What are pro forma financial statements and how can I use them to benefit my business?
In this article, we will be defining these unique financial reports in detail. You will know how they are similar and different to the financial statements you are already familiar with. You will also know the general process of creating one for yourself.
What Are Pro Forma Financial Statements?
These are like regular financial statements, except they deal with hypothetical future financial situations. They are both important in terms of financial reporting, but they differ in terms of what they communicate.
Let’s go deeper into the distinctions. Regular financial statements show you an actual picture of financial performance using historical data.
On the other hand, pro forma statements are financial projections and forecasts. They also use historical data but account for hypothetical factors added and subtracted to these statements. Along with historical data, likely outcomes and financial assumptions are building blocks for these statements. They use these to make reasonable predictions about performance in future time periods usually projected over the course of a year.
Why Are Pro Forma Financial Statements Important?
Forecasting and Financial Planning
Pro forma statements allow you to make feasible guesses as to what your financial position will be in the next quarter and year. These inform important business decisions concerning things like budgeting, cost-cutting, increasing sales, or potential investments. It can help you to anticipate multiple different factors that can happen after you make a major business move.
These statements allow you to see potential future risks and make adjustments accordingly. Because it’s an educated guess about the future of performance, it shows you a glimpse of where you’re headed. This then can reveal the theoretical efficacy of certain business strategies.
These projections and forecasts are crucial to demonstrate your business’s potential to stakeholders and investors. Because pro forma statements exclude one-off expenses and purchases, they can actually provide a more accurate look at your profitability. These statements can show investors a breakdown of how their money can be used to improve operations. This hypothetical forecasting and budgeting can show them that you already have a plan for their ROI.
Types of Pro Forma Statements
We can make pro forma statements using the same templates as the “big three” financial statements.
Pro Forma Income Statement
An income statement, also known as a profit and loss statement, shows the revenue and expenses of a business over a specific period. Through the net income equation, one can determine their bottom line and how much funds they have to carry over to the next period. You create these more frequently than other statements.
Pro forma income statements are useful because they can reveal how a potential transaction changes certain elements on the statements. For instance, how revenues change in a merger or acquisition or how much more taxes you might need to pay.
Pro Forma Balance Sheet
A balance sheet shows you the financial position of a company. It shows the list of assets, liabilities, and equity of a business. This statement is usually prepared yearly. A pro forma balance sheet can be prepared to project a future financial state. It can show you the depreciated value of your assets like equipment or inventory. It can also show you how much you would owe suppliers or other entities if prices and interest rates remain the same or change.
Pro Forma Cash Flow Statement
A cash flow statement shows you the inflow and outflow of cash in your business. It shows you what you earn and spend on operating, investing, and financing activities. Your income statement and balance sheet informs it. A pro forma cash flow statement can show you how your business will look if cash flows maintain a consistent rate. It can reveal if your company will be in the negative or positive months and years from now.
What Are the Advantages and Disadvantages of Pro Forma Financial Statements?
The main benefit of pro forma statements is it gives you an informed peek into your financial future. Lots of people weigh the pros and cons of making decisions. Pro forma can help you do this using real numbers and historical data to project how a financial decision could impact your business.
You can improve budgeting, forecasting, and overall financial planning by looking at your goals and objectives and weighing them against your pro formas. It can show you areas in need of more attention and strategic intervention. You can also assess these potential strategies, investments, and other partnership opportunities. You can perform risk analysis and play with imaginary money to determine a reasonable amount to get you to a more profitable place. You can continue to play out your current scenario and see where it takes you.
Not “Real” Numbers
Because pro forma statements aren’t GAAP compliant, these hypothetical numbers are just that. This is the main limitation of pro forma because these scenarios hinge on multiple factors going the way you expect them to. Also, investors may be skeptical when you present them with pro forma statements, as you can embellish these numbers.
Hence, it is important, when creating pro formas, to be as realistic and conservative as possible. Wise creation is looking at past data, analyzing trends, and using dependable financial assumptions to forecast future growth. This way, any information from these pro forma statements can be more reliable. They can not only actionably inform your other financial plans but also give investors peace of mind.
Also, mention how you came to a certain conclusion in your pro forma statements. List your assumptions, cite your sources (market research, past financial statements, etc.), and make it all available to your investors.
How Do I Create a Pro Forma Financial Statement?
Creating a pro forma statement is very similar to making other financial statements. You can use the same methods and templates that you would for a balance sheet, income statement, and cash flow statement. The only difference is including your hypothetical transactions.
The first thing we need to do is create reasonable financial assumptions. Financial assumptions are predictions, forecasts, or guidelines assumed to be true that you base your financial plans on. Some examples of financial assumptions include forecasted prices of your products, revenues, or supplier rates and COGS.
Good assumptions are based on market data, historical financial data, and outcomes that are likely. For instance, say you conduct market testing and it shows that your product is popular. You have numbers to show how much and how fast the product sold. Using this you can make a financial assumption that your new product will be successful and can bring in a certain amount of revenue. Whether it is investing, assets, liabilities, or other line items, make sure any forecasting done is based on good financial assumptions.
What’s the Difference Between Pro Forma and GAAP Financials?
Pro forma financials are predictions of outcomes. As such, there aren’t really any standardized rule sets governing their creation. Pro forma earnings vary in accuracy, sometimes being way off. This is because predictions can be both conservative in their estimates or bloated.
Important: While not technically illegal, we do not recommend inflating your numbers though. Just because it’s pro forma, that doesn’t mean it’s pro deception. Optimistic projections are one thing, but you need to make sure they are reasonable and attainable. The last thing you want is to under-deliver on your performance and deter future investors.
Be an honest salesman. Base your pro forma on historical data, financial and market analysis, and data-driven financial assumptions. On the other hand, Generally Accepted Accounting Principles or GAAP are the standards, rules and methods used by accountants in the U.S. These rules help keep reporting and recording consistent, accurate, and legally compliant.
Because these govern bookkeeping and accounting practices, including how we make financial reports they must use real historical data. Unlike pro forma statements, we can use these documents for tax preparation and filing. Whether done knowingly or unknowingly, serving pro forma statements as if they were GAAP compliant statements can get you in trouble. That is why you need to label them as “pro forma”. Basically, pro formas report hypothetical data. GAAP compliant statements report historical data.
Frequently Asked Questions
What types of pro forma financial statements are commonly used?
The balance sheet, income statement, and cash flow statement are the most common three. These form the basis for more specific statements like risk assessment analysis and mergers and acquisitions.
What types of assumptions are used in pro forma statements?
Financial assumptions refer to guidelines and expectations made about your business. These predictions are an important part of financial strategy and planning. It’s essential that these assumptions are as true to reality as possible, grounded on facts and historical data.
Are pro forma financials used for internal or external purposes?
We can create these statements for both internal use and external review. Internal teams can view the information in these statements to weigh multiple options for moving the business forward. Members of the public may also have access to these statements. Investors can look at these to see a glimpse of their potential impact if they were to finance a business. Business owners can also look at pro formas forecasting the outcomes of a merger or acquisition deal.
How do pro forma financial statements differ from historical financial statements?
Historical financial statements look at past financial information to give you a current picture of your financial standing. These statements are GAAP compliant. Pro forma statements are based on both historical data and financial assumptions. They paint hypothetical financial scenarios. They exclude one-time expenses. These guessed numbers might not be completely accurate and are not GAAP compliant.
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Interested in learning more? Schedule a call with our CEO, Nathan Hirsch.
And here’s some free resources:
- Monthly Finance Meeting Agenda
- 9 Steps to Master Your Ecommerce Bookkeeping Checklist
- The Ultimate Guide on Finding an Ecommerce Virtual Bookkeeping Service
- What Is a Profit and Loss Statement?
- How to Read & Interpret a Cash Flow Statement
- How to Read a Balance Sheet & Truly Understand It
Pro forma financial statements are an essential part of financial planning and forecasting. They assist in decision-making, strategy creation, and attracting investors. While not GAAP compliant, these statements, when done properly, can show you a realistic view of your future financial position.