Lessons in Corporate Finance

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. Morgan, a new banker, who was considering lending to PIPES.

This chapter will answer the question: Should Mr. Morgan 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 ...