FINANCE/ACCOUNTING ISSUES:DEBIT, USES OF PRO FORMA STATEMENTS

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Strategic Management MGT603

Lesson 38

FINANCE/ACCOUNTING ISSUES

Learning objectives

The main objective of this chapter to enable to students about accounting and finance issue relating to

strategy implementation.

Like marketing and human resource concern while implementing strategy the other important issue is

accounting and finance.

Several issue that concern with accounting and finance to strategy

implementation: obtaining desired amount of

needed capital, developing pro forma financial

statements, preparing financial budgets, and evaluating the worth of a business. Some examples of

decisions that may require finance/accounting policies are:

1. To raise the amount of capital by issuing shares or obtaining a debt from external parties.

2. To enhance the inventory turn over level

3. To make or buy fixed assets.

4. To extend the time of accounts receivable.

5. To establish a certain percentage discount on accounts within a specified period of time.

6. To determine the amount of cash that should be kept on hand

7. To determine an appropriate dividend payout ratio.

8. To use LIFO, FIFO

Acquiring Capital to Implement Strategies

Without sufficient amount of capital the strategy can not be proceed. Two basic sources of capital for

an organization are debt and equity. Creditors have a debt right and owners have an equity right in the

business. An appropriate mix of debt and equity in a firm's capital structure plays an important role for

strategy implementation. The most important is debt and equity analysis. The debt to equity ratio

(D/E) is a financial ratio, which is equal to an entity's total liabilities divided by shareholders' equity.

The two components are often taken from the firm's balance sheet (or statement of financial position),

but they might also be calculated using their market values if both the company's debt and equity are

publicly traded. It is used to calculate a company's "financial leverage" and indicates what proportion of

equity and debt the company is using to finance its assets.

D/E = Debt (total liabilities) / Equity

A similar ratio is debt to total assets (D/A)

D/A = debt / assets = debt / (debt + equity)

It also include an Earnings per Share/Earnings before Interest and Taxes (EPS/EBIT) analysis is the

most widely used technique for determining whether debt, stock, or a combination of debt and stock is

the best alternative for raising capital to implement strategies. This technique involves an examination

of the impact that debt versus stock financing has on earnings per share under various assumptions as

to EBIT.

DEBIT

A financial measure defined as revenues less cost of goods sold and selling, general, and administrative

expenses. In other words, operating and no operating profit before the deduction of interest and

income taxes.

Earning Per share

A company's profit divided by its number of outstanding shares. If a company earning Rs. 2 million in

one year had Rs. 2 million shares of stock outstanding, its EPS would be Rs. 1 per share. In calculating

EPS, the company often uses a weighted average of shares outstanding over the reporting term. The

one-year (historical) EPS growth rate is calculated as the percentage change in earnings per share. The

prospective EPS growth rate is calculated as the percentage change in this year's earnings and the

consensus forecast earnings for next year.

Theoretically, an enterprise should have enough debt in its capital structure to boost its return on

investment by applying debt to products and projects earning more than the cost of the debt. In low

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earning periods, too much debt in the capital structure of an organization can endanger stockholders'

return and jeopardize company survival. Fixed debt obligations generally must be met, regardless of

circumstances. This does not mean that stock issuances are always better than debt for raising capital.

Some special concerns with stock issuances are dilution of ownership, effect on stock price, and the

need to share future earnings with all new shareholders.

EPS/EBIT analysis is a valuable tool for making capital financing decisions needed to implement

strategies, but several considerations should be made whenever using this technique. First, profit levels

may be higher for stock or debt alternatives when EPS levels are lower. For example, looking only at

the earnings after taxes (EAT) values in Table 8-3, the common stock option is the best alternative,

regardless of economic conditions. If the Brown Company's mission includes strict profit

maximization, as opposed to the maximization of stockholders' wealth or some other criterion, then

stock rather than debt is the best choice of financing.

Another consideration when using EPS/EBIT analysis is flexibility. As an organization's capital

structure changes, so does its flexibility for considering future capital needs. Using all debt or all stock

to raise capital in the present may impose fixed obligations, restrictive covenants, or other constraints

that could severely reduce a firm's ability to raise additional capital in the future.

Pro Forma Financial Statements

Pro forma (projected) financial statement analysis is a central strategy-implementation technique because it

allows an organization to examine the expected results of various actions and approaches.

"A financial statement showing the forecast or projected operating results and balance sheet, as in pro

forma income statements, balance sheets, and statements of cash flows."

USES OF PRO FORMA STATEMENTS

BUSINESS PLANNING A company uses pro forma statements in the process of business planning

and control. Because pro forma statements are presented in a standardized, columnar format,

management employs them to compare and contrast alternative business plans. By arranging the data

for the operating and financial statements side-by-side, management analyzes the projected results of

competing plans in order to decide which best serves the interests of the business.

In constructing pro forma statements, a company recognizes the uniqueness and distinct financial

characteristics of each proposed plan or project. Pro forma statements allow management to:

· Identify the assumptions about the financial and operating characteristics that generate the

scenarios.

· Develop the various sales and budget (revenue and expense) projections.

· Assemble the results in profit and loss projections.

· Translate this data into cash-flow projections.

· Compare the resulting balance sheets.

· Perform ratio analysis to compare projections against each other and against those of similar

companies.

· Review proposed decisions in marketing, production, research and development, etc., and assess

their impact on profitability and liquidity.

Simulating competing plans can be quite useful in evaluating the financial effects of the different

alternatives under consideration. Based on different sets of assumptions, these plans propose various

scenarios of sales, production costs, profitability, and viability. Pro forma statements for each plan

provide important information about future expectations, including sales and earnings forecasts, cash

flows, balance sheets, proposed capitalization, and income statements.

Management also uses this procedure in choosing among budget alternatives. Planners present sales

revenues, production expenses, balance sheet and cash flow statements for competing plans with the

underlying assumptions explained. Based on an analysis of these figures, management selects an annual

budget. After choosing a course of action, it is common for management to examine variations within

the plan.

It includes:

1. Pro forma income statement

2. Pro forma balance sheet etc.

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Pro forma income statement

A pro forma income statement is similar to a historical income statement, except it projects the future

rather than tracks the past. Pro forma income statements are an important tool for planning future

business operations. If the projections predict a downturn in profitability, you can make operational

changes such as increasing prices or decreasing costs before these projections become reality.

Pro forma income statements provide an important benchmark or budget for operating a business

throughout the year. They can determine whether expenses can be expected to run higher in the first

quarter of the year than in the second. They can determine whether or not sales can be expected to be

run above average in June. The can determine whether or not your marketing campaigns need an extra

boost during the fall months. All in all, they provide you with invaluable information--the sort of

information you need in order to make the right choices for your business.

How do I create a pro forma income statement?

Sit down with an income statement from the current year. Consider how each item on that statement

can or will be changed during the coming year. This should, ideally, be done before year's end. You will

need to estimate final sales and expenses for the current year to prepare a pro forma income statement

for the coming year.

Pro forma balance sheet

A pro forma balance sheet is similar to a historical balance sheet, but it represents a future projection.

Pro forma balance sheets are used to project how the business will be managing its assets in the future.

For example, a pro forma balance sheet can quickly show the projected relative amount of money tied

up in receivables, inventory, and equipment. It can also be used to project the overall financial

soundness of the company. For example, a pro forma balance sheet can help quickly pinpoint a high

debt-to-equity ratio.

This type of analysis can be used to forecast the impact of various implementation decisions (for

example, to increase promotion expenditures by 50 percent to support a market-development strategy,

to increase salaries by 25 percent to support a market-penetration strategy, to increase research and

development expenditures by 70 percent to support product development, or to sell $1 million of

common stock to raise capital for diversification). Nearly all financial institutions require at least three

years of projected financial statements whenever a business seeks capital. A pro forma income

statement and balance sheet allow an organization to compute projected financial ratios under various

strategy-implementation scenarios. When compared to prior years and to industry averages, financial

ratios provide valuable insights into the feasibility of various strategy-implementation approaches.

A Pro Forma Income Statement and Balance Sheet

Prior

Projected

Remarks

Year

Year 2005

2005

PRO

FORMA

INCOME

STATEMENT

Sales

1000

1500

50% increase

Cost of Goods Sold

700

1050

70% of sales

Gross Margin

300

450

Selling Expense

100

150

10% of sales

Administrative Expense

100

150

10% of sales

Earnings Before Interest and Taxes

100

150

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Strategic Management MGT603

Interest

Earnings Before Taxes

100

Taxes

50% rate

Net Income

Dividends

Retained Earnings

PRO

FORMA

BALANCE

SHEET

Assets

Cash

7.75

Plug figure

Accounts Receivable

4.00

Incr. 100%

Inventory

45.00

Total Current Assets

56.75

Land

15.00

Plant and Equipment

80.00

Add 3 new plants at

$10 million each

Less Depreciation

20.00

Net Plant and Equipment

60.00

Total Fixed Assets

75.00

Total Assets

131.75

Liabilities

Accounts Payable

10.00

Notes Payable

10.00

Total Current Liabilities

20.00

Long-Term Debt

70.00

Borrowed $30 million

Additional Paid-in-Capital

35.00

Issued 100,000 shares

at $150 each

Retained Earnings

6.75

2 + 4.75

Total Liabilities and Net Worth

131.75

There are six steps in performing pro forma financial analysis:

1. Prepare income statement before balance sheet (forecast sales)

2. Use percentage-of-sales method to project CGS and expenses

3. Calculate projected net income

4. Subtract dividends to be paid from Net Income and add remaining to Retained Earnings

5. Project balance sheet times beginning with retained earnings

6. List comments (remarks) on projected statements

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Strategic Management MGT603

Financial Budgets

"Document that details how funds will be obtained and spent for a specified period of time."

Types of Budgets

Cash budgets

Operating budgets

Sales budgets

Profit budgets

Factory budgets

Capital budgets

Expense budgets

Divisional budgets

Variable budgets

Flexible budgets

Fixed budgets

Annual budgets are most common, although the period of time for a budget can range from one day to

more than ten years. Fundamentally, financial budgeting is a method for specifying what must be done

to complete strategy implementation successfully. Financial budgeting should not be thought of as a

tool for limiting expenditures but rather as a method for obtaining the most productive and profitable

use of an organization's resources. Financial budgets can be viewed as the planned allocation of a firm's

resources based on forecasts of the future.

Financial budgets have some limitations. First, budgetary programs can become so detailed that they are

cumbersome and overly expensive. Over budgeting or under budgeting can cause problems. Second,

financial budgets can become a substitute for objectives. A budget is a tool and not an end in itself.

Third, budgets can hide inefficiencies if based solely on precedent rather than periodic evaluation of

circumstances and standards. Finally, budgets are sometimes used as instruments of tyranny that result

in frustration, resentment, absenteeism, and high turnover. To minimize the effect of this last concern,

managers should increase the participation of subordinates in preparing budgets.

Evaluating the Worth of a Business

Evaluating the worth of a business is central to strategy implementation because integrative, intensive,

and diversification strategies are often implemented by acquiring other firms. Other strategies, such as

retrenchment and divestiture, may result in the sale of a division of an organization or of the firm itself.

All the various methods for determining a business's worth can be grouped into three main approaches

1. What a firm owns

2. What a firm earns

3. What a firm will bring in the market.

The first approach in evaluating the worth of a business is determining its net worth or stockholders'

equity. Net worth represents the sum of common stock, additional paid-in capital, and retained

earnings.

The second approach to measuring the value of a firm grows out of the belief that the worth of any

business should be based largely on the future benefits its owners may derive through net profits.

The third approach, letting the market determine a business's worth, involves three methods.

1. First, base the firm's worth on the selling price of a similar company. A potential problem,

however, is that sometimes comparable figures are not easy to locate, even though substantial

information on firms that buy or sell to other firms is available in major libraries.

2. The second approach is called the price-earnings ratio method. To use this method, divide the market

price of the firm's common stock by the annual earnings per share and multiply this number by the

firm's average net income for the past five years.

3. The third approach can be called the outstanding shares method. To use this method, simply multiply

the number of shares outstanding by the market price per share and add a premium. The premium

is simply a per share dollar amount that a person or firm is willing to pay to control (acquire) the

other company.

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