Pro Forma Income Statements and Balance Sheets

QUESTION

Great Lakes Industrial Supply, Inc.
Chuck Kolias, Chief Financial Officer of Great Lakes Industrial Supply, Inc. was preparing for a
meeting with his company’s bank later in the week. At that meeting, Mr. Kolias intended to
present a request that the bank grant Great Lakes Industrial Supply a five-year loan to finance
anticipated growth in the company and the expansion of the company’s warehouse facilities.
In preparation for his meeting, Mr. Kolias had gathered some recent financial statements for
Great Lakes. (see Excel template and Exhibit 1).
Company Background
Great Lakes Industrial Supply, Inc (Great Lakes) was a rapidly growing distributor of industrial
hoses, fittings and related supplies in the upper mid-west United States. Supplies were sold to
industrial clients through a chain of 12 outlets located throughout Ohio, Pennsylvania Michigan,
and Illinois. These outlets kept sufficient inventory on hand to service immediate customer
demand, but the bulk of Great Lakes’ inventory was managed at a central warehouse outside
Cleveland, Ohio. Individual stores could be easily serviced by this warehouse, which could
usually fill orders from individual outlets within 24 hours.
For the year ended December, 2022, Great Lakes had sales of $23,505,000. Net income for that
period was $1,190,000. During the previous three years, sales had grown at a compound annual
rate in excess of 20%. This record was a reflection of Great Lakes’ reputation for excellent
service and competitive pricing, which yielded high levels of customer satisfaction.
Past Relationship with SkyBank
In 2019, Great Lakes had borrowed funds from SkyBank to build a warehouse. This loan was
being repaid in equal annual installments of $125,000. At the end of 2022, the balance due on the
loan was $875,000. Also, in 2018, Great Lakes established a line of credit at SkyBank. The
company had not yet borrowed any money under this credit arrangement.
The Current Financial Need
Great Lakes had decided to expand its warehouse facilities to accommodate future growth.
Indeed, the current warehouse facilities were practically bulging at the seams. During the next 18
months, Great Lakes planned to invest $2,400,000 on its expansion, $2,000,000 of which would
be spent during 2023 (no other capital expenditures were planned for 2023 and 2024). This
expansion would fulfill the company’s anticipated needs for several years. The warehouse
construction project was expected to be completed in early 2024. Therefore, Great Lakes would
not be able to deduct any depreciation on the new building in 2023. However, Mr. Kolias was
told by his accountant that in 2024, Great Lakes could recognize a depreciation expense of 5% of
the warehouse’s total cost. The dollar value of Great Lakes’ depreciation expense on its other
assets in 2023 and 2024 would be the same as it was in 2022.
The warehouse expansion project was designed so that disruption of the company’s current
operations would be minimized. However, management expected that by the end of 2023, Great
Lakes would temporarily have to decrease its inventories to a level of $1,625,000, significantly
lower than the $2,190,000 shown on the balance sheet at the end of 2022. This cutback in
inventories was expected to last only until the warehouse construction project was completed in
early 2024. Mr. Kolias had estimated that, by the end of 2024, inventory would rise back to the
proportional relationship to sales that it had in 2022.
Other than this temporary drop in inventory in 2023, the warehouse expansion was not expected
to affect Great Lakes’ operations in any other material respects. Operating margins were
expected to be consistent with recent past experience (the temporary drop in inventory would not
affect cost of goods sold as a percentage of sales, for example). Likewise, current accounts other
than inventory were expected to maintain steady relationships to sales. Cash balances, for
instance, would be maintained at a level of 3% of sales during the next two years. Although the
Federal statutory marginal corporate tax rate was 35%, the average tax rate on Great Lakes’ pre-
tax income had typically been higher than this due to miscellaneous local taxes. The higher
overall level of taxation was expected to continue in the future at rates consistent with the most
recent past experience. In view of this anticipated stability, Mr. Kolias expected Great Lakes’
dividend payout policy to remain unchanged in the foreseeable future.
Great Lakes had preliminary discussions with SkyBank about borrowing money to finance the
warehouse expansion and the growth of the business. The proposed terms of the financing called
for taking down (i.e., borrowing) the loan in two separate parts on an as-needed basis: one in
2023 and one in 2024. The loan would be repaid in four equal annual installments. The first
installment payment would take place one year after the construction of the warehouse was
completed (i.e., in 2025). The interest rate was set at 10% per year.
Mr. Kolias’ Task
In preparation for his meeting, Mr. Kolias intended to develop a set of pro forma financial
statements for the company. He and his staff had projected a 20% increase in sales each year in
2023 and 2024 from $23,505,000 to $28,206,000 and $33, 847,000, respectively. Mr. Kolias’
first priority was to predict what the rest of the income statement and the balance sheet for the
firm would look like at the end of 2023 and 2024