Pro forma financial statements are prepared using hypothetical figures and analysis of historic results by businesses. A business can use these statements for several purposes.
Pro forma statements do not follow the GAAP rules. These statements are often used by the management for analysis purposes. Investors and creditors can also use pro forma statements to predict the future financial capabilities of a business.
All three major financial statements can be constructed on a pro forma basis. There are several other types of pro forma statements depending on the usage.
Let us discuss the concept of pro forma financial statements and their different types.
What Does Pro Forma Mean?
The word pro forma means “for the sake of form”. It means preparing something with projections or assumptions.
In financial accounting, pro forma is used for invoices, budgeting, and financial statements. All of these statements and reports can be prepared on a pro forma basis.
What are Pro Forma Financial Statements?
Pro forma statements are prepared by using projections, hypothetical values, and analysis of historic results of a business. It means pro forma statements provide information that can be different from actual figures.
Pro forma statements do not follow the US GAAP rules. Hence, these statements may contain information that does not comply with the accounting rules.
While standard financial statements are based on past records, pro forma statements are often made for projections and forecasts. These statements are forward-looking to help management analyze different scenarios.
Pro forma statements use data from historic results. Managers include assumptions and hypothetical what-if scenarios to construct pro forma statements. The purpose of these statements is to serve the management with forecast analysis and projections.
Investors and creditors can also use pro forma statements to assess the future performance of a business. However, it must be done carefully as pro forma statements would use several hypothetical figures.
Another key distinction in pro forma statements is the exclusion of certain one-time events. One-off events may include buying/selling of an asset, employee layoff, closure of a segment, and so on.
Under the US GAAP rules, all such one-time events must be reported in the financial statements. It can significantly change the revenues and other financial results of a business.
Types of Pro Forma Financial Statements
Pro forma financial statements can be prepared for all three major financial statements; balance sheet, income statement, and cash flow statement.
Pro Forma Balance Sheet
Managers can prepare a pro forma balance sheet by forecasting any changes in the assets, liabilities, and owners’ equity for the next year.
Projections for the fixed assets, long-term liabilities, and owners’ equity can be made with better accuracy as these events are less frequent.
Pro Forma Income Statement
The forecasts or projections for a pro forma income statement would include adjustments for revenues, costs of goods sold, operating expenses, taxes, and interest costs to name a few.
One method to prepare pro forma income statement entries is to adjust the previous year’s figures in percentage terms for the next year.
Pro Forma Cash Flow Statement
Similarly, any events that significantly affect the cash flow of a business can be projected to prepare a pro forma cash flow statement.
Unlike a common notion, managers use realistic estimates and calculations to prepare pro forma figures. Often, already available historic results become the starting point for the preparation of these statements.
Uses of Pro Forma Financial Statements
Pro forma financial statements can be used by the management, investors, creditors, and shareholders for different purposes.
Funding or Investment Purposes
A business looking for outsider funding through debt or equity can present pro forma financial statements. It will help creditors and investors to forecast the financial performance of the applicant business.
These projected statements can also help a business in choosing the right type of financing.
Risk Analysis
One of the common uses of pro forma statements is for risk analysis. Managers can prepare these projections and statements to analyze different outcomes.
A business can use what-if scenarios to analyze the effects of potential decisions. Pro forma statements can help managers evaluate the best-case and the worst-case scenarios.
Forecast Results in Mergers and Acquisitions
Achieving synergic gains is often the biggest motive behind mergers and acquisitions for many acquirers. Pro forma statements can forecast these synergic gains or losses.
A business can use pro forma projected statements to evaluate the potential outcome of a merger or acquisition. Managers can use the historic financial results of both companies and consolidate the financial statements.
Full Year Pro Forma – Performance Forecast
Businesses often need to reassess their financial planning. Pro forma statements are useful tools to help managers in forecasting the performance of a business.
The management can use currently available results, compare them with the initial projections, and prepare pro forma statements accordingly. It can help the management to forecast results as well as make adjustments.
How to Prepare a Pro Forma Financial Statement?
Pro forma financial statements must be prepared using realistic figures. Assumptions and projections must be based on historic results and careful analysis of the company’s performance.
Here are a few key steps for preparing a pro forma statement. (Income Statement as an example).
- Calculate the projected sales figures of your business. Using random figures should be avoided. Historic results and economic factors should be considered in forecasting figures.
- Estimate the costs of goods sold, operating costs, tax obligations, interest costs, depreciation of assets, and payroll expenses.
- Calculate the gross profit and net profit from projected figures.
- Estimate the cash flow changes such as the purchase or sale of a fixed asset.
- Estimate the retained earnings and dividends.
Important: A business must disclose the purpose of the pro forma financial statements to avoid any confusion for lenders, shareholders, and compliance authorities.
Challenges with Pro Forma Financial Statements
Preparation of pro forma statements in itself is challenging. Managers rely heavily on historic results as a starting point. These results can change quickly and may not remain relevant for the use of pro forma forecasts.
One of the biggest challenges for the users of pro forma financial statements is their non-compliance format with the GAAP rules.
Managers often omit one-time events such as employee layoffs, asset disposal, etc. It means the figures projected in pro forma statements can be misleading.
Businesses often create pro forma statements to portray the positive financial health of a business. Analysts and users of these statements must keep a cushion for adjustments in the reported figures.
Pros and Cons of Pro Forma Statements
Pro forma statements cannot be prepared with full accuracy. These statements have some shortcomings in preparation. However, managers and investors can use these statements as a reference for the performance projections of a company.
Pros of using pro forma financial statements are:
- Help in projections, budgeting, and forecast planning.
- Risk assessment and performance evaluation.
- Benchmarking against internal and industry standards.
- Help in the evaluation of different scenarios with different decisions.
Cons of using pro forma financial statements are:
- Exclusion of one-time events from pro forma projections.
- Non-compliance format with the GAAP rules.
- Pro forma projections rely heavily on historic results that may change quickly over the next year.
- Some projections can be exaggerated and misleading for the users of pro forma statements.
