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“What if” is one of those key turns of phrase that business owners need to think about virtually all the time. What if we made an acquisition? What if we lose that account? What if we get hit with higher taxes?
Pro forma financial statements are essentially “what-if” generators, giving you the ability to play through different hypothetical scenarios and explore their potential impact on your business.
In Latin, the term “pro forma” is roughly translated as “for form” or “as a matter of form.” So, what is a pro forma statement?
Pro forma financial statement definition
Essentially, pro forma financial statements are financial reports based on hypothetical scenarios that utilise assumptions or financial projections.
They are useful tools that business owners, investors, creditors, or decision-makers can use to examine different iterations of future events based on certain financial assumptions. This can help predict how well the business is likely to perform in the future.
What is the purpose of a pro forma statement?
There are many reasons why producing pro forma financial statements could be beneficial for your business.
They’re an extremely helpful tool for business planning, as they enable you to conduct side-by-side comparisons based on different financial assumptions that can help you decide between two proposals or potential strategies. It’s essentially a form of A/B testing for strategic planning.
Pro forma statements can be used to project the impact of financial decisions on your business. For example, if you’re considering refinancing debt or your business is about to enter a new tax bracket, you can use pro forma financial statements to determine the effect that this decision will have on your business, enabling you to plan for the future as you move forward.
Pro forma statements can also play a major role in getting your business financed. When you seek investment, you can present a pro forma financial statement which indicates how you’ll use the investment capital to grow your business sustainably. In many cases, pro forma statements (or at least some form of financial projections) are prerequisites for investment.
Creating a pro forma financial statement
Now that you know a little more about pro forma statements, let’s explore how to create them in more detail. There are three main types of pro forma statements: pro forma statements of income, pro forma cash flow statements, and pro forma balance sheets. Here’s a step-by-step guide to producing each of these documents:
To create a pro forma statement of income:
First off, you’ll need to set a sales goal for the period you’re looking into.
Next, you should create a production schedule that will allow you to achieve this goal and map it across the time period.
Now, you need to think about how you’re going to match this production schedule, whether that’s by growing your sales by a fixed amount each month or gradually increasing your sales quota.
At this point, you’ll need to calculate the COGS (cost of goods sold) and deduct it – as well as any other operating expenses – from your sales.
Then, you can create your pro forma statement of income using the data gathered in the previous steps.
To create a pro forma balance sheet:
First, you should transfer the change in retained earnings from your pro forma statement of income across to the balance sheet.
Next, identify any adjustments to your current assets/liabilities that may vary depending on the sales variance that you’ve used in your projection.
Then, add assets, owner’s equity, and total liabilities to complete the pro forma balance sheet.
To create a pro forma cash flow statement:
Add your cash-on-hand and cash receipts (i.e. sales, loans, interest income).
Then, list your outgoing cash flows, such as the cost of sales, salaries, etc.
Next, add up all your operating expenses, as well as any other expenses like income taxes and cash disbursements.
Finally, calculate the total cash payments, net cash change, and end cash position to arrive at your completed pro forma cash flow statement.
Remember, the process that you use to create these pro forma statements doesn’t differ in any meaningful way from the process used to create regular financial documents. The main distinguishing factor is the adjustments, not the calculations themselves.
Limitations of pro forma financial statements
Although pro forma statements can be an insightful way to explore hypothetical scenarios, it’s important to remember that they’re based on assumptions, not facts. As such, there’s always a possibility that the scenarios projected by your pro forma financial statements are going to be wildly inaccurate. Therefore, it’s important to be cautious when evaluating these sorts of financial statements and use them alongside other financial documents to get a clearer picture of the business’s actual finances.
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