Pro forma financial statements: How to use them to make smarter business decisions

You need to know where your business is headed. To make that happen, you have to frequently make informed projections about sales, production, and costs. Pro forma financial statements are a great way to assess the financial impact of those assumptions.

Here we’ll be covering definitions, uses, and benefits of pro forma statements. To go to a particular section, use the jump-to menu below.

• Pro forma definition
• What are pro forma financial statements?
• What are pro forma financial statements used for?
• What are the benefits and limitations of pro forma financial statements?
• Types of pro forma financial statements
• Pro forma example
• Make pro forma statements work for you

Pro forma definition

Pro forma is a Latin term that roughly translates to “as a matter of form,” and is most often used to describe a document that is based on financial assumptions or projections, such as a pro forma balance sheet.

What are pro forma financial statements?

Pro forma financial statements are used in a business plan to present the best-case, expected, and worst-case scenarios for a proposed transaction. With pro forma statements, businesses can better make assumptions on what decisions are best for the company, such as labor increases, production increases, or even expansion.

You can also use pro forma statements to generate financial ratios. If, for example, you want to calculate the impact on the debt-to-equity ratio in future years, you can use the data from pro forma reports.

For business owners, the term pro forma means “what if?” Owners create a set of projected financial statements, including the balance sheet, income statement, and cash flow statement, based on a set of assumptions.

Every small business should create a budget, and the budgeted financial results are pro forma statements. The budget makes assumptions about sales, production, and pricing. An owner may create pro forma reports to assess the potential profitability of a product, or to determine if a business expansion makes financial sense.

What are pro forma financial statements used for?

Pro forma financial statements or projections can be used in a variety of scenarios:

• Business loan: A commercial lender will need financial statements from prior years and pro forma financial reports for future years. Pro forma earnings, for example, project net income and, consequently, the ability of the borrower to repay the loan.
• Capital investment: A company’s capital structure may include some combination of debt and equity. Potential investors need a pro forma income statement to assess a firm’s ability to generate increased sales and profits.
• Financial modeling: Pro forma statements are used to analyze the financial impact of a major business decision. If you’re considering adding a product line, opening a new location, or closing a company department, pro forma reports will project the outcome of your decision.

Keep in mind that the American Institute of Certified Public Accountants (AICPA), and the Securities and Exchange Commission (SEC) both have guidelines for creating pro forma statements.

Please note: Pro forma financial reports do not comply with generally accepted accounting principles (GAAP). You must distinguish between pro forma and actual financial statements: The Financial Accounting Standards Board (FASB), the governing body that establishes GAAP, requires that pro forma reports must be clearly labeled as such.

What are the benefits and limitations of pro forma financial statements?

Like all things, not every aspect of pro forma is perfect. There are both benefits and downsides to the assumption structure that pro forma is built upon. 

Benefits

Pro forma financial statements help owners identify growth opportunities and limit risk. Assume, for example, that a retailer creates a pro forma income statement for the upcoming year. The income statement includes these categories:

• Sales: How much product you sold
• Cost of goods sold: Direct material and labor costs incurred
• Gross profit: Sales minus cost of goods sold
• Operating expenses: Overhead costs
• Net income: Gross profit minus operating expenses

Each of the line items can be changed to create different scenarios. For example, sales might be presented as 15% higher (best case), 5% higher (expected), 20% lower (worst case). If material costs increase sharply, or there is a shortage of labor, the cost of sales will increase.

An owner can create pro forma financial statements and consider these questions:

• If I take on a new customer to increase sales by 15%, what is the cash flow impact if the customer pays in 30 days? What if the accounts receivable balance isn’t paid for 45 days?
• If I start buying materials from a new supplier, what is the impact on production if the supplier ships materials 20 days later than promised?
• To add a new product line that my customers want, I need to borrow from my line of credit. How much in total liabilities can I take on and still make the required principal and interest payments?

Pro forma financial statements are a great tool to evaluate alternatives. Most businesses have limited resources, and pro forma reports can help you make better decisions with what you have.

Limitations

Unfortunately, there are also disadvantages that accompany pro forma financial statements. 

The limitation of these statements is that they show the business owner nothing more than a prediction. No matter how good or bad that portrayal may seem, it’s only a good guess as to what may happen. 

These assumptions can be off by a little or a lot, but the bottom line is their outcomes should not be weighed too heavily in decision-making without other indicators to back up the assumption. And as we mentioned earlier, they are not in compliance with GAAP, which means they have to be labeled as pro forma and cannot replace formal financial statements. 

Types of pro forma financial statements

It’s common to use different types of pro forma financial statements for different scenarios. The baseline is still the income statement, balance sheet, and statement of cash flows, however, each type has a different purpose associated with it. 

Investment projection

An investment projection would showcase what an influx of cash could potentially do to your business. For example, if you were contemplating taking on an investor, it would give you a risk vs. reward scenario. 

These types of projections are best for:

• Pitching to potential investors
• Giving a better financial picture to current investors
• Swaying partners to allow additional investors
• Making your case for additional financing 

Full-year projection

A full-year projection is just what the name suggests—accounting for the current year. For example, if it’s currently April and you want to perform a full-year pro forma projection, you would account for all the financials up to April and project the remainder of the year. 

These types of projections are best for:

• Showcasing financials for the remainder of the year
• Giving a projection of what outside factors may have on the remainder of the year
• Receiving a general forecast to base business decisions on for the remainder of the year

Risk analysis projection

A risk analysis projection entails analyzing future possible risks and scenarios that the company may face. For example, what if your landlord raises your location’s rent? How will you be able to handle it? 

These types of projections are best for:

• Forecasting next year 
• Viewing a best-case and worst-case scenario of possible events
• Mapping out upcoming changes to see possible business implications 

Acquisition projection

Within business, it’s common for one company to acquire the other. Another possibility is a merger, where one business joins another. In either case, an acquisition projection needs to be run. This is when you take the financial statements of your business and merge them with financial statements of the other to see what your previous year might’ve looked like and what it may look like in the future. 

These types of projections are best for:

• Looking into mergers
• Weighing the options for acquisitions

Creating a pro-forma statement

To illustrate the process of creating pro forma financial statements, meet Sally, the owner of Centerfield Sporting Goods. Centerfield is a small firm that manufactures baseball gloves, and Sally is creating pro forma reports for the 2021 fiscal year.

The process starts with the income statement.

Pro forma Income statement

Step 1: Sally estimates the number of gloves sold in 2023 and uses that total to calculate sales, which is the first line item in the income statement below: $520,000

Step 2: She then projects costs for leather and other raw materials and the hourly rate she must pay for labor. These material and labor costs make up the cost of goods sold (COGS): $420,000

Step 3: Sally estimates overhead expenses, including office salaries and depreciation: $90,000

Step 4: After estimating all gross profit and operating expenses, she calculates the projected profit. Sally’s business is only a few years old, and she projects a small profit of $10,000 for the year. 

Pro forma balance sheet

After completing the pro forma income statement, Sally will create the balance sheet using the information gathered and the projected profit. 

A pro forma balance sheet is a projection of a company's financial health at a later date. Keep in mind that since this information is based on projections and assumptions, it shouldn’t be considered a guarantee of actual results. However, the pro forma balance sheet can be a valuable financial planning tool. It can help you anticipate your future financial position, enabling you to make informed choices about investments, financing, and operations.

A pro forma balance sheet shows the following:

• Projected assets:
• Anticipated cash on hand
• Estimated accounts receivable (money owed to the company)
• Projected inventory value
• Value of fixed assets (property, equipment) after depreciation
• Projected liabilities:
• Estimated accounts payable (money owed by the company)
• Anticipated loan balances and other debts
• Accrued expenses (unpaid costs)
• Projected equity:
• Owner's investment in the business
• Retained earnings (accumulated profits)
• Overall financial health:
• A pro forma balance sheet allows businesses to assess their future liquidity, solvency, and financial stability.
• It helps them identify potential financial risks and opportunities.

Using the Centerfield example, here’s how Sally creates the pro forma balance sheet: 

• Sally uses her sales estimate to estimate the dollar amount of inventory at the end of 2023. The sales total and customer payment history help the firm determine the accounts receivable balance. Both balances are listed in the chart below.

• Centerfield will carry a $100,000 bank loan, and Sally’s $10,000 in net income is posted to retained earnings in the balance sheet. 
• 2021 will be the first year of profit for the company.
• Sally learns from this statement that she projects $185,000 in current assets and $150,000 in liabilities, which gives her $35,000 in owner’s equity.

Now the income statement, balance sheet, and other data can be used to create the statement of cash flows.

Pro forma statement of cash flows

Inflows and outflows of your business can impact your cash flow. A pro forma statement of cash flows can help you understand the potential influences they will have in the future. It forecasts your cash flow by assessing significant outflows like material purchases and payroll costs and identifying potential challenges. You can then use this knowledge to take proactive measures and help maintain financial stability and growth.

A pro forma cash flow statement shows the following:

• Cash from operating activities:
• Estimated cash received from sales of goods or services
• Projected cash paid for operating expenses (including material purchases, payroll costs, rent, utilities, etc.)
• Cash from investing activities:
• Anticipated cash spent on acquiring or selling assets (equipment, property)
• Projected cash received from investments
• Cash from financing activities:
• Estimated cash received from issuing debt (loans) or equity (stock)
• Anticipated cash paid for debt repayment or dividends
• Net change in cash: The overall change in the company's cash balance over the projected period
• Ending Cash Balance: The estimated amount of cash the company will have at the end of the period

Let’s look at the Centerfield example and how it illustrates the creation of the pro forma cash flow statement:

• Sally budgets for a $10,000 equipment purchase in 2021, and for the repayment of $15,000 in loans. 
• The ending balance in the cash flow statement ($40,000), agrees with the cash balance in the balance sheet.
• From these results, Sally can infer that she will have a profit of $40,000 at the end of the year.

Make pro forma statements work for you

Pro forma financial statements are a great tool for financial management, to assess your financial position in the current year, and for any future time period. If you’re considering a major decision, such as a business merger or a new product launch, creating pro forma statements is important.

QuickBooks accounting software allows you to create pro forma statements and make changes as needed. You can make pro forma adjustments based on new information and use these statements to find opportunities, reduce risk, and increase profits.