Updated: Oct 23, 2020
In the previous post, we looked at how to confirm the integrity of the pro forma financial model by auditing the spreadsheet for errors. This audit is the first step in the process of evaluating a pro forma financial model to ensure business owners and investors can rely on the model to make critical business decisions.
After confirming the integrity of the model, we now need to confirm the integrity of the pro forma financial statement. Specifically, we want to be certain that the pro forma financial model accurately represents the underlying business model.
First, we need to understand how the business operates. The company's industry and the type of business dictate the financial structure of the firm. So the first two questions to ask are:
What is the Company's Industry?
It is not possible to list all industry sectors in this blog post. Two excellent resources to learn about industry sectors are:
The U.S. Bureau of Labor Statistics - Here you will find a list of all industry sectors, a description of the industry, a list of the subsectors, and related labor statistics.
IBISWorld - This organization has an extensive list of very detailed Industry Research Reports, but they are not free. You can become a member or buy a single report.
What is the Company's Business Structure?
There are essentially five types of businesses:
Limited Liability Company
The composition of a company's balance sheet and income statement depends on its industry. Here are some things you should expect to see in each section depending on the industry.
The Balance Sheet - Assets
Manufacturer - Inventory includes raw materials, work in process, finished goods, with fixed assets comprising a large percentage of total assets.
Wholesaler/Distributor/Retailer - Heavy equipment and machinery. Fixed assets will comprise a significant portion of total assets.
Services Companies - If there are any fixed assets, they will be a very small percentage of total assets. Receivables and perhaps cash will be the largest component of total assets.
The Balance Sheet - Liabilities
Financial Services and Manufacturers are likely to have a high level of long term debt. Financial services firms will typically have a very high level of debt relative to equity.
Since they rely on trade debt and sell on credit, you can expect Wholesalers, Retailers, Distributors and Service Companies to have a significant level of short term debt in the form of bank debt and accounts payable.
The Income Statement
As a general rule., Cost of Goods Sold will be a separate line item for most companies other than Services Companies.
Operating Profit has to be sufficient to pay debt, dividends and reinvest in the company. You will want to do some research to determine what is a common Operating Margin for the type of company you are reviewing.
Income and Expenses
Dollars flow from the Income Statement to the Balance Sheet, so you need to understand how the company makes money to ensure the pro forma financial model is an accurate representation of the business. Here are some questions you should ask:
Income - How Does the Company Earn Its Money?
What are the revenue-earning activities?
What factors affect income?
Who are the company's customers?
What is the expected rate of growth for sales?
Where is this data - assumptions, calculations, output - in the pro forma financial model?
Expenses - What Costs Are Incurred to Earn Revenue?
Which costs are variable?
Which costs are fixed?
Does the pro forma financial model correctly distinguish between fixed and variable costs when calculating projected expenses?
What is the formula for calculating variable costs? Is the formula shown in the pro forma financial model? Is the formula correct?
Now that we have confirmed the pro forma financial model accurately represents the business model, we move on to actually analyzing the pro forma financial statements.