The pro-forma financial model remains a staple of any capital markets transaction and it is the rare investor that disregards it. The logic underlying a corporate model highlights management’s investment process and is thus informative to the investor’s capital allocation decision. A sound investment process identifies and tracks performance indicators, extracts implicit assumptions, subjects these to testing and then articulates the results into investment decisions based on established value.
While projections consistently lack the inevitable realities of recession impact, cash-flow shortfalls, cost overruns and intense price corrections, companies with operating history have the advantage of historical data and investors can thus base decision-making on accomplishments in addition to projections. Management savvy, peer comparisons, market traction and incentive structures are all revealed from historical data and are useful indicators as to how management might perform in the future as allocators of your investment capital.
Projection and Perception: Important and Inevitable
Components of a robust pro-forma financial model include:
Any given price drives some to consume a product or service and others to provide it. While this relationship is often relatively efficient, the cannabis regulatory environment combined with the restirctio interstate commerce cause dramatic differences in addressable markets. This relationship makes it imperative to utilize supply as well as demand analysis to model one’s Total Addressable Market (TAM). A model should allow a user to feed inputs into an operational forecast and act as a spot check to identify potentially erroneous projections.
Does the model have a detailed monthly schedule of product or service sell-through by channel? The accurate assignment of variable costs depends on a well-articulated schedule.
Are costs broken out into their raw material components? Is the model stress tested for changes in the prices of these as well as finished formulations during the forecast period? Cannabis companies have exposure to volatile raw materials prices and management price expectations is of particular investment importance.
Does the model show a monthly revenue schedule by product and channel? Do quantities and pricing match the sell-through schedule? It is important that these align as clean data is essential to effective investor presentations.
Does the inventory schedule also utilize outputs from the sell-through schedule and does it reflect the direct cost of purchases as a function of forecast demand? Does the Cost of Goods Sold (COGS) schedule reference the inventory schedule to capture working capital builds?
The relationship between Accounts Receivables and Accounts Payables (AR/AP) is critical to understanding actual cash needs. Often, estimates for days receivables and days payables are used with little empirical support. Companies with an operating history can extrapolate both accounts using historical precedent. Companies without operating history are well served to eliminate reliance on trade credit in the cannabis industry.
Are there reserves for returns and are there assumptions surrounding the realized costs of both facilitating those returns as well as restocking returned items that can be resold compliantly?
How are expense accounts separated on the Income Statement? Suggested categories include rent, personnel, general and administrative, marketing and public relations, and income tax. Are variable expenses not included in COGS captured and tied to the appropriate underlying assumptions? Are income taxes assessed in accordance with section 280E of the Internal Revenue Code
Is capex separated into two categories: maintenance capex and growth capex? Does growth capex capture build-outs and equipment costs that are necessary to realize revenue projections? Does maintenance capex capture the economic reality that assets need to be maintained as well as replaced?
Is there a plan for cash flow distribution and is it driven by a minimum and maximum cash balance level? While money is often best used for reinvestment in corporate growth, excess cash sitting on a Balance Sheet does not reward the investor.
Are monthly and annual income statements, cash flow statements, and balance sheets incorporating all of the assumptions of the model detailed for at least three and preferably five years?
A well-organized model will easily provide summary data without an investor having to hunt down or deconstruct assumptions. Ratio comparison is essential in investment decision making and made far easier with readily accessible summary data.
The highest and best use of any model is to track performance post capital deployment. Accurate prognostication requires tight feedback loops and will undergo continual revisions as assumptions face reality.
Pro-forma financial statements are necessary to any business and carry with them the advantages of helping with business planning as well as the absurdities of near-certain inaccuracy in prognostication. Large gaps between assumption and accomplishment are often caused by the fundamental conflict between the purpose of the model and the nature of reality. We tend to value that which we can measure most accurately, leading us to being precisely wrong more often than it does to us being approximately right.