A pro forma financial statement is a projection showing numbers that do not reflect the actual results from a company’s history. These financial statements can help investors and managers estimate how the company might perform under different assumptions.
When analyzing a business, you may want to project how the company will perform in the future. That’s where pro forma financials come in, and we’ll discuss how they work below.
Definition and Examples of Pro Forma Financials
Pro forma financial statements project how a company might perform in the future if the business takes an assumed course of action. It may include a best-case or worst-case scenario.
For example, the company might merge with or purchase another business, and the outcome could affect both cash flow and profits. Alternatively, the organization might need to make a major equipment purchase, and it’s important to know the financial impact of that transaction. In both cases, a pro forma could detail the expected results.
- Alternate name: Pro forma financial statement
While pro forma often refers to assumptions about future events, it can also refer to financial reports with irregular transactions removed. For example, if a company experienced significant restructuring charges in a given period, a pro forma might show how the company would have performed if those charges never occurred.
How Pro Forma Financial Statements Work
When deciding whether or not to invest in a company or a project, it’s reasonable to wonder how the future will unfold. There’s no way to predict the future with certainty, but you can analyze multiple “what if” scenarios to understand the potential outcomes. Pro forma financial statements enable investors to do that with available information.
Companies in the U.S. follow Generally Accepted Accounting Principles (GAAP) as a best practice. While GAAP standards set guidelines on reporting information accurately and transparently, sometimes it’s useful to include or exclude information. In particular, you might want to know how an anticipated change may affect a company’s earnings. For example, if an energy company is planning to build a new power plant, investors may wonder how that project will affect the company’s profits. Pro forma exercises provide a preview of expected outcomes.
While pro forma financial statements project the future, there is no guarantee that those predictions are accurate. Unexpected events, bad assumptions, and other factors can lead to dramatically different results.
A pro forma financial statement is supposed to include reasonably accurate information. However, companies that create these documents have some leeway in their assumptions. They might be overly optimistic or omit important information investors need to know about.
Companies are generally prohibited from creating misleading or fraudulent pro forma financial statements. Still, there may be some gray areas, so use caution when relying on future projections.
Types of Pro Forma Statements
Some of the most commonly used financial statements for pro forma are the income statement, the cash flow statement, and the balance sheet.
Pro forma financial statements might show the expected impact of any projects in the pipeline. For example, they may assume a company plans to build a new facility to produce more goods for customers.
A pro forma income statement would show how the company’s revenues and expenses might change and ultimately affect company profits. Income statements would show how much it would cost a company to pursue the project and how much revenues might improve after completion.
A pro forma cash flow statement could detail any payments involved in a hypothetical project. For example, the company might have to pay for land, materials, and fees to contractors who build the facility. Later, after the project is completed, the cash flow statement might assume increased payments from customers.
The pro forma balance sheet might change if the new facility adds to the company’s property, plant, and equipment entries. And if the company uses debt to fund the project, there might also be a substantial loan balance on the liabilities side of the balance sheet.
What It Means for Individual Investors
Pro forma financial statements provide predictions on how the future might unfold for companies you’re investing in. With that information, you can conduct ratio analyses using hypothetical numbers and gain insight into how projects might affect the value of your investment.
While it’s helpful to know what a company’s management has planned, it’s important to view these projections with skepticism. Nobody can predict the future, and managers might (even with the best intentions) use overly optimistic assumptions in their pro formas. So consider the possibility of less-optimistic outcomes as well.
- Pro forma financial statements illustrate how a company’s financial position might change in the future.
- Projections about the future are not required to follow the strictest accounting standards, but companies must avoid committing fraud when creating pro formas.
- Because it’s impossible to predict the future, pro forma financial statements should only be considered an estimate.