HOW TO PREPARE PRO FORMA FINANCIAL STATEMENTS STEP BY STEP?

Financial Accounting, Financial Statements

Pro forma financial statements are projected financial statements that are produced using several presumptions or projections.

The business preparing the pro forma financial statements make some presumptions and prepare projected financial statements based on those presumptions.

For example, the business might prepare pro forma financial statements to see the impact of possible litigation on the business.

Since pro forma financial statements are based on certain projections and presumptions, the accuracy and reliability of the financial statements must be ensured.

Any presumptions made in the preparation of these financial statements must be disclosed clearly.

Once initial pro forma financial statements are prepared, they must constantly be updated from time to time to reflect the most accurate information.

Pro Forma Financial Statements Uses

Pro forma financial statements have many uses. Some of the uses of pro forma financial statements are as follows.

Planning and Control

Pro forma financial statements can be used to estimate future sales and budgets. These can be used as a planning tool to set standards for the future operations and activities of the business.

Once standards are established, these financial statements can be used to monitor and control actual performance according to the set standards.

This can be achieved by using different tools such as ratio analysis and variance analysis.

Financial Modeling

Pro forma financial statements can also be used to make a summary of all the incomes and expenses of a business.

The financial models are based on presumptions made by the business. Financial modeling is a great decision-making tool.

These models can be used to estimate the income and costs of a business or a project that the business is undertaking.

Reporting

Some businesses such as public listed companies may be required by legislation or standards to prepare pro forma financial statements.

For example, businesses may be required to report any effects of changes in the accounting policies of the business using pro forma financial statements.

Furthermore, pro forma financial statements can be used as a reporting tool to the stakeholders of the company, for instance, the owner, potential investors, creditors, etc.

Pro Forma Financial Statements

There are three main financial statements that are prepared based on presumptions and projections. These are the balance sheet, the income statement, and the cash flow statement.

The pro forma financial statements should all be prepared in conjunction with each other.

The presumptions used for the preparation of these financial statements must be consistently applied to all financial statements.

Pro Forma Income Statement

When preparing pro forma financial statements, the pro forma income statement should be prepared first because the other two pro forma financial statements rely on figures from the pro forma income statement.

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The pro forma income statement is based on the most recent income statement of the business, which is usually the financial statements of the last period.

Once the most recent income statement of the business is available, the pro forma income statement can be prepared using the following steps:

  1. A percentage should be determined to use to add or subtract to the recent income statement figures to forecast future figures. This percentage is based on the presumptions a business makes. For example, if the business expects its revenues to increase by 20% next year, this should be the percentage used to inflate all other items of the pro forma income statement as well.
  2. Once a percentage is determined, it should be applied to both the revenues and cost of goods sold of the business in its last income statement. By doing this, the business will ensure that a consistent rate is applied to all the variable expenses. So, according to the previous example, if the business determines that its sales will increase by 20%, it is highly likely that the cost of sales will rise by the same percentage. The predicted gross profit should then be calculated by subtracting the project cost of goods sold from the projected revenues.
  3. For operating expenses, every item should be evaluated individually. If the business determines that the rent expense will increase in the period for which the pro forma income statement is prepared, then it should increase the expense accordingly. Similarly, if the business is looking forward to cutting down any expenses in the future, then the expenses should be adjusted in the pro forma income statement.
  4. Once the operating expenses are adjusted, the net profit of the business can be calculated. This net profit should then be multiplied with the expected tax rate for the period for which the pro forma income statement is prepared to calculate the estimated tax expense. Once an estimated tax expense is determined, the net profit after tax should be calculated.

Once the pro forma income statement is prepared, the figures are then taken to the pro forma balance sheet.

Pro Forma Balance Sheet

Since the preparation of the balance sheet depends on figures obtained from the income statement, the pro forma balance sheet is the next pro forma financial statement to be prepared.

The step by step method to prepare a pro forma balance sheet is as follows:

  1. The net profit after tax figure should be transferred from the pro forma income statement and adjusted in the retained earnings balance on the balance sheet.
  2. Based on the adjustments in the pro forma income statement, other balances in the pro forma balance sheet should also be adjusted. For example, if the business based its pro forma income statement on a 20% expected increase in its revenues, then it is highly likely that the debtor balances of the business will also go up. Similarly, the cost of goods sold will also increase in line with the increase in the revenues of the business, thus, resulting in higher creditor and inventory balances.
  3. Once the balances related to the figures in the pro forma income statement are adjusted, the remaining balances should be evaluated individually for any expected changes. For example, if the business expects to purchase a fixed asset during the period for which the pro forma financial statements are prepared, then the fixed asset balances are adjusted accordingly. Similarly, all other assets, equity, and liability balances should be evaluated.
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Once the pro forma balance sheet is prepared, the pro forma cash flow statement can be prepared.

Pro Forma Cash Flow Statement

When preparing pro forma financial statements, the pro forma cash flow statement is prepared at last.

This is because the cash flow statement relies on figures from both the pro forma income statement and the pro forma balance sheet.

The pro forma cash flow statement can be prepared using either the direct method of cash flow statement preparation or the indirect method. The steps to prepare them are as follows:

Direct Method

  1. For the direct method of pro forma cash flow statement preparation, the most recent cash and cash equivalent balances of the business should be taken. These balances should be taken from the same financial statements that the pro forma income statement is based on.
  2. Any expected receipts of cash should be added to the cash and cash equivalent balances. These expected receipts should be in line with the expected fluctuations in the pro forma income statement and any expected changes in the debtor and inventory balances of the business. Any expected receipts from other sources should also be added to the balances.
  3. Any expected payments of cash should be subtracted from the cash and cash equivalent balances. Like the receipts, these payments should be in line with the fluctuations in the cost of goods sold and operating expenses in the pro forma income statement. They should further be adjusted for any expected changes in the inventory and creditor balances in the pro forma balance sheet. Furthermore, any special payments, for example, the purchase of a fixed asset, should also be adjusted in the payments.
  4. Finally, the net movement in the cash and cash equivalent balances should be calculated and added to the opening cash and cash equivalent balances taken in step 1 to arrive at the closing cash and cash equivalent balances.
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Indirect Method

  1. For the indirect method of pro forma cash flow statement preparation, the net profit before taxation figure should be taken from the pro forma income statement. Any non-cash expenses, such as depreciation and amortization, should be added back to the amount.
  2. Any cash flows from operating activities should be adjusted against the net profit before taxation figure. These may include changes in current assets and current liabilities balances such as debtor balances, inventory balances, and creditor balances.
  3. Any cash flows from investing activities should be adjusted against the net profit before taxation figure. These may include any cash inflows or outflows from investing activities of the business such as the purchase of fixed assets or investments made.
  4. Any cash flows from financing activities should be adjusted against the net profit before taxation figure. These may include cash inflows from receipt of equity or debt finance or outflows for payment of long-term debt obligations.
  5. Finally, the net movement in the cash and cash equivalent balances should be calculated and added to the opening cash and cash equivalent balances to arrive at the closing cash and cash equivalent balances of the business. This opening cash and cash equivalent balance is taken from the most recent financial statements of the business.

The closing cash and cash equivalent calculated using both methods should be equal to the cash and cash equivalent balances in the pro forma balance sheet.

Conclusion

Pro forma financial statements are forecasted financial statements of a business based on certain presumptions or projections.

Pro forma financial statements are used for many purposes such as planning and control, financial modeling or reporting.

There are three main pro forma financial statements that businesses prepare. These are the pro forma income statement, balance sheet and cash flow statement.

The pro forma income statement is prepared first, followed by the pro forma balance sheet and finally, the pro forma cash flow statement.

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