Method 2 Detailed Financial Pro Forma Projections

The second and more common method of projecting economic cash flows during the initial period is to project complete financial statements. This requires providing individual components for the economic cash flows you ultimately seek. Doing so is often (but not always) better than projecting economic cash flows directly for three reasons:

A more sophisticated method attempts to model the complete financials, not just the "end product," the economic cash flows.

1. As just noted, neither cash flow nor earnings forecasts are particularly reliable. Cash flows are difficult to project directly, because they tend to be volatile and lumpy. Net income is smoother but contains many fictional accounting accruals that are not true cash. You are caught between the proverbial rock and hard place.

2. The full projection method can make it easier to incorporate your knowledge of the underlying business into the economic cash flow estimates. For example, you may happen to know that unusual expenses will be zero next year, or that a new payment system may speed the collection of receivables. By forecasting the individual items, you can integrate such economic knowledge into your cash flow estimates.

3. The full projection method can help you judge other important information—such as working capital availability, suitable debt-equity ratios, and your interest rate coverage. Especially for entrepreneurs who are often in danger of a liquidity crisis, such information can be just as important as the economic cash flows themselves. In fact, all the ratio analysis, such as the financial health and profitability ratios, are often more useful when See Section 10 -4.E applied to pro forma financials than when applied to current financials. Ratio analysis can thereby help you judge whether the firm is on a sound or critical path.

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