{"id":142,"date":"2018-11-14T20:37:53","date_gmt":"2018-11-14T20:37:53","guid":{"rendered":"https:\/\/courses.lumenlearning.com\/suny-personalfinance\/?post_type=chapter&p=142"},"modified":"2018-11-16T18:36:37","modified_gmt":"2018-11-16T18:36:37","slug":"4-4-using-financial-statements-to-evaluate-financial-choices","status":"publish","type":"chapter","link":"https:\/\/courses.lumenlearning.com\/suny-personalfinance\/chapter\/4-4-using-financial-statements-to-evaluate-financial-choices\/","title":{"raw":"4.4 Using Financial Statements to Evaluate Financial Choices","rendered":"4.4 Using Financial Statements to Evaluate Financial Choices"},"content":{"raw":"
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Learning Objectives<\/h3>\r\n
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  1. Define pro forma financial statements.<\/li>\r\n \t
  2. Explain how pro forma financial statements can be used to project future scenarios for the planning process.<\/li>\r\n<\/ol>\r\n<\/div>\r\n \r\n\r\n<\/div>\r\n

    Now that you understand the relationship of time and value, especially looking forward, you can begin to think about how your ideas and plans will look as they happen. More specifically, you can begin to see how your future will look in the mirror of your financial statements. Projected or pro forma financial statements<\/strong>[footnote]Projected results for financial statements in the future, given assumptions about what will happen in the meantime.[\/footnote] can show the consequences of choices. To project future financial statements, you need to be able to envision the expected results of all the items on them. This can be difficult, for there can be many variables that may affect your income and expenses or cash flows (CF), and some of them may be unpredictable. Predictions always contain uncertainty, so projections are always, at best, educated guesses. Still, they can be useful in helping you to see how the future may look.<\/p>\r\n

    We can glimpse Alice\u2019s projected cash flow statements and balance sheets for each of her choices, for example, and their possible outcomes. Alice can actually project how her financial statements will look after each choice is followed.<\/p>\r\n

    When making financial decisions, it is helpful to be able to think in terms of their consequences on the financial statements, which provide an order to our summary of financial results. For example, in previous chapters, Alice was deciding how to decrease her debt. Her choices were to continue to pay it down gradually as she does now; to get a second job to pay it off faster; or to go to Vegas, hit it big (or lose big), and eliminate her debt altogether (or wind up with even more). Alice can look at the effects of each choice on her financial statements (Figure 4.14 \"Potential Effects on Alice\u2019s Financial Statements\"<\/a>)<\/p>\r\n\r\n

    \r\n\r\n[caption id=\"\" align=\"aligncenter\" width=\"1183\"]\"image\" Figure 4.14 Potential Effects on Alice\u2019s Financial Statements[\/caption]\r\n\r\n<\/div>\r\n

    Looking more closely at the actual numbers on each statement gives a much clearer look at Alice\u2019s situation. Beginning with the income statement, income will increase if she works a second job or goes to Vegas and wins, while expenses will increase (travel expense) if she goes to Vegas at all. Assume that her second job would bring in an extra $20,000 income and that she could win or lose $100,000 in Vegas. Any change in gross wages or winnings (losses) would have a tax consequence; if she loses in Vegas, she will still have income taxes on her salary. Figure 4.15 \"Alice\u2019s Pro Forma Income Statements\"<\/a> begins with Alice\u2019s pro forma income statements.<\/p>\r\n\r\n

    \r\n\r\n[caption id=\"\" align=\"aligncenter\" width=\"309\"]\"image\" Figure 4.15 Alice\u2019s Pro Forma Income Statements[\/caption]\r\n\r\n<\/div>\r\n

    While Vegas yields the largest increase in net income or personal profit if she wins, it creates the largest decrease if she loses; it is clearly the riskiest option. The pro forma cash flow statements (Figure 4.16 \"Alice\u2019s Pro Forma Cash Flow Statements\"<\/a>) reinforce this observation.<\/p>\r\n\r\n

    \r\n\r\n[caption id=\"\" align=\"aligncenter\" width=\"306\"]\"image\" Figure 4.16 Alice\u2019s Pro Forma Cash Flow Statements[\/caption]\r\n\r\n<\/div>\r\n

    If Alice has a second job, she will use the extra cash flow, after taxes, to pay down her student loan, leaving her with a bit more free cash flow than she would have had without the second job. If she wins in Vegas, she can pay off both her car loan and her student loan and still have an increased free cash flow. However, if she loses in Vegas, she will have to secure more debt to cover her losses. Assuming she borrows as much as she loses, she will have a small negative net cash flow and no free cash flow, and her other assets will have to make up for this loss of cash value.<\/p>\r\n

    So, how will Alice\u2019s financial condition look in one year? That depends on how she proceeds, but the pro forma balance sheets (Figure 4.17 \"Alice\u2019s Pro Forma Balance Sheets\"<\/a>) can give a glimpse.<\/p>\r\n\r\n

    \r\n\r\n[caption id=\"\" align=\"aligncenter\" width=\"308\"]\"image\" Figure 4.17 Alice\u2019s Pro Forma Balance Sheets[\/caption]\r\n\r\n<\/div>\r\n

    If Alice has a second job, her net worth increases but is still negative, as she has paid down more of her student loan than she otherwise would have, but it is still larger than her asset value. If she wins in Vegas, her net worth can be positive; with her loan paid off entirely, her asset value will equal her net worth. However, if she loses in Vegas, she will have to borrow more, her new debt quadrupling her liabilities and decreasing her net worth by that much more.<\/p>\r\n

    A summary of the critical \u201cbottom lines\u201d from each pro forma statement (Figure 4.18 \"Alice\u2019s Pro Forma Bottom Lines\"<\/a>) most clearly shows Alice\u2019s complete picture for each alternative.<\/p>\r\n\r\n

    \r\n\r\n[caption id=\"\" align=\"aligncenter\" width=\"307\"]\"image\" Figure 4.18 Alice\u2019s Pro Forma Bottom Lines[\/caption]\r\n\r\n<\/div>\r\n

    Going to Vegas creates the best and the worst scenarios for Alice, depending on whether she wins or loses. While the outcomes for continuing or getting a second job are fairly certain, the outcome in Vegas is not; there are two possible outcomes in Vegas. The Vegas choice has the most risk or the least certainty.<\/p>\r\n

    The Vegas alternative also has strategic costs: if she loses, her increased debt and its obligations\u2014more interest and principal payments on more debt\u2014will further delay her goal of building an asset base from which to generate new sources of income. In the near future, or until her new debt is repaid, she will have even fewer financial choices.<\/p>\r\n

    The strategic benefit of the Vegas alternative is that if she wins, she can eliminate debt, begin to build her asset base, and have even more choices (by eliminating debt and freeing cash flow).<\/p>\r\n

    The next step for Alice would be to try to assess the probabilities of winning or of losing in Vegas. Once she has determined the risk involved\u2014given the consequences now illuminated on the pro forma financial statements\u2014she would have to decide if she can tolerate that risk, or if she should reject that alternative because of its risk.<\/p>\r\n\r\n

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    Key Takeaway<\/h3>\r\n

    Pro forma financial statements show the consequences of financial choices in the context of the financial statements.<\/p>\r\n\r\n<\/div>\r\n<\/div>\r\n

    \r\n

    Exercises<\/h3>\r\n
      \r\n \t
    1. What do pro forma financial statements show?<\/li>\r\n \t
    2. What are pro forma financial statements based on?<\/li>\r\n \t
    3. What are the strategic benefits of making financial projections on pro forma statements?<\/li>\r\n<\/ol>\r\n<\/div>\r\n<\/div>\r\n<\/div>","rendered":"
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      <\/div>\n<\/div>\n
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      Learning Objectives<\/h3>\n
        \n
      1. Define pro forma financial statements.<\/li>\n
      2. Explain how pro forma financial statements can be used to project future scenarios for the planning process.<\/li>\n<\/ol>\n<\/div>\n

         <\/p>\n<\/div>\n

        Now that you understand the relationship of time and value, especially looking forward, you can begin to think about how your ideas and plans will look as they happen. More specifically, you can begin to see how your future will look in the mirror of your financial statements. Projected or pro forma financial statements<\/strong>[1]<\/sup><\/a> can show the consequences of choices. To project future financial statements, you need to be able to envision the expected results of all the items on them. This can be difficult, for there can be many variables that may affect your income and expenses or cash flows (CF), and some of them may be unpredictable. Predictions always contain uncertainty, so projections are always, at best, educated guesses. Still, they can be useful in helping you to see how the future may look.<\/p>\n

        We can glimpse Alice\u2019s projected cash flow statements and balance sheets for each of her choices, for example, and their possible outcomes. Alice can actually project how her financial statements will look after each choice is followed.<\/p>\n

        When making financial decisions, it is helpful to be able to think in terms of their consequences on the financial statements, which provide an order to our summary of financial results. For example, in previous chapters, Alice was deciding how to decrease her debt. Her choices were to continue to pay it down gradually as she does now; to get a second job to pay it off faster; or to go to Vegas, hit it big (or lose big), and eliminate her debt altogether (or wind up with even more). Alice can look at the effects of each choice on her financial statements (Figure 4.14 “Potential Effects on Alice\u2019s Financial Statements”<\/a>)<\/p>\n

        \n
        \"image\"<\/p>\n

        Figure 4.14 Potential Effects on Alice\u2019s Financial Statements<\/p>\n<\/div>\n<\/div>\n

        Looking more closely at the actual numbers on each statement gives a much clearer look at Alice\u2019s situation. Beginning with the income statement, income will increase if she works a second job or goes to Vegas and wins, while expenses will increase (travel expense) if she goes to Vegas at all. Assume that her second job would bring in an extra $20,000 income and that she could win or lose $100,000 in Vegas. Any change in gross wages or winnings (losses) would have a tax consequence; if she loses in Vegas, she will still have income taxes on her salary. Figure 4.15 “Alice\u2019s Pro Forma Income Statements”<\/a> begins with Alice\u2019s pro forma income statements.<\/p>\n

        \n
        \"image\"<\/p>\n

        Figure 4.15 Alice\u2019s Pro Forma Income Statements<\/p>\n<\/div>\n<\/div>\n

        While Vegas yields the largest increase in net income or personal profit if she wins, it creates the largest decrease if she loses; it is clearly the riskiest option. The pro forma cash flow statements (Figure 4.16 “Alice\u2019s Pro Forma Cash Flow Statements”<\/a>) reinforce this observation.<\/p>\n

        \n
        \"image\"<\/p>\n

        Figure 4.16 Alice\u2019s Pro Forma Cash Flow Statements<\/p>\n<\/div>\n<\/div>\n

        If Alice has a second job, she will use the extra cash flow, after taxes, to pay down her student loan, leaving her with a bit more free cash flow than she would have had without the second job. If she wins in Vegas, she can pay off both her car loan and her student loan and still have an increased free cash flow. However, if she loses in Vegas, she will have to secure more debt to cover her losses. Assuming she borrows as much as she loses, she will have a small negative net cash flow and no free cash flow, and her other assets will have to make up for this loss of cash value.<\/p>\n

        So, how will Alice\u2019s financial condition look in one year? That depends on how she proceeds, but the pro forma balance sheets (Figure 4.17 “Alice\u2019s Pro Forma Balance Sheets”<\/a>) can give a glimpse.<\/p>\n

        \n
        \"image\"<\/p>\n

        Figure 4.17 Alice\u2019s Pro Forma Balance Sheets<\/p>\n<\/div>\n<\/div>\n

        If Alice has a second job, her net worth increases but is still negative, as she has paid down more of her student loan than she otherwise would have, but it is still larger than her asset value. If she wins in Vegas, her net worth can be positive; with her loan paid off entirely, her asset value will equal her net worth. However, if she loses in Vegas, she will have to borrow more, her new debt quadrupling her liabilities and decreasing her net worth by that much more.<\/p>\n

        A summary of the critical \u201cbottom lines\u201d from each pro forma statement (Figure 4.18 “Alice\u2019s Pro Forma Bottom Lines”<\/a>) most clearly shows Alice\u2019s complete picture for each alternative.<\/p>\n

        \n
        \"image\"<\/p>\n

        Figure 4.18 Alice\u2019s Pro Forma Bottom Lines<\/p>\n<\/div>\n<\/div>\n

        Going to Vegas creates the best and the worst scenarios for Alice, depending on whether she wins or loses. While the outcomes for continuing or getting a second job are fairly certain, the outcome in Vegas is not; there are two possible outcomes in Vegas. The Vegas choice has the most risk or the least certainty.<\/p>\n

        The Vegas alternative also has strategic costs: if she loses, her increased debt and its obligations\u2014more interest and principal payments on more debt\u2014will further delay her goal of building an asset base from which to generate new sources of income. In the near future, or until her new debt is repaid, she will have even fewer financial choices.<\/p>\n

        The strategic benefit of the Vegas alternative is that if she wins, she can eliminate debt, begin to build her asset base, and have even more choices (by eliminating debt and freeing cash flow).<\/p>\n

        The next step for Alice would be to try to assess the probabilities of winning or of losing in Vegas. Once she has determined the risk involved\u2014given the consequences now illuminated on the pro forma financial statements\u2014she would have to decide if she can tolerate that risk, or if she should reject that alternative because of its risk.<\/p>\n

        \n
        \n

        Key Takeaway<\/h3>\n

        Pro forma financial statements show the consequences of financial choices in the context of the financial statements.<\/p>\n<\/div>\n<\/div>\n

        \n

        Exercises<\/h3>\n
          \n
        1. What do pro forma financial statements show?<\/li>\n
        2. What are pro forma financial statements based on?<\/li>\n
        3. What are the strategic benefits of making financial projections on pro forma statements?<\/li>\n<\/ol>\n<\/div>\n<\/div>\n<\/div>\n\n\t\t\t
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