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A pro forma financial statement is a report prepared base on estimates, assumptions, or projections. In other words, it’s not an official GAAP statement issued to investors and creditors to relay information about past company performance. Instead, it’s a tool created by management to help project future performance and plan future events.

You can think of it as a “what if” financial statement. What would the cash flow statement look like if this happened? Management is trying to figure out what the business looks like if a business event happens in the future by starting with standard report and adjusting it for the new projections.

These reports are typically used for internal planning purposes, but many companies do issue them to the public for speculative purposes. For instance, management usually talks about the growth of the company in the management discussion and analysis section of the annual report. If their growth projections are based on landing a new client or project, they might include an estimated income statement to show the effects of the new project on the bottom line.

Pro forma financial statements can be prepared separately or in a set like general-purpose financials. Let’s take a look at each report in the set and why management would choose to create a pro-forma version.

Types of Pro Forma Financial Statements

There are four main types of Pro Forma Financial statements. Accountants and business management use each financial statement to analyze business performance and predict future performance in different ways.

Here are the four types of Pro Forma Financial statements:

• Future projections
• Investing or financing projections
• M&A analysis projections
• Risk Management & Analysis

Let’s take a look at each.

Projections

Projections are a fundamental application of pro forma financial statements. These statements project the company financial performance based on future assumptions or theoretical events. The pro forma income statement, for instance, estimates future revenues and expenses, offering a preview of potential profitability. This is invaluable for setting realistic revenue targets, expense budgets, and gauging overall financial viability.

The pro forma balance sheet, on the other hand, predicts future assets, liabilities, and equity. It aids in assessing the potential financial stability of a business under different scenarios. By projecting the financial position at a specific point in time, companies can anticipate capital needs, evaluate solvency, and make strategic decisions regarding asset allocation and debt management.

Funding

Pro forma financial statements are instrumental in securing funding for businesses. When seeking loans or investments, potential financiers often require projections of financial performance. The pro forma statements serve as a tool to demonstrate the feasibility and profitability of proposed projects or business ventures.

For instance, a startup seeking venture capital funding may use pro forma financial statements to outline projected revenue growth, expenses, and potential return on investment. Likewise, a company looking to secure a bank loan for a new facility might provide pro forma statements to showcase its ability to meet debt obligations.

M&A Analysis

In mergers and acquisitions (M&A), pro forma financial statements are essential for evaluating the financial impact of combining two entities. These statements facilitate a side-by-side comparison of the financials of both companies before and after the merger or acquisition.

The pro forma income statement helps in estimating the combined entity’s potential revenues and expenses. It aids in identifying potential cost synergies, revenue enhancements, and any potential risks or uncertainties associated with the transaction.

The pro forma balance sheet allows for an assessment of the combined entity’s financial position, including assets, liabilities, and equity. It helps in understanding the new capital structure, potential changes in working capital requirements, and any adjustments needed to maintain financial stability.

Risk Management

Pro forma financial statements also play a critical role in risk management. By providing projections based on different scenarios, businesses can identify and mitigate potential financial risks.

For example, a company may create pro forma statements to assess the financial impact of an economic downturn, allowing for contingency planning and adjustments to operational strategies. By simulating various scenarios, businesses can develop strategies to weather economic uncertainties and position themselves for resilience.

Pro Forma vs GAAP Financial Statements

Pro forma financial statements and Generally Accepted Accounting Principles (GAAP) financial statements serve distinct purposes in the financial reporting process. While both are essential tools for assessing a company’s financial health, they have significant differences in their preparation, content, and application.

Content Differences between GAAP and Pro Forma

Purpose

Pro Forma: Pro forma statements are forward-looking projections based on hypothetical scenarios and assumptions. They are not bound by strict accounting standards and serve primarily for planning and decision-making.

GAAP: GAAP financial statements are historical records of a company’s financial transactions, prepared in accordance with standardized accounting principles. They offer an accurate representation of past financial performance for external stakeholders.

Adjustments

Pro Forma: Pro forma statements often include non-standard adjustments like hypothetical mergers or acquisitions, anticipated changes in revenue, or other factors that may not align with GAAP guidelines.

GAAP: GAAP financial statements follow specific rules and principles for recording revenue, expenses, assets, and liabilities, ensuring consistency and comparability across different companies.

Scope

Pro Forma: Pro forma statements can cover a wide range of scenarios, from potential mergers to changes in capital structure, allowing for flexibility in forecasting.

GAAP: GAAP financial statements follow a standardized format, including the income statement, balance sheet, and cash flow statement, providing a comprehensive view of a company’s financial performance over a specific period.

Application Differences between GAAP and Pro Forma

Intended Audience

Pro Forma: Pro forma statements are primarily used for internal decision-making, providing management with insights into the potential impacts of various scenarios on the company’s financials.

GAAP: GAAP financial statements are designed for external stakeholders such as investors, creditors, and regulators, providing an accurate and standardized representation of a company’s financial position.

Regulatory Compliance

Pro Forma: Pro forma statements do not have strict regulatory requirements, allowing companies to exercise flexibility in their assumptions and projections.

GAAP: GAAP financial statements must adhere to specific accounting standards and regulations set by accounting bodies to ensure transparency and comparability in financial reporting.

Pro Forma Income Statement

The income statement is probably the most commonly pro forma-ed financial statement because management, investors, and creditors all want to see what happens to profits if certain business deals take place in the future. Thus, management will create an estimated income statement based on certain assumptions.

For example, management might anticipate closing a distribution deal with Wal-Mart in the next six months that will lead to an additional $5M in sales. Management will start with the standard income statement and add the estimated $5M sales projection along with the corresponding expenses needed to produce and ship these goods to the distributor. If the future deal with Wal-Mart goes through, the company is prepared for it and investors and creditors have an idea about the risks and rewards involved in the future.

Pro Forma Balance Sheet

Estimating and projecting the balance sheet is also a common practice because investors and creditors want to use the balance sheet to analyze debt ratios, liquidity levels, and overall leverage of the company.

Going back to our Wal-Mart example, let’s assume the company can’t support that many purchase orders and has to draw a line of credit in order to fund it. Now the projected sale has not only put more income on the bottom line, it has also put more debt on the balance sheet.

Creditors, in particular, would be concerned about this because additional debt might violate preexisting debt covenants. Meanwhile, investors might not care because the growth in income outweighs the increase in debt.

Pro Forma Cash Flow Statement

Typically a projected cash flow statement is not issued to the public. Instead management uses it to analyze what would happen to current inflows and outflows of cash if a business deal happened in the future.

In our Wal-Mart example, the company would receive a large amount of cash from the line of credit and the new sales. It would also have additional cash outflows funding the extra purchase orders and paying the interest and principle on the new debt.

As you can see, pro forma financial statements are a great tool that management can use to play out what if scenarios and future projects. They can be used to plan the future by evaluating upcoming cash requirements, credit terms on new debt obligations, and the logistics of entering into new contracts.

Management uses these reports regularly in the course of business and only occasionally issues them to outside investors and creditors.

Common Issues with Using Pro Forma Financial Statements

Pro forma financial statements are valuable tools for forecasting potential financial outcomes based on hypothetical scenarios and assumptions. However, they come with their own set of challenges that need to be considered when utilizing them for decision-making and planning.

Assumption Sensitivity

Pro forma statements heavily rely on assumptions, which can significantly impact the projected results. Small changes in these assumptions, such as sales growth rates or expense estimates, can lead to vastly different outcomes. This sensitivity makes it crucial to validate assumptions rigorously.

Lack of Standardization

Unlike GAAP financial statements, pro forma statements do not follow standardized accounting principles. This can lead to inconsistencies in reporting, making it difficult to compare projections across different companies or scenarios.

Potential for Bias

Since pro forma statements are not bound by strict accounting standards, there’s a risk of bias in the way certain items are adjusted or presented. Companies may be tempted to present pro forma statements in a way that paints a rosier picture than reality, potentially misleading stakeholders.

Inherent Uncertainties

The future is inherently uncertain, and pro forma statements are based on assumptions about future events and conditions. Unexpected changes in the business environment, market conditions, or regulatory landscape can render pro forma projections inaccurate.

Overlooking Contingencies

Pro forma statements often focus on the main projections but may overlook contingencies or risk factors. Factors like economic downturns, unforeseen expenses, or changes in competitive landscape should be carefully considered.

FAQ

What is a pro forma financial statement?

A pro forma financial statement is a forward-looking projection of a company’s expected financial performance, typically based on assumptions and hypothetical scenarios. It provides an estimate of future revenues, expenses, and profits, aiding in decision-making and financial planning.

What is the purpose of a pro forma statement?

The purpose of a pro forma statement is to provide a forward-looking projection of a company’s financial performance based on certain assumptions or hypothetical scenarios. It helps in planning, decision-making, and assessing the potential impact of various business strategies.

How are pro forma financial statements used?

Pro forma financial statements are used to project a company’s expected financial performance based on specific assumptions. They assist in financial planning, decision-making, and evaluating the potential impact of different business strategies or scenarios.

Why is creating a pro forma statement important?

Creating a pro forma statement is important because it allows businesses to make informed financial projections based on assumptions and hypothetical scenarios. This aids in planning, decision-making, and assessing the potential outcomes of various business strategies.

What are the types of pro forma statement?

The types of pro forma statements include the pro forma income statement, which projects future revenue and expenses; the pro forma balance sheet, which estimates future assets, liabilities, and equity; the pro forma cash flow statement, which forecasts cash inflows and outflows; and the pro forma statement of retained earnings, which outlines expected changes in retained earnings. These statements are used for financial planning and decision-making.

Financial StatementsStatement of Shareholders’ Equity

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The statement of retained earnings is a financial statement that is prepared to reconcile the beginning and ending retained earnings balances. Retained earnings are the profits or net income that a company chooses to keep rather than distribute it to the shareholders.

In other words, assume a company makes money (has net income) for the year and only distributes half of the profits to its shareholders as a distribution. The other half of the profits are considered retained earnings because this is the amount of earnings the company kept or retained.

The retained earnings calculation or formula is quite simple. Beginning retained earnings corrected for adjustments, plus net income, minus dividends, equals ending retained earnings. Just like the statement of shareholder’s equity, the statement of retained is a basic reconciliation. It reconciles how the beginning and ending RE balances. In other words, how did the RE balance on January 1 turn into the RE balance on December 31?

Although this statement is not included in the four main general-purpose financial statements, it is considered important to outside users for evaluating changes in the RE account. This statement is often used to prepare before the statement of stockholder’s equity because retained earnings is needed for the overall ending equity calculation.

Format

This statement has five main sections:

• — Beginning RE
• — Prior Period Adjustments
• — Additions
• — Subtractions
• — Ending Balance

The beginning equity balance is always listed on its own line followed by any adjustments that are made to retained earnings for prior period errors. These adjustments could be caused by improper accounting methods used, poor estimates, or even fraud. The sum or difference is usually subtotaled at this point.

Next, additions and subtractions are listed. Additions include net income if the company is profitable. If the company is not profitable, net loss for the year is included in the subtractions along with any dividends to the owners. Dividends are always subtracted from RE because once dividends are declared, the company owes its shareholders the funds and must take these funds out of its retained earnings even if they are simply declared and not paid.

The last line on the statement sums the total of these adjustments and lists the ending retained earnings balance.

Like all financial statements, the retained earnings statement has a heading that display’s the company name, title of the statement and the time period of the report. For example, an annual income statement issued by Paul’s Guitar Shop, Inc. would have the following heading:

• Paul’s Guitar Shop, Inc.
• Statement of Retained Earnings
• For the Year Ended December 31, 2015

Example

Here is an example of how to prepare a statement of retained earnings from our unadjusted trial balance and financial statements used in the accounting cycle examples for Paul’s Guitar Shop.

As you can see, the beginning retained earnings account is zero because Paul just started the company this year. There were no retained earnings in prior years. Likewise, there were no prior period adjustments since the company is brand new.

Paul’s net income at the end of the year increases the RE account while his dividends decrease the overall the earnings that are kept in the business.

This ending retained earnings balance can then be used for preparing the statement of shareholder’s equity and the balance sheet.

Cash Flows StatementFinancial Statements

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The statement of cash flows prepared using the indirect method adjusts net income for the changes in balance sheet accounts to calculate the cash from operating activities. In other words, changes in asset and liability accounts that affect cash balances throughout the year are added to or subtracted from net income at the end of the period to arrive at the operating cash flow.

The operating activities section is the only difference between the direct and indirect methods. The direct method lists all receipts and payments of cash from individual sources to compute operating cash flows. This is not only difficult to create; it also requires a completely separate reconciliation that looks very similar to the indirect method to prove the operating activities section is accurate.

Companies tend to prefer the indirect presentation to the direct method because the information needed to create this report is readily available in any accounting system. In fact, you don’t even need to go into the bookkeeping software to create this report. All you need is a comparative income statement. Let’s take a look at the format and how to prepare an indirect method cash flow statement.

Format

The indirect operating activities section always starts out with the net income for the period followed by non-cash expenses, gains, and losses that need to be added back to or subtracted from net income. These non-cash activities typically include:

• Depreciation expense
• Amortization expense
• Depletion expense
• Gains or Losses from sale of assets
• Losses from accounts receivable

The non-cash expenses and losses must be added back in and the gains must be subtracted.

The next section of the operating activities adjusts net income for the changes in asset accounts that affected cash. These accounts typically include:

• Accounts receivable
• Inventory
• Prepaid expenses
• Receivables from employees and owners

This is where preparing the indirect method can get a little confusing. You need to think about how changes in these accounts affect cash in order to identify what way income needs to be adjusted. When an asset increases during the year, cash must have been used to purchase the new asset. Thus, a net increase in an asset account actually decreased cash, so we need to subtract this increase from the net income. The opposite is true about decreases. If an asset account decreases, we will need to add this amount back into the income. Here’s a general rule of thumb when preparing an indirect cash flow statement:

Asset account increases: subtract amount from income
Asset account decreases: add amount to income

The last section of the operating activities adjusts net income for changes in liability accounts affected by cash during the year. Here are some of the accounts that usually are used:

• Accounts payable
• Accrued expenses

Get ready. If you weren’t confused by the assets part, you might be for the liabilities section. Since liabilities have a credit balance instead of a debit balance like asset accounts, the liabilities section works the opposite of the assets section. In other words, an increase in a liability needs to be added back into income. This makes sense. Take accounts payable for example. If accounts payable increased during the year, it means we purchased something without using cash. Thus, this amount should be added back. Here’s a basic tip that you can use for all liability accounts:

Liability account increases: add amount from income
Liability account decreases: subtract amount to income

All of these adjustments are totaled to adjust the net income for the period to match the cash provided by operating activities.

Example

It might be helpful to look at an example of what the indirect method actually looks like.

As you can see, the operating section always lists net income first followed by the adjustments for expenses, gains, losses, asset accounts, and liability accounts respectively.

Although most standard setting bodies prefer the direct method, companies use the indirect method almost exclusively. It’s easier to prepare, less costly to report, and less time consuming to create than the direct method. Standard setting bodies prefer the direct because it provides more information for the external users, but companies don’t like it because it requires an additional reconciliation be included in the report. Since the indirect method acts as a reconciliation itself, it’s far less work for companies to simply prepare this report instead.

Balance SheetStatement of Retained Earnings

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The cash flow statement presented using the direct method is easy to read because it lists all of the major operating cash receipts and payments during the period by source. In other words, it lists where the cash inflows came from, usually customers, and where the cash outflows went, typically employees, vendors, etc.

After all of the sources are listed, the total cash payments are then subtracted from the cash receipts to compute the net cash flow from operating activities. Then the investing and financing activities added to arrive at the net cash increase or decrease. Let’s take a look at how this report is formatted and structured.

Format

Here’s a list of the most common types of receipts and payments used in the direct method format:

• Receipts received from Customers
• Payments paid to Suppliers
• Payments paid to Employees
• Interest Payments
• Income Tax Payments

As you can see, listing these payments gives the financial statement user a great deal of information where receipts are coming from and where payments are going to. This is one of the main advantages of the direct method compared with the indirect method. Investors, creditors, and management can actually see where the company is collecting funds from and whom it is paying funds to. The indirect method doesn’t list these types of details. That’s exactly why FASB recommends that all companies issue their statement of cash flows in the direct method.

The problem with this method is it’s difficult and time consuming to create. Most companies don’t record and store accounting and transactional information by customer, supplier, or vendor. Business events are recorded with income statement and balance sheet accounts like sales, materials, and inventory. It’s laborious for most companies to compile the information with this method.

For example, in order to figure out the receipts and payments from each source, you have to use a unique formula. The receipts from customers equals net sales for the period plus the beginning accounts receivable less the ending accounts receivable. Similarly the payments made to suppliers is calculated by adding the purchases, ending inventory, and beginning accounts payable then subtracting the beginning inventory and ending accounts payable.

Keep in mind that these formulas only work if accounts receivable is only used for credit sales and accounts payable is only used for credit account purchases. This is why most companies don’t issue this method. It’s difficult to gather the information.

Plus, the direct method also requires a reconciliation report be created to check the accuracy of the operating activities. The reconciliation itself is very similar to the indirect method of reporting operating activities. It stars with net income and adjusts non-cash transaction like depreciation and changes in balance sheet accounts. Since creating this reconciliation is about as much work as just preparing an indirect statement, most companies simply choose not to use the direct method.

I know what you are probably thinking. If you have to do an additional reconciliation, why is it called the direct method. It seems like a whole like more work. Well, it is. The reason why it’s called that has nothing to do with how much work is involved in preparing the report. It has to do with how the operating cash flows are derived. This method looks directly at the source of the cash flows and reports it on the statement. The indirect method, on the other hand, computes the operating cash flows by adjusting the current year’s net income for changes in balance sheet accounts.

This is the only difference between the direct and indirect methods. The investing and financing activities are reported exactly the same on both reports.

Let’s look at an example.

Example

Here’s an example of a cash flow statement prepared using the direct method.

As you can see, all of the operating activities are clearly listed by their sources. This categorization does make it useful to read, but the costs of producing it for outweigh the benefits to the external users. This is why FASB has never made it a requirement to issue statements using this method.

Balance SheetStatement of Retained Earnings

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The statement of cash flows, also called the cash flow statement, is the fourth general-purpose financial statement and summarizes how changes in balance sheet accounts affect the cash account during the accounting period. It also reconciles beginning and ending cash and cash equivalents account balances.

This statement shows investors and creditors what transactions affected the cash accounts and how effectively and efficiently a company can use its cash to finance its operations and expansions. This is particularly important because investors want to know the company is financially sound while creditors want to know the company is liquid enough to pay its bills as they come due. In other words, does the company have good cash flow?

The term cash flow generally refers to a company’s ability to collect and maintain adequate amounts of cash to pay its upcoming bills. In other words, a company with good cash flow can collect enough cash to pay for its operations and fund its debt service without making late payments.

Format and Template

The cash flow statement format is divided into three main sections: cash flows from operating activities, investing activities, and financing activities.

Operating Activities

Cash flows from operating activities include transactions from the operations of the business. In other words, the operating section represent the cash collected from the primary revenue generating activities of the business like sales and service income. Operating activities are short-term and only affect the current period. For example, payment of supplies is an operating activity because it relates to the company operations and is expected to be used in the current period.

Operating cash flows are calculated by adjusting net income by the changes in current asset and liability accounts.

Investing Activities

Cash flows from investing activities consist of cash inflows and outflows from sales and purchases of long-term assets. In other words, the investing section of the statement represents the cash that the company either collected from the sale of a long-term asset or the amount of money spent on purchasing a new long-term asset. You can think of this section as the company investing in itself. The investments are long-term in nature and expected to last more than one accounting period.

Investing cash flows are calculated by adding up the changes in long-term asset accounts.

Financing Activities

Cash flows from financing consists of cash transactions that affect the long-term liabilities and equity accounts. In other words, the financing section on the statement represents the amount of cash collected from issuing stock or taking out loans and the amount of cash disbursed to pay dividends and long-term debt. You can think of financing activities as the ways a company finances its operations either through long-term debt or equity financing.

Financing cash flows are calculated by adding up the changes in all the long-term liability and equity accounts.

Here’s a tip!

Here is a tip on how I keep track of what transactions go in each cash flow section.

Operating Activities: includes all activities that are reported on the income statement under operating income or expenses.

Investing Activities: includes all cash transactions used to buy or sell long-term assets. Think of these as the company investing in itself.

Financing Activities: includes all cash transactions that affect long-term liabilities and equity. Whenever long-term debt or equity is involved, it is considered a financing activity.

Like all financial statements, the statement of cash flows has a heading that display’s the company name, title of the statement and the time period of the report. For example, an annual income statement issued by Paul’s Guitar Shop, Inc. would have the following heading:

• Paul’s Guitar Shop, Inc.
• Cash Flow Statement
• December 31, 2015

Example

Here is the statement of cash flows example from our unadjusted trial balance and financial statements used in the accounting cycle examples for Paul’s Guitar Shop.

How to Prepare a Cash Flow Statement

The statement of cash flows is generally prepared using two different methods: the direct method and the indirect method. Both result in the same financial statement showing how financial transacations affected would have affected the bank account of the company. Each method is used for a slightly different reason and typically used for different sized companies. Let’s take a look at how to create a statement using both the direct and the indirect methods in the next aritcles.

Balance SheetStatement of Retained Earnings

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