It would be nice if companies could borrow a page from a blockbuster superhero movie and travel to alternate dimensions. You know, maybe to see what would happen if they merged with the quickly-rising Widgets R' Us, or were acquired by Global Conglomerate, Inc. But, alas, even Embark can't provide that type of insight. We can, however, give you the next best thing ‒ a detailed explanation of pro forma statements and how to create them.
Granted, pro formas aren't quite to Sorcerer Supreme levels of omniscience, but they sure do come in handy when it's time to look at a what-if scenario or two. Want to know what the financial results from a potential business combination might look like a year from now? There's a pro forma for that. Or maybe you want to look backward and see where you might be today if that combination occurred last year. That's what makes pro formas so powerful and, to that point, why we're going to spend the next few minutes discussing their applications and how to create them.
What is a Pro Forma Financial Statement?
As we said, a pro forma statement is a look at a what-if scenario. It's a tool that business owners, decision-makers, stakeholders, investors, creditors, and others use to examine hypothetical conditions. They can look forward or backward, revealing financial information that standard financial statements simply cannot provide.
Further, while there's definitely a right way and a wrong way to format a pro forma ‒ just ask the AICPA, FASB, and SEC ‒ the term pro forma could mean an income statement, cash flow statement, or balance sheet. In other words, they're basically the same financials you're already accustomed to, just using hypothetical data. So as you'll see once we discuss how to create pro formas in just a little bit, they don't require you to recreate the financial reporting wheel, at least in terms of format.
One caveat we must deliver before we go any further, however, stems from a word we've already used several times now – hypothetical. Yes, pro formas are enormously helpful in looking at different iterations of events based on various assumptions. They really have no equal in that particular department. But according to the good folks at Merriam-Webster, hypothetical means "involving or being based on a suggested idea or theory." Put another way, pro formas use information that can vary substantially from actual data. So while they're extremely helpful at looking at events from different angles, never take them as gospel, only well-informed conjecture.
When to Use Pro Forma Financial Statements
Now that we understand what a pro forma is and why they're so uniquely insightful, let's zoom in on the different ways that companies use them.
Business Planning & Financial Modeling
It's helpful for business leaders to look at side-by-side comparisons based on different assumptions to guide their strategies. If, for instance, management is trying to decide between two separate proposals or business plans, they can use pro forma statements for each scenario to see which might serve their goals and vision best. In fact, creating the pro forma statements for each of those scenarios is a useful exercise in of itself, letting the decision-makers:
- Identify the different assumptions driving each of the scenarios
- Create sales and budget projections for each
- Collect the results in P&L projections
- Use the data to generate cash flow projections
- Compare the resulting pro forma balance sheets
- Gauge the effectiveness of each scenario against industry benchmarks using financial ratio analysis
In a sense, pro forma financial statements allow management to A/B test different strategies without any real-world impact.
Gauge the Impact of Financial Decisions
Yes, that subheader is a mouthful, but there's a reason for that – it encompasses an awful lot. One of the most common uses of pro forma statements is projecting the impact of a significant event, perhaps a business combination or refinancing debt. Just like the previous section, a company can use a pro forma income statement, balance sheet, and cash flow statement to project how a significant event might affect its financial position.
In this case, think of pro forma statements like dipping your toe in the water before diving into a pool. If the water feels too cold – i.e., the pro forma projections aren't favorable – it's probably not a great idea to take a dip. But if the water is to your liking, then you might benefit from a nice swim.
Naturally, pro formas aren't just useful for internal purposes. Companies use them in external reports for stockholders, creditors, and potential investors. Publicly traded companies have to include pro forma statements with any SEC filing, registration statements, or proxy statements. This only makes sense since stockholders need to know the impact of significant changes – relative to the company's financial statements – that have either already occurred or are going to occur. Some of those changes might include:
- The impact of a change in newly adopted accounting standards
- An updated estimate on the economic life and net residual value of an asset
- A business combination from an acquisition, disposition, investment, or combined interests of two or more existing business lines
- Correcting errors made in previously filed reports
Also, it's important to remember that the Securities and Exchange Commission, AICPA, and FASB have specific guidelines regarding the form, content, and necessity of pro forma financials under particular circumstances. Therefore, whatever prompts the need for pro forma statements, you must be sure to adhere to any mandatory guidelines. For instance, SOX regulations state that a company must file a set of statements that conform to generally accepted accounting principles (GAAP) in conjunction with any pro formas to avoid giving the public a false impression of a company's actual financial status.
Creating Your Pro Forma Statements
We're going to take you through the steps necessary to create a basic pro forma projection using an income statement, cash flow statement, and balance sheet. However, context is everything when using pro formas. Obviously, formatting isn't as strict and particular for internal purposes as it would be for an SEC filing.
So what exactly are we trying to say, you ask? Take the following walk-throughs with a grain of salt as we provide them as a glimpse into the process. If you're trying to attract investment capital or a buyer for your business, you'll want to use something more detailed and tailored for the purpose. Fortunately, you already happen to know a team of experts that can do just that for you. Wink, wink.
Pro Forma Income Statement
Let's begin with the income statement. We're going to use a percent of sales forecast to keep everything straightforward. Start with an income statement from your most recent fiscal year and identify which items you will adjust for the projection.
As a slight aside, for more in-depth insights on pro forma adjustments, as well as some handy best practices and examples, we urge you to look at our Ultimate Guide to Pro Forma Statements. For these walk-throughs, however, we're assuming you've already looked over the different events and scenarios that can prompt pro forma adjustments.
Anyhoo, back to our regular programming. Now that you have your income statement in-hand and adjustments ready to roll, it's time to begin the pro forma calculations. These should look incredibly familiar since it's the same process you use when creating your typical income statements. In fact, the same holds for the cash flow statement and balance sheet as well.
- Gross profit: Take all of your expected revenue adjustments – i.e., price changes, new product lines & customers, promotional offers – and inflate them by the expected amount. Do the same with the cost of goods sold (COGS) to arrive at your pro forma gross profit.
- Total operating expenses: Look through every line item and identify what costs you will cut in the following year. Make those cuts and then inflate your expenses by your projected rate for your pro forma total operating expenses.
- Net income before taxes: Net your gross profit and total operating expenses
- Taxes: Multiply your estimated tax rate by your net income
- Net income after taxes: Subtract your tax bill from your net income before taxes to arrive at your pro forma profit after taxes.
Keep in mind that because we used a sales-driven projection, other variables like operating expenses, depreciation & amortization, and interest expense were unaffected by our pro forma adjustments. This won't necessarily be the case in a real-world application.
Pro Forma Balance Sheet
Given the linkage between your income statement and balance sheet, you'll want to create the pro formas for each in conjunction with one another. Create the pro forma balance sheet with these steps:
- Transfer the change in retained pro forma earnings from your hot-off-the-presses pro forma income statement to the balance sheet
- Identify adjustments to your current assets and liabilities that will vary according to the sales variance used in the projection
- Use the usual suspects – assets, total liabilities, owner's equity – to complete the balance sheet.
Remember, what distinguishes these pro forma statements from your standard financials are the adjustments, not the calculations or even the format. As we said, certain regulatory bodies and scenarios will require specific information but, from a foundational perspective, the framework for each is essentially the same as what you already use when preparing your financials.
Pro Forma Cash Flow Statement
Finally, with the pro forma income statement and balance sheet compete, we can knock out the cash flow statement as well.
- Start with your cash-on-hand, then add all of the cash receipts like sales, loans and injections of cash, interest income, and others.
- List all of your outgoing cash payments like cost of sales, salaries, supplies, etc.
- Add up your operating expenses as well as any other expenses, including cash disbursements to owners, interest expense, income taxes, etc.
- Calculate your total cash payments, net cash change, and ending cash position. Once again, this is the same process you follow for your normal cash flow statement.
Putting Them Altogether
Now that you've done the brunt of the heavy lifting, you want to double-check that you've correctly linked the data between the pro formas. Make sure you:
- Add net income from the pro forma income statement to the accompanying balance sheet and statement of cash flows.
- Add depreciation back to capital expenditure on the cash flow statement, which then feeds PP&E on the balance sheet.
- Financing activity affects the balance sheet and cash. The income statement should contain interest from financing.
- Your balance sheet's closing cash balance is the sum of the previous period's closing cash and the current period's cash from operations, financing activities, and investing.
Other Pro Forma Scenarios
As we said earlier, pro forma statements are instrumental for a company to look at the potential impact of a proposed transaction or investment capital. In the case of a business combination, for instance, you can use a pro forma statement to combine the financial reports of the two companies to calculate the net acquisition costs, as seen in the following:
Alternatively, when you want to demonstrate the impact of different capital investment amounts, you can create multiple pro formas so a potential investor can see the varying effects on, as an example, the pro forma balance sheet.
Our point is, pro formas aren't a one-trick pony. They have multiple uses for multiple scenarios, ranging from simple sales growth projections to more intricate M&A or investment purposes. Whatever you're using them for, just make sure that you're organized, detailed, and accurate throughout. Otherwise, you're limiting the insights that you're creating the pro formas for in the first place. And if it all seems a bit much, Embark is always around to swoop in and save the day.