The Pro Forma Income (P&L) and Cash Flow Statements
The Balance Sheet that was discussed earlier in this lesson provides a snapshot in time of the financial health of a firm or the valuation (again, at a snapshot in time) of a specific investment project. The last two financial statements - the P&L and the cash flow statement - are used in two ways, depending on whether the entity under analysis is a company or a specific project. Either way, they have roughly the same format.
At this point, please read "A Primer on Financial Statements." The first big table in the article lays out the structure of the P&L statement pretty nicely, at least up until the row that is labeled "Net Income." The rows below Net Income pertain to calculating financial metrics for valuation of specific companies. The P&L and cash flow statements for U.S. companies, at least those that are publicly traded, are laid out in a mandatory quarterly filing to the Securities and Exchange Commission called the Form 10K. Some companies publish similar information in their annual reports to shareholders, but these annual reports are not subject to any sort of regulatory scrutiny, whereas 10K filings can be audited if necessary. So, the 10K is the real deal as far as determining the financial position of a company. This is not to say that all companies massage the numbers in their annual shareholder reports, only that you may find differences between the annual report and the 10K, if you look hard enough. 10K filings in the U.S. are public information, so you should be able to easily find them, as long as the company is required to file one.
Individual energy projects are often evaluated using P&L and Cash Flow statements that jointly are known as the "pro forma." Unlike the P&L and Cash Flow statements for a company, which should represent actual historical data, the pro forma represents the analyst's evaluation of the financial worthiness of a potential energy project. (It is possible to put together a historical pro forma for an individual energy project, but we'll focus on the pro forma for evaluation of potential energy projects.)
As we go through the various parts of the pro forma, it will be useful to refer to a numerical example, to keep things a little less abstract. I have posted a simple pro forma statement for a hypothetical natural gas power plant, in Microsoft Excel format. Look for the Pro Forma Example.xlsx file in thein Canvas. Please download the spreadsheet for reference (for those who do not have access to Excel, the spreadsheet should be easily opened in Open Office or in a Google Spreadsheet). The spreadsheet has four tabs:
- The Plant Properties tab contains some overview information about the power plant. This is reprinted here as Table 4.7.
- The Depreciation tab contains the annual depreciation allowances (the A(t) values) assuming that all components of the plant are eligible for 10-year MACRS depreciation.
- The P&L tab contains the P&L statement for a fifteen-year operational period.
- The Cash Flow tab contains the Cash Flow statement for the same fifteen-year operational period.
Our hypothetical natural gas power plant has the following properties that are shown in Table 4.7 (from the Plant Properties tab). Some of these plant properties aren't relevant to us right now, but we will come back and use this hypothetical plant as an example in future lessons.
|Annual discount rate||10%|
|Decision Horizon (N)||10||Years|
|Marginal Cost||$60||per MWh|
|Fixed O&M||$10,000||per year|
Below this table on the Plant Properties tab, you will notice a set of assumed annual sales prices, in $ per MWh, for the fifteen-year operational period.
Table 4.8 shows the first few years of the P&L statement (not all fifteen; for the full P&L statement, please refer to the Excel spreadsheet in Canvas). We will refer to Table 4.8 as we go through the items on the P&L statement.
First, note that we label the construction year as "Year 0" and the operational years as "Year 1-15." That is just a numbering convention indicating that we assume that the power plant is built this year and is operated beginning the following year for fifteen subsequent years.
The first section of the P&L, on lines (1) through (5), outlines the costs and revenues of the power plant project.
- Line (1) contains the construction cost from the Plant Properties tab. This cost is assumed to be incurred only in Year 0.
- Line (2) contains the annual revenue from energy sales, equal to the annual production of 4,500 MWh times the annual electricity price (which changes from year to year).
- Line (3) contains the annual variable operating cost, which is equal to the annual production of 4,500 MWh times the sum of the marginal cost and the variable O&M cost (both are assumed to be constant at $60 per MWh and $5 per MWh, respectively).
- Line (4) contains the fixed O&M cost, assumed to be $10,000 per year.
- Line (5) shows net operating revenue before taxes and depreciation, also known sometimes as the EBIDTA (Earnings Before Interest, Depreciation and Taxes). This is equal to total revenues minus total expenses, or Line (2) less the sum of Lines (3) and (4).
|Year 0||Year 1||Year 2||Year 3|
|(2)||Annual Operating Revenue||$428,175||$305,332||$383,445|
|(3)||Annual Variable Operating Cost||$292,500||$292,500||$292,500|
|(4)||Annual Fixed Operating Cost||$10,000||$10,000||$10,000|
|(5)||Annual Net Operating Revenue||$125,675||$2,832||$80,945|
|(9)||Taxable Net Income||$75,675||$(87,168)||$8,945|
|(13)||Income Net of Taxes||$49,189||$(87,168)||$5,814|
Lines (7) and (9) incorporate the depreciation allowance. The depreciation allowance is calculated using the $500,000 book value of the plant (i.e., the construction cost) and the annual depreciation allowance percentages from the MACRS table (the Depreciation tab in the spreadsheet). Taxable net income on Line (9) is calculated as the net operating revenue or EBIDTA, less the allowable tax deduction for depreciation.
Taxes owed by the plant are shown in Line (11), equal in this example to 35% of taxable net income, as long as taxable net income is positive. In year 2, for example, you will notice that the plant has a large negative taxable net income. This is not because the plant did not make any money (it made a little bit as you could see from Line (5) in Table 8.8) but because the allowable depreciation expense is so large that for tax purposes it appears as though the plant lost money. In this case, there is no income to be taxed, and the plant would not pay any taxes that year. On the P&L statement, its income net of taxes (Line (13) in Table 4.8) would be negative.
Of course, the plant did not really lose money in year 2, because the depreciation expense is not a real expense, in the sense of representing a cash outlay by the company that owns the power plant. For the purposes of calculating tax liability, however, the depreciation allowance is treated as a real expense.
Finally, we move onto the Cash Flow statement. In this example, the Cash Flow statement is much easier to put together than the P&L statement. Table 4.9 shows the first few years of the Cash Flow statement for purposes of illustration.
|Year 0||Year 1||Year 2||Year 3|
|(3)||Net Income from Operating||$49,189||$(87,168)||$5,814|
|(7)||Net increase or decrease|
The first line on the Cash Flow statement lists all investment activities in that year - these represent outlays of cash (even if the Balance Sheet for that year would indicate that the investment activities were financed through debt or owner/shareholder equity). In our example, there is only one year - the construction year - with any investment activities. Line (3) is the final line item from the P&L statement, showing the post-tax net income from operating activities. The crucial point to remember here is that this figure includes the depreciation expense, which is not a real expense in the sense of any cash outlays. So, to get a real sense of how the project's cash holdings have changed throughout the year we need to add the depreciation expenses (Line (5) in Table 4.9) back to the net income (Line (3) from Table 4.9). The resulting sum is the "Net increase or decrease in cash," and it shows the end-of-year cash holdings for the power plant project. These cash holdings are used to pay back creditors and are disbursed among equity shareholders (i.e., the project's owners).