A pro forma financial statement is a report that makes use of estimates, assumptions and projections to forecast the financial statements. It is not an official report and therefore it does not need to adhere to any particular GAAP format or standards. It is a tool that internal management uses a lot to forecast future results and company performance.
A pro forma statement can be thought of as a “what if” report. Management could take a set of assumptions and then create different likely and unlikely scenarios to better understand how a company’s performance is impacted in each case. This practice is also called “scenario analysis”.
Normally, these reports are used by management for internal consumption. However, sometimes management may include one or two proforma statements in the management discussion and analysis section of the annual report.
For instance, if the management is planning to undertake an expansion project and it wants to report to its shareholders the possible impact this project will have on future sales and income, it will include a forecasted income statement and cash flow statement in the MD&A section of the annual report.
Types of Pro Forma Financial Statements
Several examples of pro forma financial statements include:
- Full-year projections: This type of pro forma financial statement tells the investors, shareholders and creditors how the company financial statements will look like at the end of the financial period. Therefore, it considers all your financials for year to date and then adds estimations and projections for the rest of the year.
- Investing or financing projections: The management might be thinking of adding to the current capacity by expanding its operations. Therefore, in order to source the funds, it creates pro forma statements for the investors to show how their funds will be utilized and what the eventual impact on the company’s “bottom line” will be like.
- Historical with acquisition projections: A company might want to look at how its financial statements are impacted if it buys another company or business. Therefore, it would take its historical statements and merge the target company’s statements with them to see how the financials would have looked like if there was an acquisition.
- Risk analysis: Management might want to do some stress testing of their financial statements to see how the “bottom line” of a company is impacted under different best-case and worst-case scenarios. They might build in certain assumptions in their models and then change these to better understand the fundamental weaknesses in their company.
There can be a lot of problems if the company’s management decides to issue its pro forma statements to the general public. This is because they will contain many assumptions and hypothetical cases based on the management’s beliefs about future business conditions. In reality, events might significantly differ from what is expected and therefore in retrospect, the pro forma statements can be called out by the investors as highly inaccurate. This will reflect badly on the management’s overall ability.
Pro Forma Income Statement
This is one of the most common pro forma financial statements prepared by management. It assists management, investor and creditors in analyzing the impact certain economic conditions, business decisions, deals, merger or acquisitions and other events have on the profitability of a company.
For example, a company forecasts the effects of an expansion project, funded by long-term debt, on its profitability. It analyzes different interest rate and macroeconomic scenarios to get a clearer picture of the financial impact of this expansion project. The following likely-, best- and worst-case scenarios can be considered by the management:
- Likely-case scenario: Interest rates stay at 4 % and economic activity in the economy remains stable.
- Best-case scenario: Interest rates fall to 1% making the cost of funds cheaper and economic activity doubles leading to more demand and capacity utilization for the company. Profitability will improve in this scenario keeping all other factors constant.
- Worst-case scenario: Interest rates increase to 7%, thereby increasing the finance cost borne by the company and the economy goes into a recession, thereby increasing piling of inventory, lowering sales and capacity utilization. Profitability will be significantly hurt in this case scenario.
Pro Forma Balance Sheet
Estimating a balance sheet is a useful tool for the investors, management and creditors to analyze how the financial position of a company is impacted. Continuing with the above example, where a company takes on huge levels of debt to fund an expansion project, the pro forma balance sheet position will show that the company has become significantly over-leveraged. This can prompt a warning signal for the stakeholders about the vulnerability of the company’s position if a worst-case scenario occurs for a company.
Creditors might also get insecure due to higher financial leverage situation of a company as this might violate existing debt covenants that are in place.
Pro Forma Cash Flow Statement
A pro forma cash flow statement for a company would tell the management as to what will happen to the cash inflows and outflows if a certain deal or decision is taken. It might also tell them if additional financing needs to raised or other lines of credit need to be arranged.
Continuing with the earlier example, the management can prepare pro forma cash flow statements to determine whether it will have enough liquidity or not to fulfill the debt servicing including repayments and interest payments.
Pro Forma Financial Statement Example
Continuing with Bob and his donut shop example, we can look into how he can make use of pro forma statements.
Assuming Bob wants to open a new shop in the future, but he anticipates that he will not have the capital to do so. Therefore, he plans to take a bank loan for this purpose. Bob will prepare his pro forma financial statements to determine the impact of this decision on the profitability, financial position and cash flow position of his business. He will make certain assumptions, estimations and projections under likely, best and worst-case scenarios and see if he should go for the option of taking more debt onto the company.