Businesses prepare financial statements; these are historical figures and do not guarantee profit or revenue in the future. If the business entity wants to predict future growth projection, there must be reliable measures and methodologies. Therefore, budgeting or forecasting is an inevitable practice in all kinds of business entities.
Besides forecasting and budgeting, companies use significant estimations and methods to quantify their future projections. Many business entities prepare Pro Forma statements to predict the impact of a recent economic event, growth opportunities, etc., with the help of hypothetical numbers.
In this article, we will discuss the purpose of pro forma statements in any business entity. But before that, it is important to understand the actual concept of pro forma statements for a company.
What Is Pro Forma Statement?
Pro forma is a Latin word that means ‘for the sake of form’ and ‘as a matter of form.’ Pro forma statements preparation is calculating financial results for a business entity based on assumptions or projections about the future.
The main focus of preparing pro forma statements is to draw prospective investors’ focus to the company’s potential earnings and revenues. The pro forma statements are issued at the time of announcing earnings to attract potential investors.
In simpler words, we can define pro forma statements as the company’s financial statements that give insights or estimations of future financial performance. The companies usually exclude one-time expenses.
The pro forma statements do not necessarily comply with GAAP (Generally Accepted Accounting Principles). Therefore, the pro forma financial figures differ from the standard financial statements prepared by following GAAP (Generally Accepted Accounting Principles). Therefore, potential investors must keep this in mind when analyzing a company’s pro forma statements.
What Is the Purpose Of the Pro Forma Statement?
Let’s understand why does a business entity prepares a pro forma statement or its purpose. A pro forma statement of the company is like a letter of intent. It is an expression of an invoice or transaction to show how it will look after completion. The pro forma statements are most commonly used to draw the attention and focus of prospective investors.
The main purpose of preparing pro forma statements for any business entity is to facilitate a comparison of the company’s current and past data to predict its future financial performance. When an investor is in the decision loop to invest in a business entity, he wants assurance that he will earn a reasonable return. With the help of pro forma statements, he can have an idea or estimate about future performance.
There are many other uses of pro forma statements as well. The most common uses are as follow:
Projection Of Future Performance: It is one of the most common uses of pro forma statements to make sale projections and production costs.
Fund Raising From Investors: A company can present its potential investors with asset growth and future financial projections for fundraising.
Mergers and Acquisition Analysis: When a business entity is undergoing merger or acquisition, its pro forma statements help in understanding and determining costs and taxes to assess if the M & A will be a successful venture or not.
Risk Analysis: Companies must stay updated about the macro and microeconomic factors affecting the company’s operations. The risk analysis can be done by using the pro forma method in risk models.
Budgeting: As discussed earlier, budgeting and forecasting can be done efficiently with the help of pro forma statements.
Types Of Pro Forma Statements
There are generally two types of pro forma statements that a business entity prepares. Following are the types of pro forma statements: Pro forma of historical profit and loss statement and Proforma projections of income.
Pro Forma Of Historical Profit And Loss Statement
This type of pro forma is commonly used in financial accounting. The business entities remove the non-recurring, one-time, or unusual transactions from the financial data. These transactions include restructuring costs, declining investment values, adjustments in the balance sheet for expenses of prior periods, accounting error adjustments, etc.
Such pro forma statements show the company’s income for a given period, excluding the unusual expenses and economic events.
Pro Forma Projections Of Income
The second type of pro forma statement is popularly used by managerial accountants. Assumptions, presumptions, and projections play an important role in the preparation of pro forma projection of income.
When a company is undergoing M & A, capital restructuring, capital investments, etc., the presumed results of the particular economic event are estimated and projected in the financial statements. The company management forecast the impact of such an event on the cash flows, income, assets, and liabilities.
What Is 5 Year Pro Forma?
A five-year pro forma is more like preparing one year proforma. However, the period of pro forma is increased. The 5-year pro forma is usually made at the inception of a company, a new project, M & A, or investment to show how the company’s revenues and cash flows will change for the project or initial years of the company.
How To Prepare Pro Forma Statement?
The steps of preparing a pro forma statement for a business entity are straightforward.
Set the revenue goals for the selected period
We will assume to prepare a pro forma for the future projection of sales. The first thing to do is to set the revenue goals. We will look at preparing a pro forma income statement. Use different forecasting and projection measures to set revenue goals for a specified period. It also includes planning for the number of units to be sold.
Set the production schedule
After setting the revenue and sales goal, the next step is scheduling the production process to meet the expected demand of the market. This process includes setting a production goal by analyzing the existing stock in hand, backup for next year, and projected units to be sold.
Plan on how to execute things as per production schedule
When a company knows how many units it has to procure or produce, the next thing is making arrangements and estimating expenses for production. It includes preparing a master production schedule, workforce requirement scheduling, planning labor hours, etc.
Calculate cost of goods sold and compare it with sales
Calculate the cost of goods sold for the annual production based on the production schedule and cost estimations. After doing so, compare and match it with the forecasted sales as the cost of goods sold is related to the sales.
Calculate other operational expenses and taxes
Account for the recurring operational expenses for the company, taxes, and interest on loan payments. Taxes are paid to the government, and other expenses like marketing, advertising, etc., are also included.
Prepare the pro forma statements by using data from the above steps
After completing the above steps, you will have all the data input for preparing the pro forma income statement. Put the figures in the income statement template and calculate the pro forma income.
Benefits Of Pro Forma Statement
There are many benefits of preparing pro forma statements for a company. Some of the benefits include:
The companies can identify the growth opportunities by adjusting the numbers that have a gigantic effect on the bottom lines of financial statements. The company is able to judge the growth prospects by a realistic analysis of costs and risks.
For instance, if a company is planning to increase production capacity, the additional insurance cost will have to be incurred for the facility. Therefore, such factors and their financial impact can be appropriated by preparing pro forma statements.
Helps in budgeting and forecasting
As mentioned earlier, the uses of pro forma statements are also extensive in budgeting and forecasting for the financial years of the business entity.
Financial Ratio Analysis
The pro forma income statement’s figures and data can be used to calculate the financial ratios to compare with industry standards and competitors.
Accuracy Of Financial Statements
One-time expenses, non-recurring economic events, and financial transactions have a huge impact on the income of a certain financial period. They have the potential of overstating or understating the income. Therefore, the pro forma statements can be used to present accurate financial statements by excluding the impact of the one-time events.
There are certain drawbacks or limitations of pro forma statements as well.
- It is a projection and forecast based on presumptions. The pro forma statements are made based on past data, and the past data does not necessarily replicate itself in the future.
- GAAP(Generally Accepted Accounting Principles) is not mandatory to be followed while preparing the pro forma financial statements. Therefore, the credibility of the statements can be questioned as there is a chance of manipulation.
- The investors should pay attention to the items or transactions that the company’s management has excluded from the pro forma statements. It is part of the due diligence by the investors or prospective investors.
Pro forma statements provide a more futuristic and optimistic picture of the company’s financial status. Most repeated users of pro forma statements are the investors or potential investors who want to know if their investment will pay off generously or not. Therefore, investing individuals or institutions should develop a deeper understanding of pro forma statements and their purpose.