What Are Pro Forma Financial Statements?

Picture this: You're the CRO of a growing tech firm. You identify a new potential revenue stream that requires a significant upfront investment, with the potential to bring massive sales to the organization in future years. Your executive team is taking a conservative approach. They're nervous about putting too much money toward an unproven service. How do you convince them your idea is worth pursuing?

You showcase what's possible with a set of pro forma financial statements. Through pro forma financial statements, you can illustrate how the new revenue stream will impact your company's income, expenses, assets, liabilities, and cash flow. While you can't guarantee prospective financial results, you can use them for informed projections in your company's financial decisions.

Introduction To Pro Forma Financial Statements

In Latin, pro forma means "for the sake of form" or "matter of form."

Pro forma financial statements differ from the financial statements you're familiar with. For one, they're essentially future financial predictions. They're what you expect your financials to look like at a specific time period, should everything go to plan. That's completely opposite of traditional financial statements based on historical performance. Here's what you need to know.

Definition And Purpose Of Pro Forma Financial Statements

Unlike audited or reviewed quarterly or annual financial reports, pro forma financial statements use assumptions and estimates to predict a company's future financial performance. While they may incorporate prior financial results as a starting point, they consider the financial impact a hypothetical decision may have on the organization.

Sometimes, people refer to pro forma financial statements as financial projections or financial forecasts. All three terms mean the same thing. So, when public companies refer to their organization's financial projections in an earnings call or proxy statement, they're talking about pro forma financial statements.

Pro forma financial statements help executives understand how decisions impact a company over future periods. A few ways organizations rely on pro forma financial statements include:

• Predicting future company earnings for a start-up's business plans
• Assessing the potential impact of business acquisitions
• Determining whether a business combination makes sense
• Deciding whether a capital investment, like equipment or a new office building, is worthwhile
• Evaluating changes in capital structure, such as taking on new debt or obtaining pre-seed investment funding

Pro forma financial statements can deviate from generally accepted accounting principles (GAAP) accounting methods — sometimes quite significantly. If you share your financial projections with external parties, note their prospective nature. You can't promise results, no matter how in-depth your forecasting process is.

Importance In Business Planning And Analysis

Business owners, executives, and managers make hundreds of business decisions every year. Some decisions are minor and won't substantially impact your financial results. For instance, switching your copier's paper brand probably won't move the needle much on yearly operating expenses. Other business decisions affect your company's profitability for years to come. Things like acquiring a company, introducing a novel product line, or buying expensive equipment fall into this category.

With the help of pro forma financial statements, you can assess major business decisions based on reasonable assumptions. They're a crucial part of the business planning process, helping you to understand the effect of a decision and decide whether to move forward (or not).

Pro forma financial statements are also helpful in projecting future financial results, even if you aren't considering any major investments. For instance, you might use them to estimate how an economic recession will impact the business or how much revenue a new client might bring to your organization. Some companies use pro forma financial statements in their standard analysis process. Doing so can improve the accuracy of their projections over time and hold departments accountable for unexpected spending deviations.  

Different Types Of Pro Forma Financial Statements

Any time you close a reporting period, you have three different financial reports: an income statement, a balance sheet, and a cash flow statement. You can create pro forma statements for all three financial documents.

Pro Forma Income Statements

A pro forma income statement projects future revenues and expenses for an organization. It uses historical earnings as a starting point and then assesses the future financial impact of certain decisions or assumptions. You can create short-term pro forma income statements for an upcoming month or quarter or extend your projections for coming years.

Pro Forma Balance Sheets

Pro forma balance sheets assess a company's future assets, liabilities, and equity. While you can use them for shorter interim periods, it's more common for longer timeframes, like three to five years. For instance, a start-up company might share a pro forma balance sheet with potential investors, who can use it to evaluate their possible return on an investment in the organization.

Pro Forma Cash Flow Statements

A pro forma cash flow statement forecasts a company's future cash inflows and outflows. It presents cash inflows and outflows in three categories: operating, investing, and financing. A pro forma cash flow statement helps management assess upcoming cash flows and how business decisions may impact them. Creditors may use a pro forma cash flow statement in the loan evaluation process. Usually, businesses look at pro forma cash flow statements in yearly increments, but you can also use them for short-term needs.

How To Construct Pro Forma Financial Statements

Whether you plan to create a pro forma income statement, balance sheet, or cash flow statement (or all three!), you'll need to follow a few steps. Start with the process below, but feel free to modify the process to suit your business needs.

Gather Historical Data

First things first: Where are your most recent financial statements? You'll need a copy to use as the initial base for your pro forma statements. To improve accuracy, consider gathering statements for several different periods, particularly if there are earnings swings due to seasonality, debt service, or other factors.

Identify The Purpose And Audience Of Your Pro Forma Financial Statements

Next, define what you plan to use the pro forma financial statements for and who will see them. Knowing why you're creating the statements and whether you'll use them internally or externally (or both) helps you understand whether you need to create a complete set of pro forma financial statements or a singular statement. If you plan to share pro forma financial statements with investors, creditors, or other external parties, be aware that you must take a realistic, conservative approach to estimates and assumptions.

Define Your Period

The time period of pro forma financial statements can be anywhere from a month to decades in the future. Shorter periods may be useful for evaluating ongoing business operations, while longer timeframes are better suited for major investments, like introducing a new product line. Keep in mind that forecast accuracy drops over time, no matter how comprehensive and careful your analysis is. There are simply too many variables (many of which you can't control, like the general economy or technological advancements) that may impact your projections.

Identify Your Assumptions

What do you expect to change over the period of your pro forma financial statements? Are you anticipating greater revenues or an increase in debt payments? Are you considering a costly investment that will impact short-term cash flow? Identify your assumptions and their financial impact. Include any supporting evidence for assumptions, such as expected monthly interest payments to service a new loan. The more detailed (and conclusive) your assumptions are, the more precise your financial projections will be.

Seek Input From Stakeholders

Other executives, managers, and employees can provide valuable supportive details for your pro forma financial statements — so get their insights, too! For instance, a sales rep might be on the cusp of signing a major new customer you're unaware of. Or, the IT department might alert you to a high-dollar upcoming software renewal you forgot about. Think of forecasting as a group effort, and you'll see improved accuracy in your forecasts.

Assemble Your Pro Formas

Once you're comfortable with assumptions and projections, you can configure your pro forma financial statements. Start with your historical base, and tack on your forecasts for the desired time frame. If you're creating multiple financial statements, carefully consider how each assumption affects each report. Remember that transactions usually impact all three financial statements — not just one.

Review Your Final Statements

Check your pro forma financial statements thoroughly before sharing them with management or external parties. Format statements using the same layout you typically use for regular reporting. If possible, ask for help in the review process, especially if you're performing a complex analysis. The more stakeholders you can involve, the more likely you will catch errors before sharing financial projections.

How To Use Pro Forma Financial Statements In Budgeting

Pro forma financial statements are helpful in many situations. Whether preparing your quarterly budget or considering a significant investment, pro forma financial statements provide clear-cut projections for informed financial decisions.

Align Pro Forma Statements With Budget Goals

Budgeting and pro forma statements fit together like a hand in a glove. You can use pro forma statements to set realistic financial goals and devise ways to accomplish your objectives through budgeting. So, let's say you need to cut expenses by 5% next year. You could use your historical financial data to source ways to cut costs, then prepare a pro forma income statement demonstrating where the cuts will occur. If you execute your plan effectively, your actual results will line up with projected ones.

Forecast And Budget For Future Business Scenarios

Any time you're considering a big business change — be it an investment, company acquisition, or purchase — pro forma financial projections help assess the future impact. If you're evaluating several scenarios, consider creating multiple financial models to account for different scenarios. You can develop various pro forma financial statements for each situation.

Leverage Pro Forma Statements For Decision Making

The next time you need to drum up support for a beneficial company investment, remember the power of pro forma financial statements. Using your historical data and reasonable assumptions, you can project the impact on your company's financial statements. Even if you don't have any big financial decisions you're considering, you can use pro forma financial statements for budgeting or measuring the effectiveness of ongoing operations. They're a handy tool for many different scenarios.

Financial professionals can help make pro forma statements more reliable. They use their skills to gather accurate historical data, analyze market trends, and make informed assumptions for creating these statements.

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