8.2: Pro Forma Financial Analysis- The Corporate Environment
Pro Forma Financial Analysis: The Corporate Environment
Pro forma refers to expected/future financial outcomes using certain assumptions. The financial analyst gathers information from numerous sources. Where he gets his/her information will depend largely on who s/he is. There are two possibilities:
The internal corporate analyst , i.e., the analyst who works for and “inside” the corporation, will collect information from the various company departments including marketing, purchasing , administration, economics, and other s , each of which will “sign off” on the data that s/he includes in his/her financial projections. This analyst is charged with compiling the data meaningfully and projecting the relative profitability and hence worthiness of alternative, and sometimes competing, possible investment projects. The purpose is to engage incorporate Financial Planning.
For example, the sales projections may come from the marketing department. This department may provide unit sales and pricing data, which the analyst compiles and includes in his/her projections. The analyst may ask that the department “ sign off ” on this portion of the overall projections and thereby take some responsibility for the data. Alternatively, the analyst may investigate the reasonableness of the data and provide alternative projections.
The external (securities) analyst, i.e., one who is not employed by the subject corporation, but perhaps who works instead for a financial institution that has some investment or equity interest in the corporation, will not have access to the same valuable information and data that the internal corporate analyst will have. The methods s/he uses will differ accordingly. The external analyst does not have access to the data regarding corporate investment projects adopted and which are now just coming on-line, or recently came online. S/he therefore will use public financial statements in order to derive inferences about the corporation’s growth prospects and future share price.
When we, individuals, think of “investing,” many of us think of investing in stocks and bonds. This is not typically what companies invest in. What do (non-financial) corporations “invest” in?
Let us remember that, here, we are all financial analysts and hence we take on a “corporate perspective.” In this sense, corporate investment refers to things that (non-financial) corporations invest in, in order to maintain and grow their businesses. Such investments include, but are not limited to, the following:
- Property, plant, and equipment – P, P, & E
- Inventory
- Research & Development (R&D) – we will not deal with R&D in our forthcoming discussions.
Some very useful definitions :
- Expense : a reduction to revenues, reported on the Income Statement. Some expenses involve the movement of cash, e.g., wages; others do not, e.g., depreciation.
- Expenditure : an outlay of funds, which may either be expensed or used (“expended”) in order to acquire an asset. If the latter, the accountant will classify the asset as “capitalized,” i.e., not expensed in the current period, but rather recorded on the Balance Sheet. P, P, & E fit this category. It may then be depreciated over future periods. Remember, land (“property”) is not depreciable even though it is capitalized. In contrast, (cash-) dividends are expenditures that involve cash outlays; dividends are not expensed.