HBP# HK1371

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WINNIE S. C. LEUNG
DICKSON CHAN

TASTE GOOD LIMITED: PREPARING PRO

FORMA FINANCIAL STATEMENTS

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Alice Chan, the Chief Financial Officer (CFO) of Taste Good Limited (Taste Good), had just
presented the latest financial accounts [see Exhibit 1] for review by the board. As the board
wished to present its business outlook to the company’s institutional investors, Alice was asked
to prepare pro forma statements of profit or loss and pro forma statements of financial position
for the next four years. 1 Taste Good was established 20 years ago, specializing in Asia’s high-
end beverage market. It manufactured its own brand products including bottled fruit juice,
coffee, and mineral water. It was headquartered in Hong Kong.
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Taste Good’s Recent Development and Funding Needs
The company was a market leader in Asia, but its leading position was being challenged by
several newly emerged international brands. Its established brand name enabled the company
to adopt a premium pricing strategy that resulted in a relatively high gross margin compared
with its industry peers. In order to maintain market share amid intense competition, its sales,
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distribution, and marketing expenses were significant.

Taste Good had been relying on debt facilities for working capital because it could obtain
favorable interest rates from creditors with its proven track record. 2 As the company had no
plan to develop new products or expand to new markets, there were no pressing funding needs.
If such needs arose, the board unanimously agreed that issuing new shares was not preferred,
as the controlling shareholders did not wish to dilute control over the company. Instead, the
No

company would borrow from the banking system.

1
Pro forma means assumed, forecasted, or informal information presented in advance of the actual or formal information.
2
Creditors tend to be more willing to lend to borrowers whose operation is more established, due to lower risk of default. And
the cost of borrowing is usually lower given less risk to be borne.

Dickson Chan prepared this case under the supervision of Dr Winnie S.C. Leung for class discussion. This case is not intended to
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show effective or ineffective handling of decision or business processes. The authors might have disguised certain information to
protect confidentiality. Cases are written in the past tense, this is not meant to imply that all practices, organizations, people,
places or fact mentioned in the case no longer occur, exist or apply.

© 2022 by The Asia Case Research Centre, The University of Hong Kong. No part of this publication may be digitized, photocopied
or otherwise reproduced, posted or transmitted in any form or by any means without the permission of The University of Hong
Kong.
Ref. 21/711C

Last edited: 28 January 2022

This document is authorized for educator review use only by Anna Gakhokidze, Caucasus University until Mar 2025. Copying or posting is an infringement of copyright.
[email protected] or 617.783.7860
 21/711C Taste Good Limited: Preparing Pro Forma Financial Statements

Taste Good just had one of its short-term loans valued at HKD100mn extended at the beginning

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of 2021, and there existed a debt covenant 3 that prevented the company’s gearing from
exceeding 40% for two consecutive years. Unfortunately, Taste Good’s latest gearing stood at

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an alarming level of 42.2% on 31 December 20214.

The board was worried the gearing level would remain high the coming year. If this was the
case, the bank had the right to demand immediate loan repayment in entirety. In the pro forma
financial statements, Alice planned to estimate the company’s gearing level for the coming four
years. If the risk of a covenant breach was eminent, measures should be taken to mitigate this

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risk.

Drafting the Pro Forma Financial Statements

Sales Growth
Taste Good experienced sales growth of 7.5% in 2021. As the competition was keen, and there

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were uncertainties about economic prospects in its major markets for the next four years, sales
growth was expected to decrease gradually after 2021. Alice predicted Taste Good would
achieve a stable growth after 2025 when the market became saturated.

Operating Costs
Among different cost categories, cost of goods sold (COGS) took up the greatest proportion of
sales. In 2021, COGS as a percentage of sales was approximately 47%. Alice expected inflation
to be high in 2022, so raw material costs would increase, although average production costs
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would probably go down due to economies of scale in purchasing and manufacturing. The
overall effect of such factors in 2022 would slightly decrease COGS as a percentage of sales
from the 2021 level. Alice anticipated relief from inflation in 2023 onward, so benefits arising
from economies of scale would offset the inflation costs and COGS as a percentage of sales
would likely stay at the 2022 level thereafter.
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Selling, distribution, and marketing expense was another major building block of operating
costs, taking up 14% of sales in 2021. Depreciation in 2021 was 16% of the net book value of
plant and machinery by end of the year. 5 Other operating expenses included recurrent costs
such as staff salaries, rentals, and utilities costs. These expenses stood at 11% of sales in 2021.
Alice estimated that these percentages would remain similar in the coming years.

Working Capital and Investment in Non-current Assets

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Working capital included inventories, accounts and other receivables, cash and cash equivalents,
and accounts and other payables. Alice expected these items to rise at same rate as that of sales.
She also forecasted investment in plant and machinery to grow at the same pace as sales.
However, no investment was planned in land and buildings, other than a HKD15mn
improvement of buildings in late 2024.

3
Debt covenants prescribe the terms agreed between lenders and borrowers. To control the risk of lending, the lender may
prescribe terms that the borrower has to abide by. This could include not seeking borrowing above a prescribed level, or giving
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the lender a right to control certain assets upon borrowers’ inability to make interest or principal repayment. Failure to comply
with the covenants could give lender a right to call back the entire loan immediately.
4
The gearing ratio was calculated as “book value of total loans divided by book value of total loans plus equity.” Loans here
refer to those interest-bearing liabilities, but exclude normal operating payables such as accounts and other payables. One
should note that there are alternative ways to calculate gearing ratio.
5 In accounting, depreciation is usually computed by methods such as straight-line depreciation and double-declining

depreciation, etc. For simplicity, depreciation here was estimated based on the current year end net book value of the property,
plant, and equipment.

This document is authorized for educator review use only by Anna Gakhokidze, Caucasus University until Mar 2025. Copying or posting is an infringement of copyright.
[email protected] or 617.783.7860
 21/711C Taste Good Limited: Preparing Pro Forma Financial Statements

Taste Good had invested in certain financial securities with very low risk. Alice predicted that

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the value of these financial securities would remain constant in the coming years. Such
investment, similar to cash and cash equivalents, would yield negligible interest revenue.

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Loans and Borrowing
Apart from short-term loans and overdrafts, 6 Taste Good had a fixed rate loan that would be
repaid at the end of 2023. Alice anticipated that this fixed rate loan would immediately be
refinanced with a similar type of loan at maturity.

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Interest was charged on the borrowing. The fixed rate loan had an interest rate of 7.5% per
annum, which was constant for the entire loan period. The short-term loans and overdrafts had
an interest rate of 6.5% per annum currently, but this rate could vary depending on the macro-
economic situation and the company’s creditworthiness.

The company planned to meet any changes in financing needs by adjusting the level in short-
term loans and overdrafts, except for the repayment of the fixed rate loan, which would be

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repaid by the refinanced loan at maturity. Any change in interest paid as a result of changes in
borrowing level or interest rate would be assumed to be effective in the next year. 7 As
aforementioned, the company was bound by certain debt covenants when taking out loans and
borrowing.

Tax and Dividends

The corporate tax rate for 2021 was 21%. It could change according to the government policy
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in consideration of different social and economic factors. Taste Good had a constant dividend
payout policy. The company paid annual dividends to its shareholders based on a fixed
percentage of profit after tax. This policy was expected to continue in the near future. In 2021,
HKD95mn was distributed as dividends.

The Way Forward

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As the board called for the preparation of the pro forma financial statements, Alice proceeded
to set out all necessary assumptions. When drafting the pro forma financial statements, Alice
had several questions in mind. Were the assumptions good enough to make a reliable financial
forecast? What would the company’s gearing look like in the coming few years? Were there
any ways to improve the company’s gearing so as to minimize the risk of breaching the debt
covenant?
No
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6 An overdraft is a kind of short-term borrowing provided by a lending institution. The overdraft allows an account holder to
withdraw money even when there are insufficient funds in the account. However, there is usually a credit limit and interests are
charged on the overdraft loans.
7
For example, if there is an increase or a decrease in borrowing in 2022, it would be assumed to happen at 2022 year end.
Therefore, effect on interest arising from such change in borrowing level would be reflected in the next year, i.e., 2023.

This document is authorized for educator review use only by Anna Gakhokidze, Caucasus University until Mar 2025. Copying or posting is an infringement of copyright.
[email protected] or 617.783.7860
 21/711C Taste Good Limited: Preparing Pro Forma Financial Statements

EXHIBIT 1: SUMMARIZED FINANCIAL ACCOUNTS OF TASTE GOOD LIMITED

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Statement of profit or loss for financial year ended 31 December 2021

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HKD million
Sales 1,580
Costs of goods sold (740)
Gross profits 840
Selling, distribution, and marketing expense (221)

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Depreciation expense (162)
Other operating expenses (174)
Operating profits 283
Net interest expense (61)
Profits before tax 222
Income tax expense (47)
Profits after tax 176

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Statement of financial position as of 31 December 2021
HKD million
Non-current assets
Lands and buildings 300
Plant and machinery 1,010
Investment in financial securities 25
Total non-current assets 1,335
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Current assets
Inventories 420
Accounts and other receivables 550
Cash and cash equivalents 32
Total current assets 1,002
Total assets 2,337
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Non-current liabilities
Fixed rate loan (repayable in late 2023) 410
Total non-current liabilities 410
Current liabilities
Short-term loans and overdrafts 371
Accounts and other payables 486
Total current liabilities 857
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Total liabilities 1,267

Equity
Share capital 220
Retained earnings 850
Total equity 1,070
Total liabilities and equity 2,337
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This document is authorized for educator review use only by Anna Gakhokidze, Caucasus University until Mar 2025. Copying or posting is an infringement of copyright.
[email protected] or 617.783.7860