CHAPTER 3
Pro Forma Forecasts (PIPES-B)

In the last chapter, we used PIPES, a mid-sized plumbing firm, to show how Sources and Uses of Funds and ratio analysis can be used to help evaluate the financial health of a firm. We found that PIPES appeared to be a profitable, well-managed firm that was growing quickly, but was unable to finance its working capital needs with its current $350,000 bank line of credit. We also introduced Mr. Garcia, a new banker, who was considering lending to PIPES.

This chapter will answer the question: Should Mr. Garcia lend to PIPES, and if so, how much? Mr. Steele, PIPES's owner and manager, should be able to answer the second part of this question. When you walk into a bank you should expect the banker to ask how much money you want to borrow (and if you don't know, you should expect the banker to send you away empty-handed). You should also expect the banker to ask you how (and when) you are going to pay back the loan.

FIRST, LET'S TAKE A CLOSER LOOK AT RATIO ANALYSIS

Finance and Accounting are both inexact and both require us to work with assumptions as well as facts.1 However, the major difference is that Financial Accounting looks backward (trying to tell it like it was), while Finance looks forward (trying to tell it like it will be), and it is easier to figure out what happened in the past than to predict the future correctly. For example, a current stock price doesn't reflect what happened in the past, but rather reflects the market's expectation of the future.

In that context, let's back up a bit and talk more about ratio analysis. Ratio analysis is an inexact tool. When we first discussed ratios, we noted there are numerous ways to compute them:

Furthermore, ratios can be computed using different time periods:

Different ratios can also reflect the same underlying economics. They just do the calculations differently (e.g., debt/equity or debt/total assets).

Moreover, within each category of ratios (profitability, activity, leverage, and liquidity) we have multiple definitions (e.g., profitability can be percentage of sales, return on assets, return on equity, etc.).

When two ratios are transformations of each other, it does not matter which one is used (e.g., days receivables is just 365 divided by receivable turns). However, we select a ratio that highlights a particular focus of the analysis (i.e., we may use return on assets if we want to understand a firm's overall profitability, while we may use return on equity if we want to highlight profitability across different financing structures). The most important thing, however, is to be consistent—that is, to use the same ratios throughout our analysis.

Ratios are used in two primary ways: first, they are used to compare a firm with others in the same industry. This requires only one year of ratios and is called a cross-sectional analysis. The ratios for PIPES can be compared to Ace Hardware and other similar firms. Of course, it is always easiest to compare firms of similar size in similar geographic locations. But even if you are not comparing similarly sized firms in similar geographies and similar industries, ratio analysis allows you to understand which firm is more or less profitable, which is best at controlling its costs, and so on. Second, ratios can be used to compare the firm's performance with itself over time. Examining ratios for a single firm over a five-year period allows you to not only look for consistency in performance, but also trends in the firm's operations.

Ratios are always the best place to start an examination of a firm, as they are the diagnostics for a firm. They are used in many ways. Ratios are used both by the firm to self-evaluate as well as by the capital market to evaluate the firm. Ratios are also used in contracts to set covenants (restrictions a lender puts on the firm to reduce the risk of not being repaid). For example, there may be covenants limiting both the amount and type of debt, limiting the amount or percentage of working capital, and/or limiting certain expenses in absolute terms or as a percentage of sales. Lending covenants are used both to evaluate the health of a firm and to set a trigger for action if they are violated (usually debt becomes fully payable on demand if a covenant is violated). There are also performance pricing contracts (or performance pricing debt) where the interest rate varies with changes in the ratios. The stronger a firm's ratios, the lower the interest rate charged and vice versa. These ratio-dependent covenants contractually allow the interest rate to fluctuate with the ratios rather than having the firm and lender renegotiate rates whenever the firm's financial health changes materially. Finally, ratios are essential in forecasting the future performance of the firm and thus are an integral part of our pro forma tools.

PRO FORMA FORECASTS

Suppose that PIPES continues to grow as it has but decides to change its payable policy and reduces accounts payable to no more than 10 days. How does that change the amount the firm needs to borrow? How do we figure it out? We prepare a pro forma forecast.

Hint: When you do pro formas, you have to forecast Income Statement and Balance Sheet items. Your authors strongly recommend that, as a first pass, you use the same line items that the company uses in its Income Statement and Balance Sheet. Financial statements can be stated several ways with different degrees of detail. It is far easier to project only the items listed on the current financial statements rather than change the categories or accounts listed. For example, if the firm separates inventory into raw materials, work in process, and finished goods inventory, we recommend your pro formas do that as well. It is both easier to do and more accurate. This may seem obvious, but occasionally we find students using different categories in the pro formas than the firm used in their own financial statements.

Note that once we have set up our pro formas, we can change our assumptions and examine “what if” scenarios. We can, for instance, assume that PIPES will extend less credit to customers so that receivables decline, and then we can examine the impact on financing needs and profits. Thus, pro formas are an extremely powerful tool for a firm to not only forecast the future, but also to understand the impact of changes.

Your authors are both old enough to have done pro formas on paper prior to the advent of computerized, now Excel, spreadsheets. Because of this, we warn that a danger with using computerized spreadsheets is the temptation to generate multiple iterations without proper justification. This can be problematic because computerized spreadsheets can sometimes make it too easy to generate new pro formas without properly understanding and questioning the underlying assumptions.

PIPES Pro Forma Income Statement for 2017

It is generally best to begin with a pro forma Income Statement. Why? Because, not only will this year's earnings affect the amount of financing necessary on the Balance Sheet, but the sales forecast is usually one of the most important forecasts and drives not only most of the Income Statement items but many of the Balance Sheet items as well. Our first pro forma Income Statement is given in Table 3.1A. It is constructed as follows:

TABLE 3.1A PIPES—2017 Pro Forma Income Statement

($000s) 2016 Assumption 2017
Sales 2,200 25% growth 2,750
Cost of goods sold 1,695 Sales * 0.7546 2,075
Gross profit 505 675
Operating expenses 344 Sales * 0.155 426
Earnings before interest and tax 161 249
Interest expense 34 Initial estimate 34
Profit before tax 127 215
Income tax 44 PBT * 35% 75
Net earnings 83 140

If we had to project the Income Statement for PIPES for 2017 without any other additional information, a first pass would have a sales increase at a rate of 25%. Why? Because this is the average rate that sales increased during each of the past three years, and each year has been close to the average.

Sales in 2016 Projected Increase Pro Forma Sales in 2017
$2,200,000 25% $2,750,000

Once our sales forecast is set, most of the remainder of the Income Statement items can be forecast using a percentage-of-sales approach. That is, we can use the ratios we calculated in the past for PIPES to predict the future. Occasionally, if something changes, as it did for accounts payable (now restricted to 10 days to get the 2% discount), we will have to modify the past ratios to incorporate new assumptions.

After sales, the next Income Statement item is COGS, which has been very stable at around 77% of sales (77.1%, 77.2%, 77.1%, and 77% in 2013 through 2016). This indicates management's ability, or at least consistency, in purchasing and pricing.

Pro Forma Sales in 2017 Projected Pro Forma COGS in 2017
$2,750,000 77% $2,117,500

However, we cannot simply use the 77% from the past. Why not? Because we are now holding payables to 10 days to obtain a 2% discount on purchases. We must adjust the original estimate based on past experience for any expected future changes. In this case, we expect to receive a 2% discount for prompt payment. This means the rate of 77% is no longer correct.

At 77% of sales, COGS is forecast to be $2,177,500 (as above sales of $2,750,000 * 77%). However, we now expect to pay 2% less than this. This means we expect a discount for prompt payment of $42,350 (2% * COGS = 2% * $2,117,500).

Original estimate for 2017 COGS $2,117,500
Adjustment for prompt payment discount $ 42,350
Revised estimate for 2017 COGS $2,075,150
Projected 2017 sales $2,750,000
Revised formula (COGS/sales) 75.46%
Original formula (COGS/sales) 77%
Adjustment (100% – discount of 2%) * 98%
Revised formula 75.46%

Note that we list COGS at 75.46% of sales. The discount (of $42,350 from above) does not appear on the Income Statement as a separate line, although it will increase both the gross profit and the profit before taxes by the amount of the discount.2

This change in COGS will also change the amount of inventory on our Balance Sheet, which we will discuss below.3

Continuing down our pro forma Income Statement, operating expenses over the past few years have remained in a narrow band around 15.5%, so we project them to be 15.5%.

Interest expense is more difficult to forecast because it can vary due to either changes in interest rates or changes in the amount of debt borrowed. In the case of PIPES, we set the interest rate at a constant 7% for bank debt and 9% for long-term debt for all years.

The debt level (or amount of debt borrowed) is a Balance Sheet item and normally a plug figure in pro formas. A plug figure means that the number is not calculated independently, but is rather determined as the last item computed—it is the amount needed to “plug” the Balance Sheet so that it will balance. In effect, we first solve all other Balance Sheet items and then solve for debt. Therefore, debt is the amount of financing needed, given all the other assumptions made on other Balance Sheet items.

Normally, we use a preliminary estimate (often the prior year's amount) for interest expense on the Income Statement. In PIPES's case, the amount of debt borrowed (what is normally the plug) is limited by the maximum loan limit set by the current bank. In this example, the current bank does not allow PIPES to borrow beyond $350,000. That is the limit to the line of credit that the bank extended to PIPES. Once PIPES reaches that limit, debt cannot grow any further, and PIPES must seek an alternative way to make the Balance Sheet balance. In prior years, PIPES used accounts payable to make the Balance Sheet balance. However, for 2017 and beyond, the suppliers have restricted accounts payable, and so now PIPES must finance with bank debt. This means the interest expense on the Income Statement will not be finally determined until the Balance Sheet is also done. Importantly, it also means that pro formas are an iterative process. Thus we initially assume that debt in 2017 is the same $450,000 ($350,000 in bank debt at an interest rate of 7% and $100,000 of long-term debt at an interest rate of 9%) as in 2016, and that PIPES's first pass pro forma interest expense remains the same.

Finally, we assume income tax remains at a constant rate of 35% of profit before tax.4

We can now generate a first-pass pro forma Income Statement, which is shown in Table 3.1A.

Note that we built the pro forma by first assuming the rate of sales growth. We then calculated COGS and operating expenses as a percentage of sales. (We did not use the historic percentage of sales for COGS due to the 2% discount.) Operating expenses are also calculated as a percentage of sales. Interest expense is not calculated as a percentage of sales since it is tied to the amount of debt on the Balance Sheet, and not tied to sales growth. We included a preliminary estimate for interest expense and will return to a final estimate after completing the pro forma Balance Sheet. Taxes are set to a historic percentage of profit before tax.

PIPES Pro Forma Balance Sheet for 2017

Once we have created the first pass pro forma Income Statement, we next create a pro forma Balance Sheet, shown in Table 3.1B. Many items on the Balance Sheet are projected using ratio analysis as a percentage of sales. As such, the sales forecast from the pro forma Income Statement impacts the pro forma Balance Sheet as well.

TABLE 3.1B PIPES—2017 Pro Forma Balance Sheet

($000s) 2016 Estimate 2017
Cash 45 Constant 45
Accounts receivable 211 Sales * 9.5% 261
Inventory 418 Sales * 0.1862 512
Prepaid expenses 28 Constant 28
Current assets 702 846
Property, plant, and equipment 350 5% increase 368
Total assets 1,052 Total 1,214
Current portion long-term debt 10 10
Bank loan 350 Plug 548
Accounts payable 223 Sales * 0.0207 57
Accruals 25 Constant 25
Current liabilities 608 640
Long-term debt 90 80
Total liabilities 698 720
Contributed capital 75 Constant 75
Retained earnings 279 Open + NI 419
Total debt and equity 1,052 1,214

For now, we will assume that cash is kept at a constant amount. (It is perfectly reasonable to have cash grow with sales, but if sales double at a single locale, there is no reason to expect the firm will need twice as much cash to facilitate transactions.) This is why finance is an art, not a science, and why, while there are clearly wrong answers, there is often more than one right answer.

Accounts receivable is our second item on the Balance Sheet. (Recall, your authors suggest that you build your pro forma Income Statements and Balance Sheets using the same structure as the firm's current Income Statements and Balance Sheets.) For our purposes here, we will set accounts receivable at 9.5% of sales. This is consistent with the historical percentages of 9.8%, 9.6%, 9.5%, and 9.6% respectively for the 2013–2016 time period.

Using 9.5% of sales will produce the same estimates as 35 days receivable or a 10.4 annual turn. It does not matter how the ratio is calculated; one measurement unit (percentage, days, or turns) translates to the others. However, as previously mentioned, your authors believe that percentage of sales is easier and more intuitive than days and turns.

The next Balance Sheet item, pro forma inventory, is going to take some additional work (as opposed to just using the same percentages as in prior years). Why? Because we have changed our accounts payable policy to pay in 10 days to obtain a 2% discount. This changes the cost of purchases and thus the ending inventory value. Inventory is adjusted to reflect the purchase discount and is now set at 18.62% of sales (as above in our calculation for COGS, we take our original rate of 19% and multiply it by 98%; 100% minus the 2% purchase discount for paying in 10 days).

Note also that we are using inventory as a percentage of sales (that is, using the selling price of the inventory sold). Alternatively, inventory can be estimated as a percentage of COGS (which is the cost to the firm of the inventory sold). If the COGS, as a percentage of sales, is stable year to year, as they are for PIPES historically, these two methods are equivalent. We assumed a one-time change from 2016 to 2017 because of the application of the 2% purchase discount. However, we assume the new ratio stays constant after 2017.

Does it make sense that the ratio of receivables to sales and inventory to sales would be basically constant? Yes, if there is no major change in a firm's operations. That is, an expansion of sales is the result of expanding the customer base to similar customers (so the accounts receivable ratio stays constant), and purchasing policy also does not change (so the inventory to sales ratio remains constant). A firm is normally expected to hold more receivables and inventory as sales increase. In this case, we expect a one-to-one relationship between receivables, inventory, and sales.

Next, we need to forecast property, plant, and equipment (PP&E). While we expect items such as accounts receivable and inventory to change in the same proportion as sales year to year in the pro forma Balance Sheet, PP&E does not. We expect PP&E to increase over time with sales, but we do not expect it to rise in direct proportion to sales on a yearly basis. PP&E increases in more of a step function rather than in a smooth linear fashion. (For example, if sales grow enough, you will have to increase the size of the store, but a 25% increase in sales per year does not mean that PIPES increases its store size by 25% a year.) For 2017, your authors assumed PP&E for PIPES did not change much, growing only slightly from 2016. This indicates the firm has substantial economies of scale in PP&E. (Sales are able to grow at 25% a year without an equal increase in PP&E.) For 2017, we assume PP&E will grow at 5% (from $350,000 to $368,000).5

Moving to the liabilities and net worth side of the Balance Sheet in Table 3.1B: the first item, the bank loan, is a plug or balancing figure (i.e., the final amount we calculate when we balance the Balance Sheet), so we will come back to it.

The long-term debt (not bank debt) on PIPES's Balance Sheet is divided into two pieces: a current portion and a noncurrent portion. The current portion of long-term debt is the amount of long-term debt the firm pays off each year and is included under current liabilities. The noncurrent portion of long-term debt is the amount due beyond one year and is included below current liabilities. Usually the repayment terms (e.g., the amount paid each year) and the maturity of the debt are fixed by the contractual debt obligation. In the case of PIPES, since the current portion of long-term debt is $10,000 for the years 2013–2016, we assume it will remain constant. This means the long-term debt figure is reduced by $10,000 each year as it is paid off: the $100,000 from the 2016 Balance Sheet will thus become $90,000 in our 2017 pro forma.

In the past, accounts payable was used by PIPES to finance itself. This was discussed under the cash cycle in Chapter 2 and was included in our discussion about whether or not to cut payables to 10 days. Once the decision is made to make accounts payable equal to 10 days of purchases, then payables can be stated as a percent of purchases and/or sales.

Since we are projecting sales to grow, we would expect accounts payable to grow as well. In the past, however, payables increased from 7.1% of sales to 10.1% (or from 32.6 to 45.9 days) over the 2013–2016 time period. However, going forward, payables will be projected at 2.07% of sales (or 10 days) to obtain the 2% purchase discount.6 This means payables for 2017 are $57,000, well below the $223,000 they were in 2016.

We leave accruals constant, both because we have no priors about how they change and because it is an extremely small number and won't have a material effect on our financing requirements.

The next two items are contributed capital and retained earnings. Combined, these two items are often referred to as net worth. Contributed capital is the amount invested by the owners of the firm. Retained earnings are the firm's cumulative total net income over time minus any dividends (which PIPES has not been paying). Contributed capital is assumed to remain constant at $75,000. Retained earnings are assumed to increase by $140,000 (from $279,000 to $419,000), which is our estimate of net income for 2017 from the first pass 2017 pro forma Income Statement (remember, retained earnings increases by the amount of net income if none of the net income is paid out as dividends).

Let us now return to bank debt, which is our plug figure. On a Balance Sheet, the most common plug items are cash and debt. That is, after all the other assets and liabilities are set, the surplus shows up as cash, while a deficit shows up as borrowings. (In PIPES's case in years past, accounts payables also served as a plug; since the amount of bank borrowing was capped, PIPES made up the deficit by delaying payment to its suppliers.)

In PIPES's 2017 Balance Sheet, total assets are greater than liabilities and net worth by $548,000 (i.e., the Balance Sheet is out of balance by $548,000 if PIPES does not obtain more external financing). This is the amount of bank debt PIPES requires in 2017 to operate the firm under our assumptions. That is, this is the plug number with an increase in sales of 25% and all the other assumptions stated above.

This is all shown directly in Table 3.1B. The bank loan of $548,000 is the plug that makes the Balance Sheet balance.

At this point, Mr. Steele almost has a number to give the banker when he walks into the bank. Why do we say Mr. Steele almost has a number? The reason is that, so far, this is only a first pass. The Balance Sheet is dependent on the Income Statement (in particular the sales forecast and the projected net income), and the Income Statement is dependent on the Balance Sheet (in particular the amount of debt on the Balance Sheet determines the net interest expense on the Income Statement). We will now return to the issue of how to finalize our computation of interest expense on the Income Statement and the amount of bank debt on the Balance Sheet.

CIRCULAR RELATIONSHIPS

After our first pass, represented by Table 3.1A and Table 3.1B, we now have to revise the interest expense in our pro forma Income Statement. Why is a correction needed? It is needed because the initial estimate was based on the assumption that the amount borrowed would be equal to the prior year. We knew this was wrong when we made it because we knew PIPES was going to need a higher loan amount to finance the increase in receivables and inventories as well as financing the reduction in payables.

We assumed that total interest-bearing debt at the end of 2016 is $450,000 (a $350,000 bank loan and $100,000 of current and noncurrent portions of the long-term debt). We also assumed an interest rate of 7% on the bank debt and 9% on the long-term debt. We will keep the interest rate assumptions the same. However, from the pro forma Balance Sheet, we now see that the long-term debt (current and noncurrent) declines to $90,000, but the bank debt increases from $350,000 to $548,000. This makes the new debt level $638,000 ($10,000 + $80,000 + $548,000) and the interest expense for 2017 now equals $46,460 (9% * $90,000 + 7% * $548,000).

This is shown in Table 3.2A, where interest expense is increased from $34,000 to $47,000. This in turn lowers profit before tax from $215,000 to $202,000 (the $13,000 change in interest expense), income tax from $75,000 to $71,000 (the tax rate times the change in interest expense), and net earnings from $140,000 to $131,000 (the change in interest expense net of the tax effect).7

TABLE 3.2A PIPES—Revised 2017 Pro Forma Income Statement

($000s) 2016 Estimate 2017
Sales 2,200 +25% 2,750
Cost of goods sold 1,695 sales * 0.7546 2,075
Gross profit 505 675
Operating expenses 344 sales * 0.155 426
Earnings before interest and tax 161 249
Interest expense 34 based on B/S 47
Profit before tax 127 202
Income tax 44 PBT * 35% 71
Net earnings 83 131

These Income Statement changes in turn affect the Balance Sheet as shown in Table 3.2B. Because pro forma net income (aka net earnings) are less by $9,000 on the Income Statement, retained earnings on the Balance Sheet will be less by the same amount. This will increase the plug figure (i.e., the desired bank loan) by an equal amount from $548,000 to $557,000. This in turn causes a further increase in interest expense ($9,000 * 7% = $630), which will then again change earnings, and so on. Today, any good spreadsheet program will iterate (and solve) this circular relationship. For our purposes here, we are going to simply stop at the second pass presented in Tables 3.2A and 3.2B, knowing that the final bank loan will be only slightly higher.8

TABLE 3.2B PIPES—Revised 2017 Pro Forma Balance Sheet

($000s) 2016 Estimate 2017
Cash 45 Constant 45
Accounts receivable 211 Sales * 9.5% 261
Inventory 418 Sales * 0.1862 512
Prepaid expenses 28 Constant 28
Current assets 702 846
Property, plant, and equipment 350 +5% 368
Total assets 1,052 Total 1,214
Current portion long-term debt 10 10
Bank loan 350 Plug 557
Accounts payable 223 Sales * 0.0207 57
Accruals 25 Constant 25
Current liabilities 608 649
Long-term debt 90 80
Total liabilities 698 729
Contributed capital 75 Constant 75
Retained earnings 279 Open + NI 410
Total debt and equity 1,052 1,214

We can now finally answer the banker when he asks: How much do you need to borrow? Mr. Steele's answer is $557,000 for next year.9

The Lender's Perspective

Now let's consider again the perspective of the banker, Mr. Garcia: you have talked to Mr. Steele, you've seen the analysis, and you've run the numbers as well. Mr. Garcia knows PIPES requires these funds to grow receivables, inventory, and PP&E, as well as to pay down the accounts payable to 10 days given PIPES's projected sales growth. A loan amount of $557,000 for next year seems to be a reasonable forecast. Are you ready to make this loan? Not quite yet.

Is there anything else you would want to know before deciding on whether to make the loan? Yes. What are all the things bankers typically want to know? They want to know the following:

  1. Why does the firm need the money?
  2. How much does the firm require?
  3. When will the bank be repaid?
  4. What is the risk involved?

The answers to questions 1 and 2 have already been answered by our ratio analysis, Sources and Uses of Funds, and pro formas. Now let's tackle the last two questions by extending our pro formas to multiple years.

However, one note before we move on. Most people think of borrowing as being done to finance plant and equipment. However, as can be seen from PIPES, firms also finance working capital: inventory and receivables. In fact, in aggregate, a large percentage of all financing is for working capital.

BACK TO (FORECASTING) THE FUTURE

While one year of pro formas is nice, it is often useful and/or necessary to project a firm's cash flows and financing requirements over a longer period. The same techniques that are used for one-year pro formas can also forecast longer time horizons. It is important to remember that our forecasts are just that: possible future outcomes. Each different assumption or ratio applied will lead to a different outcome. Projecting the future is more of an art than a science. Ten different analysts are likely to prepare 30 different forecasts. The beauty (at least to your co-authors) of finance is that there is no single right answer. There are multiple possible correct solutions. There are also definitely wrong ways to do pro formas. (It is important as a finance student to realize that finance being an art is the reason why the better practitioners are paid so well. If finance was exact and easy, the compensation levels would be much lower.)

Revising our initial projections for PIPES to include our new accounts payable assumption results in a loan request of $557,000. However, this $557,000 estimate is only the loan amount required for next year. Rather than go to the bank each year, we may ask for a line of credit sufficient to extend over several years. To do that, we will use our projections for 2017 and extend them for an additional two years (we are only using a total of three years of projections to keep our illustration simple; in practice, we would probably use five years).

Remember that forecasts are based on specific assumptions; different individuals will have different assumptions, and therefore different forecasts. For example, as noted above, your authors began with a sales increase of 25%. Is this reasonable? Based on the data given, we think so, but others can disagree. You could be more conservative and estimate a lower sales increase, no increase, or even a decrease. You could be more optimistic and predict a larger sales increase. The sales prediction is often the most important forecast, as many other projections are tied to it.

Once you are experienced in pro formas, scenarios are often run by varying different estimates (or simulations by varying multiple estimates at the same time). This allows for a determination of the firm's borrowing requirements under alternative assumptions. This is usually done for a set of pro formas covering best-case, worst-case, and expected-case scenarios.

PROJECTING OUT TO 2018 AND 2019

What should our projections for sales be for the next two years? A firm's planning horizon is usually for more than just one year. Indeed, most firms project out for a much longer period. However, the further we get from the present, the less certainty and also the less detail is attached to a forecast. For this chapter, we will now project out PIPES's performance for 2018 and 2019 in Tables 3.3A and 3.3B. In reality, as noted above, we would probably do pro formas for at least five years.

TABLE 3.3A PIPES—Pro Forma Income Statements 2017 to 2019

($000s) 2017 2018 2019
Sales 2,750 3,438 4,297
Cost of goods sold 2,075 2,594 3,243
Gross profit 675 844 1,054
Operating expenses 426 533 666
Earnings before interest and tax 249 311 388
Interest expense 47 50 56
Profit before tax 202 261 332
Income tax 71 91 116
Net earnings 131 170 216

For the 2017 pro formas, we start with an assumption of how sales will grow. In the case of PIPES, we used the historical average of 25% growth. We don't know for certain what it should be, and in a larger firm the marketing department would make suggestions, although they don't know for certain either. For our illustration, we will keep sales growth at 25%, as this is what it has averaged over the past three years and seems to be a likely starting point. In actuality, we would do scenario analysis as mentioned above (i.e., we would assume several different growth rates and examine the differential impact on the firm).

TABLE 3.3B PIPES—Pro Forma Balance Sheets 2017 to 2019

($000s) 2017 2018 2019
Cash 45 45 45
Accounts receivable 261 327 408
Inventory 512 640 800
Prepaid expenses 28 28 28
Current assets 846 1,040 1,281
Property, plant, and equipment 368 404 485
Total assets 1,214 1,444 1,766
Current portion long-term debt 10 10 10
Bank loan 557 613 711
Accounts payable 57 71 89
Accruals 25 25 25
Current liabilities 649 719 835
Long-term debt 80 70 60
Total liabilities 729 789 895
Contributed capital 75 75 75
Retained earnings 410 580 796
Total debt and equity 1,214 1,444 1,766

For Cost of Goods Sold, we again include the 2% discount on purchases going forward and use 75.46% of sales.

Operating expenses are assumed to be stable at 15.5% over the additional two years, as is the tax rate of 35% on profits before tax (remember, this assumption does not foresee the tax law change in 2018). This is all in line with past performance ratios (note our reliance on ratios when we do forecasting).

Thus, we start with the $2.75 million sales estimate for 2017, grow it by 25% for the next two years, and then use the same ratios for the rest of the numbers on the 2018 and 2019 pro formas as we did for 2017. This provides estimates for COGS, operating expenses, and taxes.

The interest expense is adjusted in an iterative process, as noted above. An initial estimate is made based on the prior year and is adjusted after finishing the pro forma Balance Sheet and computing a new required loan amount. The interest rate is set at 7% for the bank loan and 9% for the long-term debt. As above, all profits are added to retained earnings.

We also take all the same assumptions used for the 2017 pro forma Balance Sheet and apply them for the 2018 and 2019 pro forma Balance Sheets. We do make one change: we assume PP&E grows by 5% in 2017 (as above), 10% in 2018, and 20% in 2019. This is our recognition of the fact that, with so much sales growth, PIPES may need to expand its warehouse facilities.10

Notice that the required bank loan, which was $557,000 in 2017, grows to $711,000 by 2019. This means that asking for a $557,000 loan in 2017 will only finance the firm's growth through the end of 2017. During the following two years, if sales growth continues at the projected 25%, the firm will need at least $154,000 more. It is useful to realize this before negotiating with the bank rather than discovering it two years later or having the bank point it out.

Returning to our basic questions above, now looking out to 2019:

  1. Why does the firm need the money?
  2. How much does the firm require?
  3. When will the bank be repaid?
  4. What is the risk involved?

EVALUATING THE LOAN

Question number 1, why the firm needs the money, has not changed from our analysis above. The firm is experiencing rapid sales growth and primarily needs to finance the increase in inventory and receivables.

Question number 2, how much PIPES needs, is answered by the pro formas above. PIPES needs a bank loan of $557,000 in 2017, growing to $711,000 by 2019.

Question number 3, when will the loan be repaid, requires more analysis. Let's look at the term for repayment: Is the bank loan a short-term financing need for PIPES? No, it is, in fact, a long-term need! (This is regardless of the fact that the bank loan is classified as short term on the Balance Sheet. It is technically short term because the bank has the right to demand repayment within a year.)

Since most of the loan PIPES requires is to finance receivables and inventory, which are short-term assets, does this mean that PIPES should use short-term debt? No, this is a long-term need for PIPES and is not temporary; it is permanent financing. The bank must not go into this as a one-year loan, even if the repayment deadline is in one year. This should be viewed by the bank as a multiple-year loan because PIPES will need bank financing for several years.

An aside: It is common to hear people say that a firm should match the duration of its financing with the nature of the asset being financed, that is, finance short-term assets with short-term loans and fixed assets with long-term loans. Later in the book, we will demonstrate that this is not necessarily true. PIPES may prefer to issue long-term debt, rather than borrow short-term from the bank, but may not have the necessary access to the capital market to do so.

The fact that the loan is long term leads us naturally to question number 4, which is: How risky is the loan? The relationship between PIPES and the bank is long term. This means the loan's risks can't be evaluated as lasting just one year.

What are the main risks to the bank in lending money to PIPES? The bank is mostly worried about a default and not being fully repaid. Why might PIPES default on the loan? Let's consider some possibilities. There could be an economic downturn. But is this really a problem for a bank lending to PIPES? What happens to PIPES if there is an economic downturn? Sales will grow more slowly, and PIPES will need less money. As long as Mr. Steele keeps PIPES's ratios constant, as long he manages inventory cost and levels, maintains operating expenses, and properly manages the firm's receivables, all that will happen to PIPES is that it will grow more slowly or shrink slightly and require a smaller loan from the bank. Additionally, interest rates might fall in an economic downturn, which would actually improve PIPES's profit margin.

What happens if competitors come in; for instance, what if a large box store like Home Depot opens across the street and puts PIPES out of business? As long as Mr. Steele manages the reduction in sales, the banker does not have to worry. PIPES will simply liquidate and pay the bank back. The only risk is if Mr. Steele keeps increasing inventory despite the plummeting sales.

In addition, the bank is not lending money to PIPES unsecured. The bank is lending the money with PIPES's assets as collateral. How good is the collateral (the value of the receivables, inventory, and fixed assets) with which PIPES can cover the loan? Let's begin with the receivables. They have kept fairly constant as a percentage of sales, which indicates the firm's operations are probably well managed.

The bank will almost certainly include covenants requiring the firm to keep operations at a certain level. For example, COGS has been a fairly constant 77% of sales (before the discount) and 15.5% of operating expenses. A covenant may require COGS to remain below 79% and operating expenses below 17%. If PIPES exceeds the limits, the bank can demand full repayment. Likewise, a covenant may mandate that receivables remain below 40 days. This is another way ratios are used: to write covenants that reduce the lender's risk by ensuring management does not lose control over operations (or that if management begins to lose control, the bank gets repaid before the situation collapses entirely).

Bankers would prefer not to seize assets, but sometimes they have no choice. What would PIPES's assets be worth if liquidated under distress? What is the collateral?

This is a small town, and the banker probably knows most of the individuals and firms to which PIPES has extended credit, so he has a good understanding of how likely it is that the receivables will be collected. Additionally, the receivables are currently at only 35 days, which seems conservative when you compare PIPES to other firms in the industry. In a distressed liquidation, your authors estimate PIPES would likely obtain 80%11 of their receivables (there will be some bad debts and cost of collections).

In a liquidation, PIPES will not get its normal selling prices for any remaining inventory. The firm will have to offer discounts, and there will be costs to selling. However, remember that we are comparing the liquidation value to the cost of the goods; COGS is 75.46% of the normal selling price (of sales), so there is already a 24.54% discount built in. Also, the inventory held by PIPES is a commodity. It is not a specialty, custom item that will be hard to liquidate. We're talking about standard plumbing supplies. In this case, your authors believe an estimate of 60% of inventory cost being recovered during liquidation is conservative.

The fixed assets (PP&E) are primarily buildings and perhaps some trucks (forklift and delivery). The accounting value for fixed assets includes a reduction for depreciation. In this case, an estimate of 85% seems reasonable to your authors.

This leaves us with the collateral situation shown in Tables 3.4 and 3.5.

TABLE 3.4 Collateral

(000s) 2017 2018 2019
(a) Receivables with an accounting value of $261 $327 $408
(b) Inventory with an accounting value of $512 $640 $800
(c) PP&E with an accounting value of $368 $404 $485

TABLE 3.5 Collateral Evaluation

(000s) 2017 2018 2019
(a) Required cash balance $ 45 $ 45 $ 45
(b) Receivables at 80% of the accounting value $ 209 $ 262 $ 326
(c) Inventory at 60% of the accounting value $ 307 $ 384 $ 480
(d) PP&E at 85% of the accounting value $ 313 $ 343 $ 412
Total estimated liquidation value of collateral $ 874 $1,034 $1,263
Long-term debt $ 90 $ 80 $ 70
Loan $ 557 $ 613 $ 711
Total debt $ 647 $ 693 $ 781
Collateral/total debt 135% 149% 162%
Collateral/bank loan 157% 169% 178%

The coverage to the bank improves from 157% to 178% of the estimated liquidation value of the collateral. Is the bank covered? Yes, in this case it appears to be covered quite well. Note that when banks lend long term they typically have first priority to all the assets (their claims come before any other lenders, and they are paid first when the related “secured” property is sold), and they will have covenants to ensure management does not lose control over operations.12

What else should Mr. Garcia worry about? PIPES is a sole proprietorship. Is there someone who can take over if Mr. Steele is taken ill or dies? Essentially, bankers worry about catastrophic risk. The death of key management personnel, a fire, and so forth are all catastrophic risks. What can a banker do to reduce or eliminate catastrophic risks? Require the firm to carry insurance. Even with large corporations, it is not unusual for banks to require insurance on key employees, in case of fire and so on. In many countries, home mortgages require life insurance plans—if the borrower dies (or any one of the borrowers, in the case of more than one person being on the loan contract), the insurance pays off the mortgage. Banks also routinely require borrowers to have fire insurance on the financed property. Thus, unsystematic risks can often be insured.

So, is this a good loan? It is a great loan! Mr. Steele has been in business 15 years, the firm is profitable, he appears to know his business, he's controlling expenses very well, he's making money, and he's expanding like crazy! If there is an economic downturn, as long as Mr. Steele manages the downturn, all that will happen is that PIPES will borrow less. For PIPES, slower growth means borrowing less, faster growth means borrowing more. And the banker gets strong collateral that should be easy to liquidate.

What is the main reason a banker might not give a business owner a loan? A banker may be hesitant to lend to someone who displays an inability to manage their business and/or who does not know how much they require. If Mr. Steele goes into the bank and says he has no clue how much he needs, that might give a banker pause. But if he pulls out a set of pro forma financials, explains how much he needs to maintain his 25% sales growth (or, even better, has estimates for different scenarios), shows the banker the firm's collateral, and demonstrates his experience and how well he knows his business, the banker will say: “Sold, here is the loan.” It is the business owners who do not have a clue that bankers have to worry about.

What if the banker, Mr. Garcia, tells Mr. Steele he will not extend the loan? Then Mr. Steele has to find other sources of financing. Where are the other sources of financing? Given your authors' enthusiasm over this particular loan, we would suggest Mr. Steele contact another bank. Failing that, another option is to get financing from the same place PIPES obtained funding in the past: from the trade creditors. It will be more expensive than bank debt, but it is an option, unless suppliers refuse to extend any more trade credit.

Another option would be to bring in new equity. This firm is not large enough for an initial public offering of equity (an IPO), but perhaps Mr. Steele could find a partner—a key employee might be willing to invest and become an owner.

The firm could also reduce its receivables by selling them at a discount to someone else who will then collect from the customers. This is called factoring, and it is actually very common today, although it is now mostly done with credit cards. PIPES could tell its customers that they are no longer extending credit but will accept Visa. A contractor makes a purchase and pays with his Visa card. PIPES is paid the next day. The contractor still owes the money (i.e., it is still a receivable), but he no longer owes it to PIPES, as it is now a receivable to Visa. Visa does the credit check before the purchase and the collection afterward. Naturally, this is not free. Visa charges small firms 3–5% for the service (large chains pay 1–2%).

Another option is for PIPES to sell some assets. The firm could sell their fixed assets and lease them back or take a mortgage on them. Right now PIPES does not appear to have any mortgages.

Let's ask another question: Should Mr. Steele continue expanding? If the bank won't lend him the funds to grow, an alternative to external financing from another source is to simply grow more slowly. How does a firm slow growth? The best way is to raise prices (you not only slow growth, but you increase margins). Mr. Steele could also become rude to customers (e.g., hang up on every fifth caller), close on Saturdays, and so on.

We will cover the concept of investment decisions and the cost of capital later in the book, but let's do a back-of-the-envelope preview, albeit a crude one. For every $100,000 of additional sales, PIPES has a COGS of $75,460 and operating expenses are $15,500. Additionally, net working capital increases by $26,430, costing the firm (at a 7% borrowing rate) an additional $1,824. This means that an extra $100,000 of sales increases PIPES's operating profits by $9,040 ($100,000 – $75,460 – $15,500), less $1,824 in financing charges resulting in an extra $7,216 ($9,040 – $1,824) before tax, and $4,690 after tax for Mr. Steele. In our current case, if sales go up, the profits go up. Therefore, if Mr. Steele can manage it, he would like to keep expanding.

Impact of an increase in sales:
Sales increase $100,000
Increase in COGS (75.46%) $75,460
Increase in SG&A (15.5%) $15,500
Increase in financing (shown below) $ 1,824
Total change in costs $ 92,784
Additional profit before tax $ 7,216
Tax (35%) $ 2,526
Increase in net income $ 4,690
Related financing charges:
Accounts receivables (9.5% sales) $ 9,500
Plus inventory (18.62% sales) $18,620
Less accounts payable (2.07%) –$ 2,070
Change in new working capital $26,050
Borrowing rate 7%
Increased in financing costs $ 1,824

SUMMARY

  1. PIPES is a profitable firm that is short of funds. Not only is this not atypical, it is actually a common occurrence. Many firms grow faster than their ability to finance themselves internally from profits. This is why there are capital markets. Almost every firm listed on the New York Stock Exchange has public debt. Virtually every successful firm at some point needed more financing than they generated internally. (This refers to the concept of sustainable growth, which we will define in Chapter 5 and discuss in detail in Chapter 9.) This situation is very common and is the reason PIPES required external financing.
  2. The Sources and Uses of Funds indicates where a firm gets its money and what the funds are used for.
  3. Ratio analysis is used to compare a firm with others in its industry as well as itself over time (e.g., Is the firm holding expenses constant over time?). As such, ratio analysis provides a preliminary evaluation on the health of the firm. Not only are ratios used by analysts to describe the firm's health, they are also an important part of debt covenants. In that context, failing to maintain ratios within proscribed ranges can actually trigger bankruptcy of a firm. Ratios are also used when generating pro formas, since past ratios are often assumed to continue in the future.
  4. Pro forma financial statements are estimates of the firm's future Income Statements and Balance Sheets. They are based on assumptions about how the firm's current ratios will change (or remain the same) over time. In so doing, they provide estimates on the amount and duration of funding required. In the case of PIPES, the pro formas showed the firm required $557,000 in 2017, growing to $711,000 in 2019. In addition, the pro formas show that the funding needs are not short term, but permanent.

    We will repeatedly use the three tools from the last and current chapter—Sources and Uses of Funds, ratio analysis, and pro formas—throughout the book.

  5. Not all items in the pro formas are of equal importance. For example, it does not matter what assumptions are made for cash and accruals in PIPES's case because they are dwarfed by sales, receivables, inventory, fixed assets, and payables. It is important to determine and focus on the important, driving factors when generating pro formas.
  6. We reviewed the type of questions a banker might ask: Why does the firm need the money? How much does the firm require? When will the bank be repaid? What is the risk involved?
  7. This chapter also briefly touched on the issue of the cost of capital (which is discussed in the second segment of this book) and the profitability of an investment (what is the return versus the cost). We have not done these properly yet, but they have been introduced.

Coming Attractions

In the next chapter, we end our tale of PIPES after repeating the above analysis but including the impact of seasonality. But first, an important appendix.

APPENDIX 3A: ACCOUNTING IS NOT ECONOMIC REALITY

This appendix describes the underlying nature of accounting and illustrates the necessary trade-offs that limit the ability of accounting to reflect a firm's underlying economic reality.

Why does a Balance Sheet have to balance? Ask this question to an accountant and you are likely to be told that the Balance Sheet is simply the mathematical equation:

equation

If you press the accountant further, you will be told about the components of the Balance Sheet and how it is produced (with a high chance you will also be told all about the use of Debits, which means to the left, and Credits, which means to the right). The accountant will say that if a Balance Sheet does not balance, it means a mistake has been made. While true, this view misses what the Balance Sheet is really about.

The Balance Sheet must balance because on one side it reflects the resources that a firm owns and controls and that will provide the firm with future cash flows (the Assets), and on the other side, how those resources are financed (the Liabilities and Equity). Each side is measured separately, and the two sides must balance. If they aren't equal, it means a mistake has been made, which must then be found and corrected (if they are equal, however, it does not mean the Balance Sheet is free of mistakes). A Balance Sheet is seen in Table 3A.1 using a large T-account with the Assets on the left and the Liabilities and Equity on the right.

TABLE 3A.1 Typical Balance Sheet

Assets: Liabilities:
Cash Payables (owed to suppliers)
Receivables (owed to the firm) Borrowed funds
Inventory
Other short-term resources Equity:
Property, plant, and equipment Capital received from owners
Other long-term resources Retained earnings

There is a perception that accounting numbers present the truth. This probably stems from accounting's mathematical basis. However, accounting rules and practices provide managers with discretion over how they present the economic reality of a firm. The Balance Sheet is an algebraic equation, and the total debits (amounts put on the left side of the accounts) must match the total credits (amounts put on the right side of the account). However, the truth is that accounting is closer to an art than a science (albeit perhaps more scientific than finance). The accounting numbers present one of many pictures of the underlying economics of a firm—but there is no single truth to present.

Let's present an example of many different truths. Consider a simple business venture: selling T-shirts. For simplicity, the owner/investor puts in $36 (meaning both the firm's cash and the owner's equity go up). Over time, the owner purchases three identical T-shirts for $10, $12, and $14 (meaning $36 from cash is spent, and inventory goes up by $36). Note that this example involves a change in purchase prices. It does not really matter why the price changes (inflation, market conditions, etc.). Since, as stated, the T-shirts are identical, a customer will not care which one he or she is given. Before anything has been sold, the Balance Sheet will balance with $36 in inventory and $36 in owner's equity (see Table 3A.2).

TABLE 3A.2 Accrual Accounting before any Sales

Assets: Liabilities:
T-Shirt #1 $10 Amount borrowed $ 0
T-Shirt #2 $12
T-Shirt #3 $14 Equity:
Capital from owners $36
Total $36 Total $36

Now assume the business sells one T-shirt for $20. How much profit has the business venture made?

There are five possible methods to answer this question.

  1. Accrual accounting with inventory costed using the First In First Out method
  2. Accrual accounting with inventory costed using the Average method
  3. Accrual accounting with inventory costed using the Last In First Out method
  4. Cash accounting
  5. Accrual accounting with inventory valued at market

The first three are traditional accrual accounting methods based on how the firm decides to cost the one T-shirt sold. If the firm chooses to do so in the same order they were purchased, costing the oldest unit first—a method called “first in first out” (FIFO)—then the firm has a profit of $10 ($20 in revenue – $10 cost). Note, this leaves the most recently purchased T-shirts (the last two T-shirts) on the Balance Sheet as assets with a value of $26 (see Table 3A.3A).

TABLE 3A.3A First In First Out

Assets: Liabilities:
Cash $20 Amount borrowed $ 0
T-Shirt #2 $12
T-Shirt #3 $14 Equity:
Capital from owners $36
Retained profit $10
Total $46 Total $46

It is also possible to cost the inventory by computing an average cost for the three T-shirts ($36/3 = $12)—this method is simply called “average” (AVG; see Table 3A.3B). This produces a profit of $8 ($20 in revenue – $12 in cost). Note that this will value the two remaining T-shirts at $12 each for a total of $24 in inventory.

TABLE 3A.3B Average

Assets: Liabilities:
Cash $20 Amount borrowed $ 0
2 T-Shirts @ $12 = $24
Equity:
Capital from owners $36
Retained Profit $ 8
Total $44 Total $44

The third option is to cost the inventory by using the most recent purchase price—a method called “last in first out” (LIFO; see Table 3A.3C). This produces a profit of $6 ($20 in revenue – $14 in cost). Note that this leaves the earliest purchased T-shirts (the first two) on the Balance Sheet as assets with a value of $22 (the first at $10, the second at $12).

TABLE 3A.3C Last In First Out

Assets: Liabilities:
Cash $20 Amount borrowed $ 0
T-Shirt #1 $10
T-Shirt #2 $12 Equity:
Capital from owners $36
Retained profit $ 6
Total $42 Total $42

Thus, three different methods (FIFO, AVG, and LIFO), all of which are correct, results in three different profit amounts and three different Balance Sheets.

An argument in favor of FIFO is that the two units of unsold inventory on the Balance Sheet would be valued at $26 ($12 + $14), which is probably closer to a replacement cost of $28 (assuming prices have increased to $14, replacing the two units would probably mean paying the last purchase price of $14 for each one). In contrast, the inventory value computed under LIFO is much lower than the potential replacement cost: LIFO would value the remaining inventory at $22 ($10 + $12). Thus, by using FIFO and costing the oldest unit first, the Balance Sheet is more reflective of the current underlying value (replacement cost) of inventory. The inventory number under FIFO is probably more relevant, in terms of the Balance Sheet, than the number under LIFO.

So why is FIFO not mandated for all financial statement disclosures? The reason lies in the fact that firms' equity values are not based strictly by the numbers on a Balance Sheet. Most firms are valued based on their ability to generate profits in the future. A key objective in financial reporting is to provide outsiders with an ability to estimate the future cash flows of a firm, and this is done by starting with an examination of the accounting profits (we predict the future by starting with the past). For this, the outsiders use not only the Balance Sheet, but also the Income Statement (and the Statement of Cash Flows).

While FIFO may provide a more relevant valuation of inventory on the Balance Sheet, the profit generated using FIFO is $10. The profit generated using LIFO is $6. Which of these two profit numbers is a better predictor of future profits and cash flows? If the selling price remains at $20 and the purchase of new T-shirts stays at $14, then the $6 computed under LIFO is a better estimate of expected profits going forward. The $4 difference in profits ($10 – $6) will eventually be realized when the firm sells down its inventory. The extra profit on the first and second T-shirts is not sustainable, and thus LIFO may provide a better estimate of future profits and cash flows.

The average method is a compromise between the two.

Why not simply number the three T-shirts and cost the one that is actually sold? This is a valid method called specific identification and is used in high-value products where customers choose the specific product sold (e.g., automobiles). However, in the example being given, the T-shirts are of low value and identical. Costing the actual T-shirt sold would allow management to choose the profit they will report by choosing which T-shirt they gave the customer (the customer would not care, as they are identical). A key goal of accounting is to prevent management from simply choosing the profit it reports to outsiders.

It is true that by choosing the accounting method—FIFO, LIFO, or AVG—management can also alter a firm's profit. However, because firms must disclose their accounting choice, an outsider can interpret the profit number (and/or adjust it to reflect an alternative choice).13

These three traditional accounting methods—FIFO, LIFO, and AVG—demonstrate the trade-off being made between the Balance Sheet (what the assets are worth) and the Income Statement (used to estimate future cash flows). But there are two other possible methods to compute the profit made by this simplified business venture.

Another approach is to focus on cash. As we will see later when we discuss cash flows, reality is cash (or alternatively “Cash is King”). How much cash came in, and how much cash went out? Using cash accounting, there is only one asset category: cash.14 Costs are incurred when cash is paid and revenue occurs when cash is received. Thus, if the only asset recorded is cash (which is what cash accounting does), then the firm will have a loss of $16 after the sale of one T-shirt (the initial $36 outlay plus the $20 from the first sale).

Under cash accounting, our Balance Sheet looks as shown in Table 3A.3D.

TABLE 3A.3D Cash Basis

Assets: Liabilities:
Cash $20 Amount borrowed $ 0
Inventory $ 0
Equity:
Capital from owners $36
Retained profit (loss) ($16)
Total $20 Total $20

TABLE 3A.3E Mark to Market

Assets: Liabilities:
Cash $20 Amount borrowed $ 0
2 T-Shirts @ $20 = $40
Equity:
Capital from owners $36
Retained profit $24
Total $60 Total $60

The benefit of the cash basis of accounting is that it reflects one element of reality: the actual flow of cash in and out of an organization. The limitation of this basis of accounting is that it fails to value the remaining inventory or provide any ability to predict future cash flows.

Finally, under an economic concept of accounting—called mark-to-market—profit might be computed as $24. This approach values the remaining T-shirts not at their cost, but at an estimate of their value. The T-shirts would be valued at their “market value,” the price established by the last sale ($20 each).15

Thus, the firm began with an economic value of $36 (the cash invested by the owners) and ended with an economic value of $60 ($20 cash and inventory valued at $40). The difference between the opening ($36) and closing firm value ($60) is the profit, real and potential, of $24. Mark-to-market accounting reflects the fact that if we were to sell our T-shirt business to someone else, with assets of $20 cash and two T-shirts worth $20 each, we would be looking for a price of $60.

Mark-to-market accounting attempts to overcome an element not corrected by the other accounting methods: management's discretion over the accounting process. One benefit of mark-to-market accounting is that the value will be the same regardless of how many units are sold or in what order. The problem with mark-to-market is that it allows management discretion to influence the process when they value the unsold inventory. The true economic value of the inventory (or whatever is being valued) is the relevant (i.e., useful to outsiders) number. However, if there is no active liquid market for the item being valued, then a management-determined number, which may not be objective, must be used.

Note: The choice of how to cost the inventory (FIFO, LIFO, AVG, etc.) or whether to use cash accounting or mark-to-market is not required if the accounting is only done after all three T-shirts are sold. If firms only did their accounting when the business was being liquidated, all these accounting choices would give the same results. Thus, it is only because we do accounting every year (or month or quarter) that requires us to make these choices.

These examples, from a simple business venture, demonstrate why there is no single truth in accounting. Accounting faces a trade-off between providing the best valuation of the assets versus providing the best basis for estimating future cash flows. The manager decides based on the picture of the firm she wants to present to outsiders. As the business venture becomes more complex, so does the impact of these trade-offs. This is why there is no single way to determine the one “profit” number or “net value” in accounting. To understand the underlying economics of a business, the financial statements must be viewed in their totality as a starting point and not an end point and it is critical to know the accounting choices.

NOTES