Definition of Pro Forma Financial Statements
Pro Forma Financial Statements refer to the statements based on certain assumptions and projections that companies prepare before planning or deciding on transaction-based events like mergers, acquisitions, or hypothetical cases.
A company prepares many financial statements, some of which are the statement of financial position, statement of operations, statement of cash flows, etc. Apart from these, company management may want to address certain events for which the company’s financial statements have to be projected, or certain items need to be differently assumed. Such statements are known as Pro Forma.
The word Pro Forma, meaning “for the sake of”, has Latin origin and is common usage in finance and economics.
How to Create Pro Forma Financial Statements?
Let us look at some easy steps to create a Pro Forma income statement for a small business.
- Set up goals for sales in the period you are looking for: First things first; creating a Pro Forma financial statement, especially an income statement, in this case, starts with laying out the plan, which includes sales objectives, in terms of volumes and dollars, and the duration of the plan. This can involve the use of various techniques for forecasting sales and sales units.
- Set production schedule: The backend of sales is the supporting production department. Huge businesses that produce millions of units of products (finished or intermediate) are bound by the production schedule. Take, for example, the objective of production of 10 million chairs annually.
- Plan how you will match your production schedule: It is always difficult to match the set production schedule with the actual production schedule. This may require extensive planning, which can include a well-prepared Master Production Schedule (MPS), workforce consideration, realistic assumptions about sales numbers, follow-up methodologies, planning around outages and manhours, among others.
- Calculated COGS and match it with sales: Pro Forma financial statements are a complete picture of revenues and expenditures. In this sense, it is important to set up a schedule for the calculation of the cost of goods sold (COGS) and the related expenses. Then, it should be matched with the sales number (revenues and volumes) in order to arrive at a realistic plan.
- Calculate other expenses, taxes, and interest items: You might have a business where you have raised a small loan or a debt. The interest payment you are making periodically, the taxes you are paying to the government, and the various expenses like advertising, marketing and wage expenses are to be included.
- Prepare a Pro Forma income statement using the above five steps: As soon as you have completed the above-mentioned five steps, you are ready to create the statements you have been looking for. But, first, include all the necessary items you have calculated in the above steps.
|Total Sales revenues|
|Less: Cost of goods and services|
|Less: Salaries, marketing, and advertising expenses|
|Less: Interest paid|
|Profit before tax|
|Less: Taxes paid|
Example of Pro Forma Financial Statements (With Excel Template)
Let’s take an example to understand the calculation of Pro Forma Financial Statements in a better manner.
Let us assume an advertising business doing great in its initial stages and forecast its growth for the next 5 years. Let us expect the markets to be doing good.
Start with the sales numbers and follow with the sales revenues. Next, list down the actual numbers of the last 3 to 5 years. Then, start analyzing the trends and make realistic assumptions. Start with the cost of goods and services. Further, include estimates for expenses and calculate items like gross profit, operating profit, and net profit.
The Pro Forma income statement that the team of analysts has made looks like as shown below.
|Advertising business – Pro Forma Income Statement|
|Particulars (In $)||FY17||FY18||FY19||FY20||FY21||FY22||FY23||FY24|
|Sales price (Averaged)||20.00||21.00||21.80||22.0||22.5||22.5||23.0||23.0|
|Cost of goods sold||8,00,000||8,50,000||9,50,000||10,52,128||11,98,278||13,54,261||15,69,017||17,73,034|
|Profit before tax||3,70,000||4,58,000||5,44,600||6,13,904||6,89,060||7,57,125||8,70,213||10,06,463|
Uses of Pro Forma Financial Statements
- Projections: Businesses uses estimates and assumptions to make projections of sales and costs using Pro Forma statements.
- Funding: When raising funds for their business, management can use Pro Forma of what their asset growth and financial numbers will be in the future
- M&A analysis: In M&A transactions, these statements are helpful in determining synergies around costs, taxes, etc. to evaluate if M&A will succeed
- Risk analysis: Companies are constantly worried about the changing micro and macro environment, and they use Pro Forma methods in their risk models
- Budgeting: Pro Forma statements can be used to make budgets which tell about the allocation of funds for business
Pro Forma Financial Statements vs Budget
A Pro Forma Financial Statement must not be confused with a budget. However, it is true that both these statements are prepared to showcase the future condition of a business. Where on the one hand, a Pro Forma Financial Statement speaks about assumptions and predictions given a specific upcoming event or condition; a budget, on the other hand, is a plan of how a business or company will manage its finances in the future.
Nonetheless, it should be noted that budgets can be prepared based on the guidelines and recommendations of Pro Forma statements. The underlining concept is that a budget needs visibility or foresight into the future, which can be well captured by Pro Forma statements.
An example of the two statements converging is when a Pro Forma statement is prepared for a full year addressing company needs and its business well-being. On the other hand, the two statements can diverge when the Pro Forma statement targets a very specific event and can only impact the business to some extent.
Some of the advantages are given below.
- Useful for preparing a budget, risk models, M&A models, etc.
- Used in tracking business growth prospects and taking critical decisions
- Reveal company’s health and offer different perspectives of the teams involved
Some of the disadvantages are given below
- Models can face challenges of biases from the analysts
- Assumptions and estimates can always be conflicting
- No direct mention of qualitative aspects because of models based on numbers
Creating Pro Forma financial statements can differ based on the requirements and usage of the financial statements. Remember, you are using certain assumptions to make a Pro Forma statement. The more accurate and realistic your assumptions are, the better your Pro Forma statement looks. For example, sales can be estimated using a top-down and bottom-up approach. Management can critically analyze the business from a conservative perspective if high-risk assumptions are involved in preparing Pro Forma statements.
This is a guide to Pro Forma Financial Statements. Here we also discuss the definition and how to create pro forma financial statements? Along with advantages and disadvantages. You may also have a look at the following articles to learn more –