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Understanding Pro Forma Financial Statements

A typical financial statement is based on past transactions that actually happened and the details are well documented, and a pro forma financial statement is a particular set that is typically based on certain projections and assumptions.

Financial reports that are issued by a business use hypothetical conditions or assumptions about occurrences that may have taken place in the past or have the potential to pop up at some point in the short-term or long-term future – this is the essence of pro forma financial statements. These important statements are utilized to present a useful view of an entity’s results to people on the outside, potentially as a component for a money lending proposal or for a potential investment opportunity.

A budget can also be taken into account as a variation of a pro forma financial statement, as a budget presents a case of projected results within a future period of time for a business – also based on certain assumptions that are well outlined to support the numbers used.

How the Public and Investors View These Financial Statements.

The public view when digesting pro forma financial statements can be read with mixed feelings, and businesses will often be hesitant about issuing them as they are based on management’s perspectives and input about the current business climate and conditions, and they can vary widely from one person to the next in the same business depending on many internal and external factors.

The inaccuracy of them can always come into question as pro forma financial statements often paint a picture for a business being more successful than it really can be in reality based on its limited prospects, and communicating that there are more financial resources available for use is often the case. Management will be almost always more bullish than they should be about the future of the business by ignoring risks and downside and believe the business is better off in its present form than the numbers reflect.

Polished investors who have been in the industry for a good number of years can be skeptical of pro forma financial statements when evaluating them, because they have had the opportunity of comparing them to actual results as a business plays out many years later, and a good number of times they are far off and usually on the low side. These statements must be taken into account with a grain salt and often investors will discount the projections by half or even more, and pay much closer attention to normal financial statements from a business that has more merit and carry more clout.

What’s the Best-Case Scenario?

With that being said, pro forma financial statements can still play their part as an important tool to lower potential risks and threats from competitors, help to plan for the future, and assist with securing loans or funding capital in return for equity. If anything else, they help outsiders understand what management believes their business is capable of achieving on the high-end of the scale – if everything goes perfectly.

The Meaning of Pro Forma.

Before we go into more detail about the different types of pro forma financial statements and what they contain, let’s take a step back to understand the meaning of pro forma. The Latin translation of pro forma means “for the sake of form” or alternatively, “as a matter of form.” From a business perspective, it essentially means forecasted, predicted, or assumed.

Key Types of Pro Forma Financial Statements.

There are numerous types of pro forma financial statements – varying from industry to industry and from business to business, but there are some that tend to be seen more frequently – especially from a small business point of view. Below, we look at the invoice statement, cash flow, analysis, and income statement.

Invoice Statement.

A pro forma invoice statement is a preliminary bill that gets sent to a vendor before the delivery of products or services takes place. Included in these – the description of the good, the per unit cost, and any shipping and delivery fees. An invoice is typically a binding agreement, whereas an estimate is not.

Statement of Cash Flows.

The pro forma statement of cash flows is representative of a business’ balance sheet activity and how much money is sitting in the bank at that exact time. Many people agree that the management of cash flow is one of the most important elements that a business needs to effectively do – especially ones that are smaller in size.

Analysis.

The pro forma analysis includes various elements such as how potential changes in the marketplace or the economy might affect the future performance of the business, sales forecasts, and projections that can look at when the business may have better prospects in certain upcoming quarters as opposed to others and supporting theories as to why. The analysis will often be greatly debated and questioned by say a potential investor, for example, who has been approached for capital, and management needs to be confident in the information they provided and be convincing with their responses to the objections put forth by outsiders.

Income Statement.

This particular pro forma financial statement includes information such as projected net profit, sales revenue, expenses, and costs of products or services.

Pro Forma Ratios.

Certain ratios are key pieces of information that executives and managers need to understand and bankers and investors readily ask for. They are a component that helps to quantify assumptions from the context of historical financial statements in three main categories including:

  • Leverage – Measures the ability of a business to raise additional debt and its prospects for paying down liabilities in a timely matter.
  • Liquidity – Measures the ability of a business to meet its current financial obligations.
  • Profitability – Measures the ability of a business to keep expenses below that of revenues to earn a healthy ROI. 
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