August 29, 2023
Adam Hoeksema
Effective business planning hinges on the ability to foresee and navigate potential financial scenarios. This is where Pro Forma Financial Statements come into play. More than just a reflection of a company's current financial standing, pro forma financial statements illuminate the possible paths a business could tread in the future. By offering a 'what could be' outlook based on specific assumptions, they play a critical role in forecasting the financial outcomes of various business decisions or events.
In this guide, we'll explore the following Pro Forma questions:
What are pro forma financial statements?
Pro forma financial statements are financial reports that depict a company's hypothetical financial performance under certain assumed conditions or events. The term "pro forma" is Latin for "as a matter of form" or "for the sake of form". Unlike standard financial statements which reflect the company's actual historical performance, pro forma statements are based on certain adjustments or hypothetical scenarios. These could range from potential mergers and acquisitions to changes in the company's capital structure or a significant shift in its operations.
What are pro forma financial statements based on?
Pro forma financial statements are based on various assumptions and scenarios that a company believes might occur in the future or are contingent upon a certain event taking place. These assumptions might include:
- Sales and revenue projections based on market research.
- Anticipated costs and expenses.
- Projected capital expenditures.
- Expected changes in the industry or regulatory environment.
- Proposed business strategies, such as mergers, acquisitions, or expansions.
- Any known future events that may have a significant impact on the company's finances.
What is the purpose of pro forma statements?
The main purpose of pro forma statements is to provide stakeholders, especially management and potential investors, with a forward-looking view of a company’s potential financial position. These statements offer a structured and organized way to assess the potential financial implications of certain business decisions, actions, or events before they occur. By previewing these hypothetical scenarios, a company can better prepare, strategize, and make informed decisions.
What are pro forma financial statements used for?
Pro forma financial statements serve multiple purposes:
Decision Making: Management teams use these statements to assess the potential outcomes of various business strategies and make informed choices.
Investor Relations: Companies can use pro forma statements to communicate potential changes to their investors, ensuring transparency and managing expectations.
Financing Activities: When seeking financing or undergoing mergers and acquisitions, pro forma statements can provide potential lenders or acquirers with a clearer picture of a company’s financial trajectory post-transaction.
Budgeting and Planning: These statements allow businesses to create more accurate budgets, foresee potential financial challenges, and make necessary adjustments in advance.
Risk Assessment: By visualizing different financial scenarios, companies can evaluate potential risks and develop contingency plans.
How to create pro forma statements
Creating pro forma statements requires a systematic approach, ensuring accuracy and the incorporation of all relevant assumptions. Here's a step-by-step process:
Step 1: Establish the Objective
Determine why you're creating the pro forma statements. Is it for a potential investment, a change in business operations, a potential merger or acquisition, or securing financing? Your objective will guide your assumptions.
Step 2: Gather Historical Data
- Start with your most recent financial statements. This includes the income statement, balance sheet, and cash flow statement.
- Analyze historical trends in revenues, costs, and other pertinent financial metrics.
Step 3: List Down Assumptions
- Clearly articulate and document assumptions that will be used in the pro forma. Common assumptions include projected sales growth, anticipated changes in costs, expected capital expenditures, or macroeconomic factors.
- Consider internal factors, like changes in operations or strategies, and external factors, like market conditions or regulations.
Step 4: Create the Pro Forma Income Statement
- Project revenues based on your sales forecasts and other assumptions.
- Estimate cost of goods sold (COGS) based on past percentages or any known changes in costs.
- Project operating expenses, considering historic trends and any anticipated changes.
- Estimate other income and expenses, such as interest or taxes.
- Calculate the net profit or loss by subtracting total expenses from total revenues.
Step 5: Develop the Pro Forma Balance Sheet
- Forecast assets:
- Current assets (cash, accounts receivable, inventory)
- Fixed assets (property, equipment)
- Intangible assets (patents, copyrights)
- Forecast liabilities:
- Current liabilities (accounts payable, short-term debts)
- Long-term liabilities (long-term debts, lease obligations)
- Calculate equity, which is derived from assets minus liabilities.
Step 6: Construct the Pro Forma Cash Flow Statement
- Start with the projected net income from the pro forma income statement.
- Adjust for non-cash expenses, like depreciation.
- Consider changes in working capital (accounts receivable, accounts payable, inventory).
- Factor in projected capital expenditures.
- Deduct any planned debt repayments or dividends to project the end-of-period cash balance.
Step 7: Integrate Contingent Events (If Applicable)
If your pro forma is centered around a specific event, such as a potential acquisition, merger, or introduction of a new product line, make sure you incorporate the financial impact of that event in the projections.
Step 8: Review, Adjust, and Validate
- Continuously compare the pro forma statements against actual financial results as they come in.
- Adjust your assumptions and projections if you observe significant variances.
- Validate your assumptions by seeking input from experts, such as industry analysts or financial consultants.
Step 9: Documentation and Presentation
- Clearly document all assumptions and methodologies used in the creation of the pro forma statements.
- Make the statements easily readable, incorporating charts or graphs if necessary.
- Remember, transparency is crucial. Ensure that stakeholders understand that these are projections based on assumptions, not guaranteed outcomes.
Step 10: Continual Updates
Business conditions change, and unforeseen events occur. Regularly update pro forma statements to reflect the latest information and insights.
Resource: Creating a Real Estate Pro Forma: A Step-by-Step Guide
Example Pro Forma Statements
Throughout this section, we will be referencing our pro forma templates. If you're searching for one tailored to your industry and spanning 5 years, we have 100+ different industry templates available for selection.
Pro Forma Income Statement
This projects revenues and expenses to show the anticipated net profit or loss.
Pro Forma Balance Sheet
This shows what the company's financial position might look like at a future date, given the assumptions made.
Pro Forma Cash Flow Statement
This projects how cash is expected to flow in and out of the business over a future period.
Pro Forma Graphs
Visual tools are often the quickest way to grasp information. Our template offers a P&L at a glance, a monthly sales forecast, and graphs that highlight monthly sales, gross profit, and net income.
Conclusion
In summary, pro forma financial statements serve as forward-looking tools, offering insights into a company's potential financial trajectory across different scenarios. Grounded in well-reasoned assumptions, these statements are invaluable for guiding management, investors, and stakeholders. Crafting such documents, however, can induce undue stress for business owners. This is where our Premium Pro Forma Templates come in. Including our Free Pro Forma Template. For business owners seeking to clarify their financial projections, our Pro Forma Template serves as a direct and effective tool, instilling confidence in guiding your business forward.
