Planning and budgeting for business changes play crucial roles in operating a successful company. However, balance sheets, income statements, and similar finance-tracking documents focus only on the history of transactions and the current economic status of your company.
If you want to plan for upcoming economic changes, you need pro forma financial statements to predict future income, identify and control risks, and secure funding for your business.
Here’s a breakdown of what pro forma financials are, why they matter for your business, and the different types of pro forma financials you need to know about.
- Pro forma statements can help predict cash flow, analyze risks, and secure funding.
- There are three main types of pro forma statements: income sheet, balance sheet, and cash flow statement.
- You can create pro forma statements by using online sample spreadsheets, templates, or existing financial statements in your accounts process.
What Are Pro Forma Financial Statements?
Pro forma financial statements help businesses estimate future cash flow and plan for major changes without upfront investment.
“Pro forma financial statements provide a hypothetical look at how a company would perform based on a credible set of assumptions about one or more transactions which a company is contemplating,” said finance coach Tanya Taylor in a video interview with The Balance. “For example, what would a company's financials look like if it merges with another company to create new synergies, or alternatively if it sold one of its lines of business?”
These projections are generally made several years out into the future and are used as inputs into the valuation process, said Robert R. Johnson, professor of finance, Heider College of Business, Creighton University, in a separate email interview with The Balance.
Pro forma statements do not follow the generally accepted accounting principles (GAAP), because reports that comply with GAAP must rely on historical data and not anticipated cash flow.
Types of Pro Forma Financials
There are three main types of pro forma statements, each with a different purpose. Taylor explained these as:
- Pro forma income statement: Also known as profit and loss (P&L) statements, these include predictions of upcoming revenues, cost of goods or services, and the company’s net profit.
- Pro forma balance sheet: These include any changes in the assets and liabilities of the business, including cash, receivables, inventories, account payables, and debt.
- Pro forma cash flow statement: These show the cash coming in and going out of the business as a result of the different hypothetical scenarios.
What Pro Forma Financials Do for Your Business
Pro forma statements can significantly benefit businesses by offering data for planning and predicting future economic changes, analyzing risks, securing funding, and making merging/selling decisions.
Here are some ways pro forma financials can benefit your company, no matter which stage of operation you’re at.
Securing Financing for Your Business
Pro forma financials offer businesses ways to make realistic assumptions about future growth rates and costs. According to Johnson, this is useful when you’re seeking outside capital (either debt or equity) to grow. “Potential capital suppliers will carefully examine pro forma financial statements (and the critical assumptions used in creating them) before committing capital to the firm,” Johnson said.
Assessing Potential Mergers
Pro forma statements offer a realistic estimate of what a merger would look like. For instance, “They can help you identify redundancies, and any new addition that needs to be made,” said Taylor. For example, through pro forma statements, you can identify that you may not need two accounting departments and two HR functions in a merger. The statements can also help you predict the economic changes that will come with the merger and how to ensure your business is ready for those.
Analyzing Risks and Planning for the Future
The hypothetical scenarios in pro forma financials can help analysts predict risks early and prepare for them before making any concrete changes.
“A key element of pro forma financials is that they allow analysts to change one or more key variables and see how the financial statements appear if certain variables are more or less optimistic than the base case,” Johnson said.
As an example, he explained that if the base case is that revenue grows by 20% over the next few years, one may want to lower that projected growth rate to, say, 10%, to see how the firm's financials look.
“This is called sensitivity analysis (determining the sensitivity of the firm's performance to different variables) and can help both firm insiders and potential suppliers of capital determine the risks of the firm,” Johnson added.
Using this as a tool, your business can come up with optimistic, realistic, and pessimistic future scenarios for the future of the company.
How To Prepare Pro Forma Statements
Creating pro forma statements is easy with dozens of free and paid tools available online.
You can use pro forma sample spreadsheets or work with an existing template in your accounting process. “There’s no need to over-engineer it,” Taylor said. “Start building the pro forma financials using the format of your current financial statements. If new lines are required, or certain lines need to be removed, make that adjustment.”
Another important thing to remember when preparing pro forma statements is to use credible data and not over-rely on hypothetical information, so your estimates are as close to accurate as possible. Taylor suggested starting the process with actual data that has been audited (if you have an auditor), or at a minimum have been validated as accurate.
Your business might benefit by following the SEC guidelines for public companies outlining how to use pro forma statements, even if you’re not a publicly traded business.
Remember pro forma financials are only a tool. These statements are useful for making estimates and analyzing future risks, but they’re not foolproof. So it’s best to use them in combination with other tools such as balance sheets, income statements, economic audits, and more.
Frequently Asked Questions (FAQs)
Why do banks require pro forma financial statements?
Pro forma financial statements give banks information about your ability to make payments while continuing to run your business. “The statements also provide them with the assurance that you understand the operations of your business and what can cause fluctuations in your earnings,” said Taylor.