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Part 2
Financial Planning and Projected Financial Statements-
A Simplistic Approach

In the previous discussion, we have seen the complex process of short-term planning and
preparation of various budgets and pro forma financial statements. The example that we took and
worked upon did explain the entire process thoroughly. Undoubtedly, the entire process is very
complex, cumbersome and time consuming. In order to ease the entire process and make things
simple, it is advised not to go for detailed budget preparations but to go for profit planning through
pro forma financial statements. A very simple approach to the preparation of pro forma financial
statements is based on the belief that the financial relationships between various financial items, as
reflected in the firm’s past financial statements, will not change in the coming period. Under this
approach, for preparing the pro forma financial statements, we need two inputs: (1) financial
statements of the preceding year and (2) the sales forecast for the coming year. On the basis of the
preceding year financial statements, we calculate the ratio relationship between different key items
and use them to project the figures for the next year. Based on these projected figures we prepare
the pro forma financial statements.

Example:
The income statement of ABC Ltd for the year 2019 is as follows:
Rs. Rs.
Sales Revenue:
2,000 units of Model X @ Rs. 100 each 2,00,000
3,000 units of Model Y @ Rs. 150 each 4,50,000 6,50,000

Less: Cost of goods Sold

Labour 97,500
Material A (Purchase) 65,000
Material B (Purchase) 32,500
Overhead 1,95,000 3,90,000

Gross Profit 2,60,000

Less: Operating Expenses 65,000

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Operating Profit 1,95,000

Less: Interest Expenses 32,500

Net Profit Before Taxes 1,62,500

Less: Taxes (0.20 X 1,62,500 = 32,500) 32,500

Net Profit After Taxes 1,30,000

Less: Equity Share Dividend 60,000

Retained Earnings 70,000

Balance Sheet of ABC Ltd as on 31 March 2019

Particulars Rs. Rs.
Equity and Liabilities
Shareholders’ Fund:
Equity Share Capital 2,50,000
Reserves and Surplus (41,150 old + 70,000 of the
1,11,500 3,61,500
year 2019 = 1,11,150)

Non Current Liabilities: Long-term Debt 1,00,000

Current Liabilities
Accounts Payable 45,500
Taxes Payable 1,950
Notes Payable 53,950
Other Current Liabilities 22,100 1,23,500

Total Liabilities and Stakeholders’ Equity 5,85,000

Non-Current Assets:
Net Fixed Assets 3,31,500

Current Assets:
Cash 39,000
Marketable Securities 26,000
Accounts receivables 84,500
Inventories 1,04,000 2,53,500

Total Assets 5,85,000

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The income statement shows that the ABC Ltd had a total sales of Rs. 6,50,000, total cost of
goods sold of Rs. 3,90,000, gross profit of Rs. 2,60,000, net profit before taxes of Rs. 1,62,500, and
net profit after taxes of Rs. 1,30,000. The company has paid Rs. 60,000 as cash dividends leaving
Rs. 70,000 to be transferred to retained earnings.

Sales Forecast
We know that the key input for preparing the pro forma financial statements is the sales
forecast. ABC Ltd.’s sales forecast for the coming year is given as under:
Unit Sales
Model X 3,000 Units
Model Y 4,500 Units
Total 7,500 Units
Sales in Rs.
Model X Rs. 140 per Unit (3,000 X 140) 4,20,000
Model Y Rs. 210 per Unit (4,500 X 210) 9,45,000
Total Sales 13,65,000

The sales forecast shows that the unit sale price has gone up from Rs. 100 to Rs. 140 for
model X and from Rs. 150 to Rs. 210 for model Y. The increase in forecasted selling price is 40%
over the previous year’s prices. The forecast team and the management believe that this increase in
selling price is necessary to earn the targeted profit after covering the anticipated increases in costs.

Preparing the Pro Forma Income Statement:

A very simple method of preparing a pro forma income statement is the percent-of-sales
method. Under this method, first of all the sales figures are forecasted. Then after, a ratio
relationship is ascertained between previous year sales and other items of income statement of
previous year. Now using this ratio, various income statement items are projected in relation to
projected sales. Let us now apply the same to our example of ABC Ltd.
Using the figures from the previous year income statement of the ABC Ltd., we now
calculate the key ratios/percentages as follows:

Cost of Goods Sold 3,90,000

= = 60%
Sales 6,50,000
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Operating Expenses 65,000

= = 10%
Sales 6,50,000

Interest Expenses 32,500

= = 5%
Sales 6,50,000

Let us now apply the above ratios/percentages to the forecasted sales of Rs. 13,65,000 for
the coming year and prepare our pro forma income statement.

Pro Forma Income Statement for the Year 2020

Sales Revenue:
3,000 units of Model X @ Rs. 140 each 4,20,000
4,500 units of Model Y @ Rs. 210 each 9,45,000 13,65,000

Less: Cost of goods Sold (60% of forecasted Sales of 13,65,000)

Labour (15% of forecasted Sales of 13,65,000) 2,04,750
Material A (10% of forecasted Sales of 13,65,000) 1,36,500
Material B (5% of forecasted Sales of 13,65,000) 68,250
Overhead (30% of forecasted Sales of 13,65,000) 4,09,500 8,19,000

Gross Profit 5,46,000

Less: Operating Expenses (10% of forecasted Sales 13,65,000) 1,36,500

Operating Profit 4,09,500

Less: Interest Expenses (5% of forecasted Sales 13,65,000) 68,250

Net Profit Before Taxes 3,41,250

Less: Taxes (0.20 X 3,41,250 = 68,250) 68,250

Net Profit After Taxes 2,73,000

Less: Equity Share Dividend (Same as previous year) 60,000

Retained Earnings 2,13,000

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In the preparation of pro forma income statement for the year 2020, we have assumed that
the company will pay the same dividend of Rs. 60,000 to equity shareholders as it paid in the
preceding year. After paying the dividend of Rs. 60,000, the remainder after tax profit of Rs.
2,13,000 will be the contribution to retained earnings. When we compare the retained earnings of
Rs. 70,000 of the year 2019 with the planned retained earnings of Rs. 2,13,000 of the year 2020, we
find a 204.29% increase in the same.

Unfolding and Resolving the Issue of Types of Costs and Leverage Advantage:
The method that we have used to prepare the pro forma income statement suffers with a
problem of assuming all costs as variable costs. It assumes that for a given percentage increase in
sales, the cost will also increase by the same percentage. In our example, sale is expected to
increase from Rs. 6,50,000 in the year 2019 to Rs. 13,65,000 in the year 2020. The forecasted sale
for the year 2020 is higher by 110 percent over the sales of the year 2019. When we project the cost
of goods sold, operating cost and interest expenses exactly by the same percentage that they had
with sales in the preceding year, we automatically assume that all costs are variable and they all
behave in the similar ways. This implies that when sale is increasing by 110%, different costs will
also increase by 110%. This is evident when we find that cost of goods sold has increased from Rs.
3,90,000 in 2019 to 8,19,000 in 2020 (a 110% increase), operating cost has increased from Rs.
65,000 in 2019 to 1,36,500 in 2020 (a 110% increase) and interest expense has increased from Rs.
32,500 in 2019 to 68,250 in 2020 (a 110% increase). This assumption applies to net profit before
taxes also as it has increased by 110% (Rs. 1,62,500 in 2019 to Rs. 3,41,250 projected for 2020).
This approach is not correct. The fallacy of this approach is that it assumes that there is no fixed
cost (operating fixed cost and financial fixed cost) and therefore the business will not get the
advantage of operating leverage and financial leverage (benefits resulting from fixed costs) when
sales are increasing.
We know that the use of fixed operating cost generates “operating leverage advantage” and
use of fixed financial cost generates “financial leverage advantage”. We have discussed the leverage
in greater detail in a separate chapter. Here, what we have to recognize is that when sales of the
business increase, the operating leverage causes a more than proportionate increase in earnings
before interest and tax. Similarly, financial leverage causes a more than proportionate increase in
earnings per share (EPS) when EBIT of the company increases. It is so because the fixed costs of
the business do not change when sales increase. At the same time, with the increase in sales,
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contribution increases, which then results in increased profits. This is known as the leverage
advantage. But remember that it works in reverse direction also. Since the fixed costs of the
business do not change, therefore, when sales decline, contribution declines, which then lowers the
profit. Given this behavior of leverage, when sale is increasing and we prepare the pro forma
income statement using the past cost ratios or percentages, we end up understating the profit.
Similarly, when sale is decreasing and we prepare the pro forma income statement using the past
cost ratios or percentages, we end up overstating the profit. This problem may be resolved if we
calculate the ratios by breaking down the historical costs into fixed cost and variable cost
components. Further, instead of using the simple ratio relationship, we should use the regression
analysis to past cost data as they relate to past sales so as to develop equations which recognize the
fixed and variable nature of each cost. These equations could then be used when we prepare the pro
forma income statement from the sales forecast. This is usually done using the statistical software
programs on computers. In practice, businesses segregate costs and expenses into fixed and variable
components on the basis of nature of costs and expenses. Then, using the ratio relationship between
variable cost and sales in the past year, the variable costs are projected for the next year for
preparing the pro forma income statement. This method is widely used for preparing the pro forma
income statement. Let us illustrate and understand this by modifying our previous example.

Example:
Let us now assume in our earlier example that fifty percent of the various manufacturing
costs and operating expenses are fixed and the rest are variable in nature in the year 2019.
Given the above modification, the actual income statement for the year 2019 and the pro
forma income statement for the year 2020 are presented as follows:
ABC Ltd’s Actual Income Statement for the Year 2019 and Pro Forma Income
Statement for the Year 2020
(On the basis of costs and expenses broken into fixed and variable cost components)
2019 2020
Actual Pro Forma
Rs. Rs.
Sales Revenue: 6,50,000 13,65,000

Less: Cost of Goods Sold

1,95,000 1,95,000
Fixed Cost a
a 1,95,000 4,09,500
Variable Cost
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Gross Profit 2,60,000 7,60,500

Less: Operating Expenses:

32,500 32,500
Fixed Expenses b
b 32,500 68,250
Variable Expenses (0.05 X Sales)

Operating Profit 1,95,000 6,59,750

Less: Interest Expenses 32,500 32,500

Net Profit Before Taxes 1,62,500 6,27,250

Less: Taxes
Year 2003 (0.20 X 1,62,500 = 32,500) 32,500 1,25,450
Year 2004 (0.20 X 6,27,250 = 1,25,450)

Net Profit After Taxes 1,30,000 5,01,800

a
In cost of goods sold of Rs. 3,90,000, the fixed cost is fifty percent, i.e., Rs. 1,95,000. The
remainder Rs. 1,95,000 is variable cost component. This is 30% of sales. Therefore, the projected
variable cost component in cost of goods sold in the year 2020 will be 30% of projected sales of the
year 2020. (30% of 13,65,000 = 4,09,500).
b
In total operating expenses of Rs. 65,000, fifty percent expenses amounting to Rs. 32,500 are
fixed. Therefore, the remainder expenses of Rs. 32,500 constitute the variable cost component in the
year 2019. This is 5% of sales of the year 2019. Therefore, the projected variable component in
operating expenses will be 5% of projected sales of the year 2020. (5% of 13,65,000 = 68,250).

From the above example, it is clear that preparing the projected income statement by
breaking the costs and expenses into fixed and variable components is logical and therefore it gives
more accurate projected profit. The projected net profit before taxes, as shown by the pro forma
income statement for the year 2020 that we prepared assuming that all costs and expenses are
variable, we find that it is equal to 25 percent of projected sales of the year 2020. When we look to
the actual income statement of the year 2019, the net profit before tax is Rs. 1,62,500 which is 25
percent of the sales of the year 2019. Thus, we find that the ratio or percentage method that we have
used to prepare the pro forma income statement suffers with a problem of assuming that fixed costs
are absent and all costs are variable costs. Therefore, under the ratio or percentage method the
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business fails to get the advantage of operating leverage and financial leverage (benefits resulting
from fixed costs) when sales are increasing. This becomes evident from the pro forma income
statement that we prepared assuming that fifty percent of the manufacturing costs and operating
expenses are fixed. This pro forma income statement, which is prepared by segregating the costs
and expenses into variable and fixed components, shows a net profit before tax of Rs. 6,27,250 and
net profit after tax of Rs. 5,01,850. The net profit before tax of Rs. 6,27,250 is about 45.95 percent
of sales. See that the net profit before tax has risen from Rs. 3,41,250 to Rs. 6,27,250 and net profit
after tax has risen from Rs. 2,73,000 to Rs. 5,01,850 when we prepared the pro forma income
statement admitting that all costs are not variable costs; we have assumed that fifty percent of the
manufacturing costs and operating expenses are fixed in nature and they deliver the leverage
advantage. As such, when we prepare a pro forma income statement using a simplified approach, it
is advisable that we segregate the costs and expenses into fixed and variable components.

A Simplistic Approach to Preparing the Pro Forma Balance Sheet— Percent of Sales Method:
As like preparing the pro forma income statement using the simplified method of ratio or
percent of sales, the pro forma balance sheet may also be prepared by using the simplified method
of ratio or percent of sales. In practice, the use of ratio or percent of sales is very widely used
method. However, it should be noted here that instead of using the ratio or percent of sales, we may
use the ratio or percent of any other reasonable variable also.
In the earlier section, we have seen the preparation of pro forma income statement using the
ratio or percent of sales method. Let us now see as to how this method is used for preparing the pro
forma balance sheet.
For preparing the pro forma balance sheet for the year 2020, we need to determine certain
ratios or percentage of sales with other assets. Using the ratios or percentages the assets are then
forecasted for the next year. Let us apply this method in our example of ABC Ltd.

Various Assets and Liabilities as a Percentage of Sales (2019)

Net Fixed Assets 3,31,500

= = 51%
Sales 6,50,000
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Current Assets 2,53,500

= = 39%
Sales 6,50,000

Cash 39,000
= = 6%
Sales 6,50,000

Marketable Securities 26,000

= = 4%
Sales 6,50,000

Accounts Receivables 84,500

= = 13%
Sales 6,50,000

Inventories 1,04,000
= = 16%
Sales 6,50,000

Current Liabilities 1,23,500

= = 19%
Sales 6,50,000

Accounts Payable 45,500

= = 7%
Sales 6,50,000

Taxes Payable 1,950

= = 0.3%
Sales 6,50,000

Notes Payable 53,950

= = 8.30%
Sales 6,50,000

Other Current Liabilities 22,100

= = 3.40%
Sales 6,50,000
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Pro Forma Balance Sheet of the ABC Ltd. for the Year 2020
(Simplified Percent of Sales Method)
Particulars Rs. Rs.
Equity and Liabilities
Shareholders’ Fund:
Equity Share Capital 2,50,000
Reserves and Surplus: Retained Earnings1 3,24,500 5,74,500

Non Current Liabilities: Long-term Debt (Unchanged) 1,00,000

New Financing Required2 2,94,650

Current Liabilities (19% of the forecasted sales of Rs. 13,65,000)

Accounts Payable (7% of forecasted sales of Rs. 13,65,000) 95,550
Taxes Payable (0.3% of forecasted sales of Rs. 13,65,000) 4,095
Notes Payable (8.3% of forecasted sales of Rs. 13,65,000) 1,13,295
Other Current Liabilities
46,410 2,59,350
(3.4% of Forecasted Sales of Rs 13,65,000)

Total Liabilities and Stakeholders’ Equity 12,28,500

Non-Current Assets:
Net Fixed Assets (51% of forecasted sales of Rs 13,65,000) 6,96,150

Current Assets: (39% of forecasted sales of Rs 13,65,000)

Cash (6% of forecasted sales of Rs 13,65,000) 81,900
Marketable Securities (4% of forecasted sales of Rs 13,65,000) 54,600
Accounts Receivables (13% of forecasted sales of Rs 13,65,000) 1,77,450
Inventories (16% of forecasted sales of Rs 13,65,000) 2,18,400 5,32,350

Total Assets 12,28,500

Notes:
1. Retained Earnings: Retained Earnings of the year 2019 is Rs. 1,11,500, i.e., 41,500 +
70,000. The projected income statement of the year 2020 shows Rs. 2,13,000 as new
retained earnings generated. Therefore, total retained earnings that will appear in the pro
forma balance sheet will be Rs. 3,24,500, i.e., 1,11,500 + 2,13,000.
2. New Financing Required: Existing Equity Share Capital is Rs. 2,50,000, retained earnings
as calculated above in point 1 is Rs. 3,24,500, existing debt is Rs. 1,00,000 and current
liabilities are Rs. 2,59,350. Assets being planned on the basis of forecasted sales give rise to
a difference of Rs. 2,94,650 between total of capital and liabilities and total of assets. This
difference shows that additional financing to the extent of Rs. 2,94,650 is required to support
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the forecasted sales of Rs. 13,65,000 and increase in various assets as warranted by their
ratios with sales. While we are in preparation process, we show this difference of Rs.
2,94,650 in pro forma balance sheet as the “new financing required.” Since this new
financing may be done either by raising new debt capital or by raising equity capital or by
the combination of the two. Therefore, after finalising the form of additional financing, the
pro forma balance sheet is modified and in place of “new external financing required”, we
write the “planned increase in the debt and/or equity capital”.

A Simplistic Approach to Preparing the Pro Forma Balance Sheet— Judgmental Method:
The above pro forma balance sheet is prepared on the basis of simple “percent of sales” criteria.
Under percent-of-sales method we simply assume that all items of assets and liabilities vary in
direct proportion to sales figure. Assuming this way is not correct as because in the field of financial
planning various assets and liabilities are required to be logically planned for so that they could be
consistent with the cost-benefit trade off. Therefore, instead of using the simple percent-of-sales
approach, the experts and scholars find it better to use “judgmental approach” for preparing the
pro forma balance sheet. It is an improved approach because it uses some judgmental planning in
estimating the values of various assets and liabilities. As compared to simple percent-of-sales
approach, Judgmental approach requires slightly more information and gives far better estimates.
Under judgmental approach, the values of some of the key balance sheet accounts are
estimated. The item of external financing in the balance sheet is used as a balancing figure (plug in
figure). Application of this approach to the preparation of pro forma balance sheet requires some
assumptions to be made. Let us illustrate this approach by preparing the pro forma balance sheet of
the ABC Ltd. for the year 2020 using the judgmental approach.
Under judgmental approach a number of assumptions are required to be made about the
levels of various accounts of the balance sheet. For our example, the assumptions are as follows:
1. Based on the past experience, growth rate and desired level of operations, a minimum cash
balance of Rs. 1,90,000 is required to be maintained.
2. The business is not intending to make any new investments in marketable securities or to
liquidate some investments in marketable securities in the coming year. Therefore, it is
assumed to keep the Marketable Securities unchanged at Rs. 26,000 in the year 2020.
3. So far as the accounts receivables are concerned, the past experience shows that on an
average they have been representing forty-five days of sales of the ABC Ltd. Forty-five days
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of a year may be expressed as 45/360 = 1/8. This implies that about 1/8 of the sales of the
ABC Ltd. represents accounts receivables. Now, since the annual sales of the ABC Ltd. are
projected to be Rs. 13,65,000, therefore, on an average the accounts receivable should be Rs.
1,70,625, i.e., 1/8 of Rs. 13,65,000.
4. It is further judged that the ending inventory will remain at the previous year’s level, i.e., at
Rs. 1,04,000. It is assumed that of the total inventory of Rs. 1,04,000, 25 percent (Rs.
26,000) is to be raw material inventory and the remaining 75 percent (Rs. 78,000) is to be
the finished goods inventory.
5. Depending on the needs of the business, a new machine costing Rs. 4,00,000 is needed to be
purchased. Total depreciation on new machine for the year 2020 is estimated to be Rs.
24,000. As such, net fixed assets for the year 2020 are ascertained as follows: net fixed
assets of the year 2019 + new machine purchased – depreciation on new machines for the
year 2020 = 1,00,000 + 4,00,000 – 24,000 = Rs. 4,76,000.
6. Based on past experience, purchases are expected to be approximately 15% of annual sales.
In our example, it is Rs. 2,04,750, i.e., 15% of Rs. 13,65,000. In terms of purchase of
Material A and material B, the breakup of total purchase of Rs. 2,04,750 is Rs. 1,36,500 of
Material A and Rs. 68,250 of Material B.
7. Regarding accounts payable, it has been observed that on an average it takes seventy-two
days to pay and clear them. Seventy-two days of a year may be expressed as 72/360 = 1/5.
This implies that about 1/5 of the purchases of the ABC Ltd. represents accounts payables.
Now, since the annual purchases of the ABC Ltd. are projected to be Rs. 2,04,750, therefore,
on an average the accounts payables should be Rs. 40,950, i.e., 1/5 of Rs. 2,04,750.
8. It is assumed that notes payable, other current liabilities and equity share capital are to
remain unchanged at their current levels of Rs. 53,950, Rs. 22,100 and Rs. 2,50,000
respectively.
9. It is expected that taxes payable will be equal to one-third of the current year’s tax liability.
10. The retained earnings will increase by the retained earnings of the year 2020.
11. There is no plan to make any equity share capital issue or to repurchase equity shares in the
year 2020.

Based on the above mentioned judgmental assumptions, a pro forma balance sheet of the
ABC Ltd. for the year 2004 is prepared and presented as follows:
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Pro Forma Balance Sheet of the ABC Ltd. for the Year 2004
(Judgmental Method pro Forma Balance Sheet prepared using the judgmental information
given as points 1 to 11 and the pro forma income statement for the year 2004 as prepared
earlier assuming that all costs are variable costs and they vary with sales.)

Particulars Rs. Rs.

Equity and Liabilities
Shareholders’ Fund:
Equity Share Capital 2,50,000
Reserves and Surplus: Retained Earnings1 3,05,300 5,55,300

Non Current Liabilities: Long-term Debt (old) 1,00,000

New Financing Required2 “Planned Increase in Long-term Debt” 73,175

Current Liabilities
Accounts Payable 40,950
Taxes Payable3 21,150
Notes Payable 53,950
Other Current Liabilities 22,100 1,38,150 1,38,150

Total Liabilities and Stakeholders’ Equity 8,66,625

Non-Current Assets:
Net Fixed Assets (1,00,000 + 4,00,000 – 24,000 Dep. = 4,76,000) 4,76,000

Current Assets:
Cash and Bank 1,90,000
Marketable Securities 26,000
Accounts receivables 70,625
Inventories: Raw Material 26,000 + 78,000 Finished Goods 1,04,000 3,90,625

Total Assets 8,66,625

Notes:
1
Retained Earnings: The total retained earnings as per the actual balance sheet of the year 2019 is
Rs. 1,11,500, which includes Rs. 41,500 of previous balance and Rs. 70,000 of the year 2019. The
total retained earnings that will appear in the Judgmental Pro Forma Balance Sheet will be as
follows: Total Retained Earnings to Appear in Judgmental Pro Forma balance Sheet of the
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year 2020 = Previous balance as appearing in 2019 balance sheet + Retained earnings of the year
2019 + Expected retained earnings of the year 2020 = 41,500 + 70,000 + 1,93,800 = 3,05,300.

2
New Financing Required: In the above pro forma balance sheet, a positive balancing figure of Rs.
73,175 is there which shows that a new external financing as “plug” is required for bringing the pro
forma balance sheet into balance. This implies that the forecasted sales level of Rs. 13,65,000 for
2020 and other judgmental (planned) activities need Rs. 73,175 as additional external financing. In
the absence of additional financing, the planned activities cannot be implemented and executed.
Precisely, when a judgmental pro forma balance sheet shows a need for additional external
financing, it implies that the forecasted level of operation is not possible if the new additional
financing is not done. The additional new financing may be done either by raising debt capital or by
raising equity capital or by reducing dividends and retaining more. After finalizing the specific
action for additional financing required, the pro forma balance sheet is modified and in place of
“external financing required”, we write planned increase in the debt and/or equity capital. In our
example, it has been planned that there will be no equity issue. Therefore, the need for Rs. 73,175 as
additional financing will be met by raising new debt. Accordingly, in our example we have right
away written “planned increase in debt capital”.
In the pro forma balance sheet, if we get a negative balancing figure, it indicates that the
forecasted levels of activities do not demand the size of funds already invested in the business. Said
simply, a negative balancing figure for “new financing required” is a situation in which the existing
financing is in excess of the needs of the planned activities. Since the planned need is less and funds
are surplus, therefore, surplus funds should be used to repay some of the debts and/or to buy back
some of the equity shares. The surplus funds may also be used for paying higher dividends. After
finalizing the specific action for excess funds, the pro forma balance sheet is modified and in place
of “external financing required”, we write planned reductions in the debt and/or equity capital.

3
Taxes Payable: Tax liability in pro forma income statement of the year 2020 is Rs. 68,250. This
tax liability will change as because the depreciation of Rs. 24,000 on new machine will reduce the
taxable income. The adjustment for new depreciation and the impact of the same on taxes and
retained earnings of the year are worked out as follows:
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Net Profit Before Taxes (as per Pro forma income

3,41,250
Statement of the Year 2020)

Less: Adjustment for New Depreciation 24,000

Modified Net Profit Before Taxes 3,17,250

Less: Taxes (0.20 X 3,17,250 = 63,450) 63,450

Net Profit After Taxes 2,53,800

Less: Equity Share Dividend (Same as previous year) 60,000

Retained Earnings 1,93,800

Tax as per the above table is Rs. 63,450. The judgmental information suggests that the tax
payable will be one third of Rs. 63,450. As such, the tax payable amount is Rs. 21,150.

Critical Evaluation of Pro Forma Financial Statements:

(A) Importance of Preparing Pro Forma Financial Statements:
Pro Forma financial statements (pro forma profit and loss account and pro forma balance
sheet) are prepared to serve the following purposes:
1. Pro forma financial statements are prepared to use them as the guide post to operate the
business in the desired direction,
2. Pro forma financial statements help assess the performance of the business. They help the
management know as to whether the business is performing on budgeted lines or not. If there is any
deviation in actual performance from the budgeted targets, the same could be timely analysed and
corrected.
3. The pro forma financial statements help management fix such targets and goals which
make the business to keep its performance in line with the expectations of shareholders as also
above the industry average level of performance. For example, the pro forma financial statements
reveal as to whether the forecasted return on equity is above the industry average, below the
industry average, or at par with the industry average. If the forecasted return on equity is below the
industry average, the managers could then analyse the cause and take the remedial action.
 P a g e | 16

4. Pro forma financial statements serve as a tool to gauge the effects of proposed operating
changes. By changing any operating variable in the pro forma financial statements, they come to
know as to whether the financial impact of change is beneficial or adverse to the business. It is
because of this, the financial managers devote a lot of time in “what if” kind of analysis.
5. Pro forma financial statements help managers ascertain the future growth and fgrowth
needs of the business.
6. Pro forma financial statements help managers ascertain the future financing needs of the
business.
7. Pro forma financial statements help management better understand the cash flows of the
business and accordingly help in ascertaining as to whether the cash position of the business on any
specific point in time is sound or not. If there is any shortage of cash on a specific date, the shortage
could be easily managed as the same is known in advance. Similarly, if there is any surplus of cash
on a specific date, the surplus could be profitably invested in some short-term investment avenue
for the period for which it is surplus.
8. Pro forma financial statements help in maximizing the value of the business and thereby
shareholders value. Managers forecast profit and rate of returns under different operating plans with
different composition of assets and financing plans, and then choose the plan that maximizes the
value of the business and shareholder value.
9. Professional security analysts prepare pro forma financial statements and make different
projections about the business under analysis. By preparing pro forma financial statements, they
forecast the profit, rate of return, liquidity, solvency, leverage, cash flows, earnings, dividend and
growth of the business. Based on these forecasts, they ascertain the fundamental value of the equity
shares of the business, and accordingly advise their clients to buy or not buy the equity shares of a
business.
10. Pro forma financial statements are of great help in business valuation process. When it
comes to valuation of business, pro forma financial statements help in anticipating and ascertaining
the future maintainable profit of the business, expected rate of return, expected rate of dividend and
future free cash flows of the business. These are very crucial factors in business valuation process as
they determine the company’s overall value.

(B) Limitations and Weaknesses of Pro Forma Financial Statements:

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In the previous section, we have seen that pro forma financial statements are of great use in
different business situations and they serve the needs of different stake holders of the business.
Investors, lenders, managers, consultants and corporate buyers frequently prepare and use the pro
forma financial statements. While pro forma financial statements are very important and they serve
great purposes, at the same time they suffer with certain weaknesses and problems, which are as
follows:
1. Preparation of pro forma financial statements is a very time consuming and difficult task.
It depends on several factors and involves various variables. It begins with sales forecasting and
then requires various manufacturing, operational, selling and administrative activities to be planned
and budgeted for. The critics say that the benefits of pro forma financial statements are not
commensurate to complexities involved, difficulties faced and time consumed in the process.
2. Since preparation of financial statements is an exercise of projecting the future. We know
that future is uncertain and therefore projecting future correctly is very difficult. Farther we go in
future, the more it goes uncertain and hazy.
3. Forecasting various items of income, cost, expenses, liabilities and assets for preparing
the pro forma financial statements is usually based on the assumption that the past financial
conditions will continue in future and they, therefore, indicate accurately their future. When we
calculate various items of income, expenses, liabilities and assets as a specific percent that they had
with the past sales, we do so by assuming that future will behave the way it behaved in the past.
This assumption is not correct. Future is never the replica of the past. Conditions which abound a
business keep changing and as they change they change all ratios and percent relationship.
Therefore, forecasting various items of income, expenses, liabilities and assets as a specific percent
of sales is seldom accurate.
4. Pro forma financial statements provide inputs and insights for developing different
managerial policies for managing the business effectively. We have seen that financial managers
and lenders use pro forma statements to analyze the cash inflows and outflows, liquidity of the
business, debt level and debt capacity of the business, profitability and value of the business. If
there is something wrong or future forecasts are not correct in the pro forma financial statements for
any reason whatsoever, the managerial policies which have been developed and put in practice are
bound to be wrong. One can easily understand the kind of havoc that the wrong managerial policies
could inflict on the business.