What are pro forma statements?
Pro forma statements are financial statements based on hypothetical conditions and assumptions.
These statements are distinct from typical financial statements because, while the former has not happened (and may never come to pass) the latter—the typical financial statement—reports on the real financial circumstances of a business.
How Are Pro Forma Statements Used?
Pro forma statements are both communication tools and tools for comparison. They are used by entrepreneurs, investors, accountants, business managers, and other financial decision makers.
Pro Forma Statements Are Communication Tools
They are used by entrepreneurs to communicate the financial details of their opportunity to investors. All serious business plans are accompanied by a standardized set of pro forma statements.
These statements are theoretical. A new venture or one that has just gotten started doesn’t have a record of financial transactions. Regardless, investors need a good idea of what to expect when it comes to financials.
This is not a license for entrepreneurs to inflate or make up numbers at will. Investors will perform due diligence and any inconsistencies will be uncovered. It is absolutely necessary that pro forma financial statements are presented with assumptions clearly stated and a robust line of reasoning behind each figure. Pro forma statements are only helpful if they are based on objective and reliable information.
Pro Forma Statements Are Comparison Tools
Investors, on the other hand, rely on pro forma financial statements to create “apples-to-apples” comparisons between different entrepreneurs and the opportunities they are pitching. Savvy investors understand that enterprising entrepreneurs will puff up the potential success of their ventures.
To make things easier and to help them better compare one venture to another in similar terms, investors will insist on a standardized business plan and a standard set of pro forma financial statements. In fact, the Latin phrase pro forma means “as a matter of form.” It is a reference to the standardized nature of pro forma statements.
What Do Pro Forma Statements Look Like?
Pro forma statements are meant to act as fact-based hypothetical financial statements to convey information to investors and are standardized for easy comparison. At a minimum, a robust business plan must include the following pro forma financial statements:
- Profit and Loss (Income Statement)
- Balance Sheet
- Statement of Cash Flows
Pro forma financial statements represent the “numbers” portion of a business, and the aforementioned statements present the clearest snapshot of what the business’s finances might look like given the provided assumptions and anchored in reasonable and reliable indicators.
Profit and Loss
This statement summarizes the revenues, costs, and expenses incurred during a specific period. It is also known as the income statement and provides a snapshot into a company’s ability to generate profit through increased revenues and reduced costs.
The balance sheet is a summary of a company’s assets, liabilities, and shareholders’ equity during a specific period. It is a great way to see the financial health of a company at a glance and is an essential pro forma statement to have when approaching investors.
Statement of Cash Flows
As the name implies, this statement summarizes the cash (or cash equivalents) entering or leaving a company’s accounts. This is especially important for the health of new businesses, as maintaining sufficient cash on hand to handle liabilities can be tough while the business attempts to generate sustainable revenue.
Other Pro Forma Statements
In addition to the core profit/loss statement, balance sheet, and statement of cash flows, other pro forma financial statements that entrepreneurs should include in their business plans consist of the following:
- Starting balances and startup costs
- Sales forecast
- Personnel expenses
While there is such a thing as including too much information, it is important to include relevant information that is pertinent to your business and to your investor pitch.
Does your business require a high equipment investment? It is important that your investors (and you as the business owner) understand how—and how quickly—that equipment will depreciate in value.
This attention to detail will round out your investor pitch and will improve your understanding of your own business.
Uses of Pro Forma Statements Beyond Seeking Funding
Pro forma statements are useful in just about any situation involving financial modeling or projection.
Managers and other decision makers use pro forma statements as a tool to help construct annual budgets.
These statements can also be helpful tools when planning capital investments or expenditures or for other long-term financial planning activities.
Pro forma financial statements can be indispensable when modeling different financial cases. For example, based on the information available, what would happen if a company switched to a supplier with a different cost profile for parts?
With the assumption that sales will increase at the approximate rate they have been over the last several years, pro forma statements are an essential tool to help decision makers understand how a change could affect the business.
Additionally, by tweaking the parameters—or assumptions—under which the statements are generated, best- and worst-case scenarios can be modeled and examined.