What are Pro Forma Financial Statements?
Contents
A pro forma financial statement is a report prepared base on estimates, assumptions, or projections. In other words, it’s not an official GAAP statement issued to investors and creditors to relay information about past company performance. Instead, it’s a tool created by management to help project future performance and plan future events.
You can think of it as a “what if” financial statement. What would the cash flow statement look like if this happened? Management is trying to figure out what the business looks like if a business event happens in the future by starting with standard report and adjusting it for the new projections.
These reports are typically used for internal planning purposes, but many companies do issue them to the public for speculative purposes. For instance, management usually talks about the growth of the company in the management discussion and analysis section of the annual report. If their growth projections are based on landing a new client or project, they might include an estimated income statement to show the effects of the new project on the bottom line.
Pro forma financial statements can be prepared separately or in a set like general-purpose financials. Let’s take a look at each report in the set and why management would choose to create a pro-forma version.
Types of Pro Forma Financial Statements
There are four main types of Pro Forma Financial statements. Accountants and business management use each financial statement to analyze business performance and predict future performance in different ways.
Here are the four types of Pro Forma Financial statements:
Let’s take a look at each.
Projections
Projections are a fundamental application of pro forma financial statements. These statements project the company financial performance based on future assumptions or theoretical events. The pro forma income statement, for instance, estimates future revenues and expenses, offering a preview of potential profitability. This is invaluable for setting realistic revenue targets, expense budgets, and gauging overall financial viability.
The pro forma balance sheet, on the other hand, predicts future assets, liabilities, and equity. It aids in assessing the potential financial stability of a business under different scenarios. By projecting the financial position at a specific point in time, companies can anticipate capital needs, evaluate solvency, and make strategic decisions regarding asset allocation and debt management.
Funding
Pro forma financial statements are instrumental in securing funding for businesses. When seeking loans or investments, potential financiers often require projections of financial performance. The pro forma statements serve as a tool to demonstrate the feasibility and profitability of proposed projects or business ventures.
For instance, a startup seeking venture capital funding may use pro forma financial statements to outline projected revenue growth, expenses, and potential return on investment. Likewise, a company looking to secure a bank loan for a new facility might provide pro forma statements to showcase its ability to meet debt obligations.
M&A Analysis
In mergers and acquisitions (M&A), pro forma financial statements are essential for evaluating the financial impact of combining two entities. These statements facilitate a side-by-side comparison of the financials of both companies before and after the merger or acquisition.
The pro forma income statement helps in estimating the combined entity’s potential revenues and expenses. It aids in identifying potential cost synergies, revenue enhancements, and any potential risks or uncertainties associated with the transaction.
The pro forma balance sheet allows for an assessment of the combined entity’s financial position, including assets, liabilities, and equity. It helps in understanding the new capital structure, potential changes in working capital requirements, and any adjustments needed to maintain financial stability.
Risk Management
Pro forma financial statements also play a critical role in risk management. By providing projections based on different scenarios, businesses can identify and mitigate potential financial risks.
For example, a company may create pro forma statements to assess the financial impact of an economic downturn, allowing for contingency planning and adjustments to operational strategies. By simulating various scenarios, businesses can develop strategies to weather economic uncertainties and position themselves for resilience.
Pro Forma vs GAAP Financial Statements
Pro forma financial statements and Generally Accepted Accounting Principles (GAAP) financial statements serve distinct purposes in the financial reporting process. While both are essential tools for assessing a company’s financial health, they have significant differences in their preparation, content, and application.
Content Differences between GAAP and Pro Forma
Purpose
Pro Forma: Pro forma statements are forward-looking projections based on hypothetical scenarios and assumptions. They are not bound by strict accounting standards and serve primarily for planning and decision-making.
GAAP: GAAP financial statements are historical records of a company’s financial transactions, prepared in accordance with standardized accounting principles. They offer an accurate representation of past financial performance for external stakeholders.
Adjustments
Pro Forma: Pro forma statements often include non-standard adjustments like hypothetical mergers or acquisitions, anticipated changes in revenue, or other factors that may not align with GAAP guidelines.
GAAP: GAAP financial statements follow specific rules and principles for recording revenue, expenses, assets, and liabilities, ensuring consistency and comparability across different companies.
Scope
Pro Forma: Pro forma statements can cover a wide range of scenarios, from potential mergers to changes in capital structure, allowing for flexibility in forecasting.
GAAP: GAAP financial statements follow a standardized format, including the income statement, balance sheet, and cash flow statement, providing a comprehensive view of a company’s financial performance over a specific period.
Application Differences between GAAP and Pro Forma
Intended Audience
Pro Forma: Pro forma statements are primarily used for internal decision-making, providing management with insights into the potential impacts of various scenarios on the company’s financials.
GAAP: GAAP financial statements are designed for external stakeholders such as investors, creditors, and regulators, providing an accurate and standardized representation of a company’s financial position.
Regulatory Compliance
Pro Forma: Pro forma statements do not have strict regulatory requirements, allowing companies to exercise flexibility in their assumptions and projections.
GAAP: GAAP financial statements must adhere to specific accounting standards and regulations set by accounting bodies to ensure transparency and comparability in financial reporting.
Pro Forma Income Statement
The income statement is probably the most commonly pro forma-ed financial statement because management, investors, and creditors all want to see what happens to profits if certain business deals take place in the future. Thus, management will create an estimated income statement based on certain assumptions.
For example, management might anticipate closing a distribution deal with Wal-Mart in the next six months that will lead to an additional $5M in sales. Management will start with the standard income statement and add the estimated $5M sales projection along with the corresponding expenses needed to produce and ship these goods to the distributor. If the future deal with Wal-Mart goes through, the company is prepared for it and investors and creditors have an idea about the risks and rewards involved in the future.
Pro Forma Balance Sheet
Estimating and projecting the balance sheet is also a common practice because investors and creditors want to use the balance sheet to analyze debt ratios, liquidity levels, and overall leverage of the company.
Going back to our Wal-Mart example, let’s assume the company can’t support that many purchase orders and has to draw a line of credit in order to fund it. Now the projected sale has not only put more income on the bottom line, it has also put more debt on the balance sheet.
Creditors, in particular, would be concerned about this because additional debt might violate preexisting debt covenants. Meanwhile, investors might not care because the growth in income outweighs the increase in debt.
Pro Forma Cash Flow Statement
Typically a projected cash flow statement is not issued to the public. Instead management uses it to analyze what would happen to current inflows and outflows of cash if a business deal happened in the future.
In our Wal-Mart example, the company would receive a large amount of cash from the line of credit and the new sales. It would also have additional cash outflows funding the extra purchase orders and paying the interest and principle on the new debt.
As you can see, pro forma financial statements are a great tool that management can use to play out what if scenarios and future projects. They can be used to plan the future by evaluating upcoming cash requirements, credit terms on new debt obligations, and the logistics of entering into new contracts.
Management uses these reports regularly in the course of business and only occasionally issues them to outside investors and creditors.
Common Issues with Using Pro Forma Financial Statements
Pro forma financial statements are valuable tools for forecasting potential financial outcomes based on hypothetical scenarios and assumptions. However, they come with their own set of challenges that need to be considered when utilizing them for decision-making and planning.
Assumption Sensitivity
Pro forma statements heavily rely on assumptions, which can significantly impact the projected results. Small changes in these assumptions, such as sales growth rates or expense estimates, can lead to vastly different outcomes. This sensitivity makes it crucial to validate assumptions rigorously.
Lack of Standardization
Unlike GAAP financial statements, pro forma statements do not follow standardized accounting principles. This can lead to inconsistencies in reporting, making it difficult to compare projections across different companies or scenarios.
Potential for Bias
Since pro forma statements are not bound by strict accounting standards, there’s a risk of bias in the way certain items are adjusted or presented. Companies may be tempted to present pro forma statements in a way that paints a rosier picture than reality, potentially misleading stakeholders.
Inherent Uncertainties
The future is inherently uncertain, and pro forma statements are based on assumptions about future events and conditions. Unexpected changes in the business environment, market conditions, or regulatory landscape can render pro forma projections inaccurate.
Overlooking Contingencies
Pro forma statements often focus on the main projections but may overlook contingencies or risk factors. Factors like economic downturns, unforeseen expenses, or changes in competitive landscape should be carefully considered.
FAQ
What is a pro forma financial statement?
A pro forma financial statement is a forward-looking projection of a company’s expected financial performance, typically based on assumptions and hypothetical scenarios. It provides an estimate of future revenues, expenses, and profits, aiding in decision-making and financial planning.
What is the purpose of a pro forma statement?
The purpose of a pro forma statement is to provide a forward-looking projection of a company’s financial performance based on certain assumptions or hypothetical scenarios. It helps in planning, decision-making, and assessing the potential impact of various business strategies.
How are pro forma financial statements used?
Pro forma financial statements are used to project a company’s expected financial performance based on specific assumptions. They assist in financial planning, decision-making, and evaluating the potential impact of different business strategies or scenarios.
Why is creating a pro forma statement important?
Creating a pro forma statement is important because it allows businesses to make informed financial projections based on assumptions and hypothetical scenarios. This aids in planning, decision-making, and assessing the potential outcomes of various business strategies.
What are the types of pro forma statement?
The types of pro forma statements include the pro forma income statement, which projects future revenue and expenses; the pro forma balance sheet, which estimates future assets, liabilities, and equity; the pro forma cash flow statement, which forecasts cash inflows and outflows; and the pro forma statement of retained earnings, which outlines expected changes in retained earnings. These statements are used for financial planning and decision-making.
