
3–19 What is the financial manager’s objective in evaluating pro forma
statements?SUMMARY
FOCUS ON VALUE
Cash flow, the lifeblood of the firm, is a key determinant of the value of the firm. The finan-
cial manager must plan and manage—create, allocate, conserve, and monitor—the firm’s
cash flow. The goal is to ensure the firm’s solvency by meeting financial obligations in a