ACC 345 Module 5 Forecasting Assignment Example

Next Year on Paper: Pro Forma Statements and Their Drivers for a Composite Fire Sprinkler Contractor

[Student Name]

Southern New Hampshire University

ACC 345: Financial Statement Analysis and Business Valuation

Module Five Assignment

[Instructor Name]

[Date]

The organization, setting and figures below are a composite written as a model document. No real employer, client, colleague or patient is described.

Next Year on Paper: Pro Forma Statements and Their Drivers for a Composite Fire Sprinkler Contractor

Introduction

The private equity firm considering the Atlanta sprinkler contractor needs a view of next year before it can value the business, and the contractor's bank needs one before renewing its line. This assignment prepares pro forma income statements and balance sheets for the coming year from explicit drivers. Koller et al. (2020) recommend building forecasts from operating drivers, revenue growth, margins and capital needs, rather than extending past totals, because drivers can be checked against the business. Every assumption below has a stated basis, and the plug, cash, shows whether the plan generates or consumes financing.

Revenue Drivers

Installation revenue of $24.0 million is forecast to grow 5 percent, based on the company's signed backlog of $14.8 million and its historical conversion of bids. Service revenue of $14.4 million is forecast to grow 13 percent, based on 94 percent contract renewal, price increases of 4 percent and new inspection contracts from buildings the company installed last year. Total revenue grows about 8 percent to $41,472,000.

Table 1. Revenue Forecast (thousands of dollars)

Income Statement

Gross margin is forecast by segment at last year's rates, 23.2 percent for installation and 36.0 percent for service, which gives 28.2 percent overall as the higher-margin segment grows faster. SG&A holds at 18 percent of revenue, as it has for three years. Depreciation is 2.1 percent of revenue, consistent with the planned fleet and equipment base. Interest rises slightly with average debt. The tax rate is 25 percent.

Table 2. Pro Forma Income Statement (thousands of dollars)

Balance Sheet Drivers

Receivables are forecast at 68 days of revenue, between last year's 73 and the prior year's 64, on the assumption that one of the two slow-paying projects closes and releases its retainage. Contract assets are 3.5 percent of revenue, contract liabilities 3.0 percent, inventory 3.0 percent, prepaid costs 0.55 percent, payables 8.5 percent and accrued liabilities 4.2 percent, each close to last year's ratio. Capital spending of $1,369,000, 3.3 percent of revenue, covers new service vans and a pipe-threading machine. The company will repay $600,000 of term debt and distribute $700,000 to the family.

Table 3. Pro Forma Balance Sheet (thousands of dollars)

Cash is the balancing figure. With the assumptions above, the company ends the year with $2,649,000, up $749,000, meaning the plan funds its own growth, debt repayment and distributions.

How the Statements Connect

A pro forma balance sheet is not a separate forecast; it is the income statement's consequences. Net income of $2,256,000 less $700,000 of distributions raises equity by $1,556,000. Capital spending of $1,369,000 less depreciation of $871,000 raises net property and equipment by $498,000. The $600,000 debt repayment lowers interest-bearing debt to $4,200,000. Every other balance sheet line is driven by revenue through a stated ratio, so the only figure left free is cash. If any link were broken, for example if depreciation in the income statement differed from the reduction in equipment, the balance sheet would still balance through the plug but the forecast would be quietly wrong, which is why each link is checked separately.

Reasonableness Checks

Three checks suggest the base case is reasonable rather than optimistic. Revenue growth of 8 percent is below the 11 percent of each of the last two years, which allows for the end of two large projects. The operating margin of 8.1 percent is only slightly above last year's 8.0 percent, with the whole improvement explained by mix. And the forecast receivables collection of 68 days assumes only partial recovery from the latest year's slowdown. A forecast that showed margins jumping or collections returning to 60 days without a named cause would deserve less trust.

Which Assumptions Matter

Nissim and Penman (2001) show that forecasts of profitability are most sensitive to the drivers of operating returns, and for this company the most sensitive driver is not margin but collection speed. Each day of receivables equals about $114,000 of cash at forecast revenue. If collections instead slipped to 80 days, receivables would be $9,092,000, about $1.37 million higher, and ending cash would fall to roughly $1.3 million, well below last year's level, with no change in profit. A one-point drop in installation gross margin, by comparison, would reduce net income by about $189,000. The bank and the buyer should therefore focus on the receivables assumption first and margins second.

A Downside Case

Table 4. Base and Downside Cases (thousands of dollars)

In the downside case, installation grows only 2 percent and service 7 percent, collections slow and the installation margin slips a point; together they cut ending cash to about $1.2 million, below last year's $1.9 million, which would likely mean drawing on the credit line or trimming distributions. Penman (2013) stresses that a forecast should be read as a range, not a point; here the range shows a business that remains profitable in a weak year but whose cash depends heavily on customers paying on time.

Conclusion

On the base case, the contractor grows revenue 8 percent to $41.5 million, earns about $2.3 million and ends the year with $2.6 million of cash after capital spending, debt repayment and distributions. The forecast is most sensitive to collections: at 80 days, cash falls by more than a million dollars. Lenders and buyers should test that assumption before relying on the base case.

References

Koller, T., Goedhart, M., & Wessels, D. (2020). Valuation: Measuring and managing the value of companies (7th ed.). Wiley.

Nissim, D., & Penman, S. H. (2001). Ratio analysis and equity valuation: From research to practice. Review of Accounting Studies, 6(1), 109-154. https://doi.org/10.1023/A:1011338221623

Penman, S. H. (2013). Financial statement analysis and security valuation (5th ed.). McGraw-Hill Education.