Usually, the financial statements are prepared on the basis of past transactions, which have already occurred. Pro forma financial statements are different from regular financial statements.
“pro forma” means: (According to Merriam-Webster)
- Made or carried out in a perfunctory manner or as a formality
- Based on financial assumptions or projections
Pro forma statements are financial reports are based on hypothetical scenarios. With this, an organization becomes aware of those situations that it believes might happen in the near future.
- In making a business plan, by considering what would be the best, worst, and most likely case scenarios in the future.
- In creating a financial forecast,
- In getting donations, funding, and loans from donors, potential investors, and lenders respectively by showing them how an organization would use the money to grow its business.
- In foreseeing the changes that may affect the business as it develops, such as when entering in a new tax bracket.
For these above-mentioned reasons, these statements are created as a part of a financial forecast. Large entities who have proper finance department can make and use pro forma statements for financial modeling different scenarios.
Both these pro forma financial statements and budget can be thought of as same because both serve the same purpose.
Both are formed to anticipate what is going to happen in future, what circumstances an organization may face and both help in planning how the available resources will be used to tackle the coming up situations. But in actual both budgets and pro forma statements are two different financial tools.
It can be better understood by considering this scenario like for example income of an organization for the current year is $30,000 so in the pro forma annual income statement, it will be shown as $49,000 for next year and when creating next year’s budget an extra $9,000 would be kept which will be used in spending $5,000 next year in order to pay a loan amount, while $4,000 would be added to savings.
So a pro forma statement can be termed as a prediction, and a budget can be termed as a plan. Budget is based on pro forma statements.
Pro forma statements include;
- Pro forma income statement
- Pro forma balance sheet
- Pro forma cash flow statement
There are four main types of pro forma statements however they all belong to same categories (income statement, balance sheet, and cash flow statement). They are distinguished on the basis of the purpose for which purpose financial forecast is being made.
1. Pro forma projection for full year
This pro forma projection considers all financials for the year up till present time and then includes projected outcomes for the remaining year. This will help the investors / partners what business finances could look like by the end of the year.
2. Pro forma projection for Financing or investment
These pro forma statements are used for attempting to convince investors or business partners of the value for financing the business.
For making such projection, the organization needs to consider an injection of cash from an outside source and interest payments that organization may need to make. This would help organization in understanding how the business would be affected.
3. Pro forma projection for acquisition
This pro forma projection considers the past financial statements of one organization and also the past financial statements of that business organization that is planned to buy.
Then it is merged to observe the picture what financials would have looked like if acquisition is made earlier. This can also be used as an example that what might be happened in coming times if the organization acquires or merge with other organization now.
4. Risk analysis pro forma projection
Under this projection, an organization looks at both best case and worst case scenarios which would help to expect what challenges it may face in the future. Analysis of multiple risks are carried out under this pro forma projection.
How to make pro forma statements
Step-wise approach should be considered while making pro forma statements detail of which is given as under;
Creating a pro forma income statement
Five steps approach for creating a pro forma income statement:
- Establish a goal for sales for the period you’re looking at.
- Establish a production schedule that will help an organization to achieve the goal.
- Plan how to match the production schedule.
- Now in order to make projection about possible loss, calculate the cost of goods sold for each month in your projection and deduct it from your sales. Deduct any other operating expenses also.
- Now pro forma income statement can be prepared by using the data that is compiled in the prior four steps.
Creating a pro forma cash flow statement
Pro forma cash flow statement can be made in much the same way as creating a normal cash flow statement. Which means transferring information from the income statement, and then using the format of cash flow statement format to foresee monetary changes in financial resources of the organization.
A few different insights will be emerged through this projected cash flow. If the projected cash flow is negative, this shows that an organization won’t have enough cash in-hand to run a business smoothly and it should make plans to borrow money for running the business without any disruption.
But if net cash flow of projected cash flow statement is positive, this shows that an organization has enough extra cash in hand to pay off the loans and it can even save for a big investment.
Creating a pro forma balance sheet
After creating pro forma cash flow statement and profit and loss, pro forma balance sheet is then easy to make. However, the need of previous balance sheet would remain there for creating pro forma balance sheet.
Though Pro forma financial statements are informatory to the investors and other stakeholders as it demonstrates several assumptions and projections for the organizations’ financials but such statements could vary considerably from real events and may be imprecise.