The Financing Plug
After the operating forecast is set, a pro-forma balance sheet rarely balances on its own. The gap between forecast assets and the sum of forecast liabilities and equity is closed by a plug, a balancing financing item, usually short-term debt (a revolver) when the firm needs cash or surplus cash when it generates more than it uses. The plug makes the accounting identity hold and reveals the firm’s external financing need. A subtle trap follows. If interest expense is keyed to total debt and the plug is itself debt, the model becomes circular, since more debt raises interest, which lowers net income, which changes the plug.
Why it matters
The balance sheet is an identity, so assets must equal liabilities plus equity in every forecast year. Once you have projected the operating lines, the two sides almost never tie out, and the difference is simply financing you have not yet specified. If assets exceed funding, the firm must raise money and the plug is new borrowing. If funding exceeds assets, the firm has spare cash and the plug parks it. The plug is therefore informative, it quantifies how much outside capital the plan actually requires. One careful point from the lecture. Interest should be charged on interest-bearing debt only, not on total liabilities, because trade payables and accruals carry no interest and including them overstates the interest bill.
Formulas
Worked examples
A pro-forma year shows total assets of US$150m. Spontaneous liabilities such as payables and accruals are US$20m, equity after retained earnings is US$90m, and existing long-term debt is US$25m. What is the plug, and why would charging 7 percent interest on all US$45m of liabilities be wrong?
Funding in place is US$20m plus US$90m plus US$25m, which is US$135m, against US$150m of assets. The plug is US$15m, a financing need the firm must cover, most naturally with short-term debt drawn on a revolver. Charging 7 percent on the full US$45m of liabilities would tax the US$20m of payables and accruals, which carry no interest, overstating the interest bill by 0.07 times US$20m, about US$1.4m. Interest should fall only on the interest-bearing US$25m of existing debt plus any new debt in the plug. Because that new debt feeds back into interest and then net income, the model is circular and must be solved iteratively.
Common mistakes
- ✗A pro-forma balance sheet balances automatically. It rarely does after the operating forecast, and the residual gap must be closed with an explicit financing plug.
- ✗Interest expense should be charged on total liabilities. Only interest-bearing debt accrues interest, so payables and accruals must be excluded or the interest bill is overstated.
- ✗The plug is a meaningless balancing trick. It quantifies the firm’s external financing need or surplus cash, which is real and useful information.
- ✗A debt plug never affects the income statement. When interest is tied to debt, the plug feeds back into interest and net income, creating a circularity the model must resolve.
Revision bullets
- •A pro-forma balance sheet seldom balances after the operating forecast
- •The plug is a balancing financing item, short-term debt or surplus cash
- •It makes the accounting identity hold and reveals external financing need
- •Charge interest on interest-bearing debt only, never on total liabilities
- •Payables and accruals are spontaneous and carry no interest
- •A debt plug that drives interest creates circularity to resolve iteratively
Quick check
In a pro-forma model, the financing plug is used to
Why is it wrong to forecast interest expense as a percentage of total liabilities?
Connected topics
Sources
- Titman & Martin, Ch. 6Titman, S., & Martin, J. D. Valuation: The Art and Science of Corporate Investment Decisions. Pearson.Balances the pro-forma balance sheet with a financing item and flags charging interest on interest-bearing debt rather than all liabilities.
- Koller, Goedhart & Wessels (2020), Ch. 13Koller, T., Goedhart, M., & Wessels, D. Valuation: Measuring and Managing the Value of Companies. 7th ed. McKinsey & Company / Wiley, 2020.Discusses the balancing item, the external financing need, and the circularity created by debt-linked interest.