Acquisition Marketplace Review - The Journal of Applied M & A Theory

Preparing Monthly Projected Financial Statements for a Valuation

There are many things more interesting than the subject of monthly financial projections or forecasts. But if you are called upon to prepare them, you will quickly discover that there is very little guidance available on the subject.

This article provides an overview of the reasons for including monthly projections in a valuation; the issues to be considered by an analyst when including them and considerations that will help an analyst prepare a more diligent set of projections.

There are three primary reasons that an analyst would want to include monthly projections as part of a valuation.

  1. There are interim financial statements that are closer to the valuation date and the analyst wants to project earnings and financial position from the interim date until the end of the fiscal year (sometimes referred to as an annualization).
  2. The interim statements reflect substantial changes to the structure of the financial statements thus making them a more reliable base for projecting forward.
  3. The analyst is concerned about the changes in a company’s financial performance and position on a short-term (month-to-month) basis.

The process of preparing monthly statements requires a deeper look into the various cyclical, seasonal and operational assumptions that impact the company. In addition to estimating monthly earnings, monthly financial statements can provide insight into:

  1. The liquidity and ability to meet its financial obligations.
  2. The adequacy of a company’s working capital in light of growth.
  3. The impact of capital expenditures and related financing activities.

Interim versus Annual Financial Statements

Interim Financial Statements are statements prepared at any time other than the end of the company’s fiscal year. The usefulness of Interim Statements is largely determined by the proximity to the valuation date and the reliability of the numbers. If the company’s business cycle(s) is seasonal or the statements suggest a significant change in financial performance, it may be useful to include them as part of a valuation.

There is an important difference between Annual (Year-End) and Interim Financials. In privately owned companies, interim statements are prepared in-house and, unless required by funding sources, are usually intended only for internal purposes. Interim Statements may not be as complete or accurate as the Year-End statements. In some companies, certain adjustments typically addressed in the Annual Statements might not be included in the Interim Statements. Such adjustments include account receivable write-offs, reconciliation of inventory (book versus physical), accrual accounts (interest, depreciation & amortization), prepaid expenses, dividends, retirement contributions, contracts-in-process, and the treatment of disbursements to owners and shareholders. Interim Statements seldom include Accountant’s Notes and other appropriate disclosures further complicating the analyst’s job. Therefore, an analyst will need to obtain the needed information from management.

An analyst who wants to include monthly projections (whether from an interim period or year-end) can either obtain them from the company being valued or prepare them on his/her own. Projections prepared by the company may be more reliable because the preparer has access to accounting information and access to plans and budgets.

Key Components of Monthly Projections

If an analyst decides to proceed with monthly projections, it’s advisable to project the Income Statement, Balance Sheet, and Statement of Cash Flows. It is a mistake to just project the Income Statement. Revenues and earnings impact Accounts Receivable, Accounts Payable, and Inventory balances as well as potentially necessitating the acquisition and disposals of Fixed Asset. Increases in revenues and earnings can easily be absorbed by the Balance Sheet sometimes, counter-intuitively, reducing bank balances.

There are four basic approaches that an analyst can use to prepare monthly projected financial statements:

  1. Use all or part of projections prepared by the client or company.
  2. Prepare projections using the Top-Down approach. In the Top-Down approach, the analyst prepares the projection on an annual basis and then allocates the numbers for each line item into the monthly projections.
  3. Prepare projections using the Bottom-Up approach. When using the Bottom Up approach, the analyst projects each line item for every individual month with the sum of the months equaling the annual amount.
  4. Prepare projections using a hybrid of all of the above.

Even in cases where the client or company has prepared detailed monthly projections; there is still a good chance that the historic statements (annual and interim) will require certain account adjustments (normalization or recasting) which will not be included in the client’s projection. Accordingly, the hybrid approach gives the analyst the flexibility to use the other three approaches as appropriate for each account.

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