What are Pro Forma Financial Statements?
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.
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.