A pro forma financial statement can be a key tool to include in your arsenal to lower your risks, plan for the future, and help secure funding.
Even if you’re a new small business trying to get your company off the ground, this technique can help – and it’s not as difficult as it sounds.
By the end of this article, you’ll know what a pro forma financial statement is used for, how to create one, and ultimately, how to start planning ahead and controlling cash flow like a major corporation.
What Does Pro Forma Mean?
Translated from Latin, pro forma literally means “for the sake of form” or “as a matter of form.”
In a business sense, it means assumed, predicted, or forecasted.
Whereas a standard financial statement is based on a company’s past performance, a pro forma financial statement shows what a company hopes to earn.
In other words, it’s based on what is predicted to happen.
A small business’s pro forma financial statement can include projected revenue, estimated expenses and costs, and cash flow usually over a three- to five-year period.
It can also be used to indicate a potential upcoming change in the company, such as an anticipated merger or acquisition.
A company can even take out one-time expenses or anything else that could warp the accuracy of its financial outlook.
A small business may provide this in addition to generally accepted accounting principles (GAAP), which are a common set of accounting principles, procedures, and standards that a company must abide by when putting together their financial statements.
“GAAP financials are based upon actual historical financial data, subject to certain reporting requirements,” explains David J. Leffler, Partner at Culhane Meadows.
“Pro forma financial statements are financials based on certain assumptions, which can be different than actual financial results and are also not subject to GAAP reporting requirements.”
The Key Types of Pro Forma Statements
While there are several different forms of pro forma financial statements, some of the key types for a small business owner are the analysis, income statement, cash flow, and invoice statements.
The pro forma analysis includes sales forecasts, projections on whether a small business may perform better in say, the fourth quarter than the third, and how changes in the marketplace or economy may affect the company’s performance.
It’s commonly used for acquiring companies, mergers, planning strategy, and for budgeting.
The pro forma income statement includes info such as:
- Costs of goods or services sold;
- Sales revenue;
- Projected net profit
According to Investopedia, a pro forma invoice is a preliminary bill sent to a vendor before the delivery of goods.
It includes a description of the goods, the cost, and packaging, shipping, and delivery fees.
Unlike an estimate, an invoice is usually a binding agreement.
Statements of Cash Flows
The pro forma statement of cash flows represents all activity on a company’s balance sheet and how much money is in the bank.
“A small business can have net income of $50,000, but have negative cash flow.
Managing cash flow is one of the most important aspects to maintain for small businesses.” explains Steve Broyles of Broyles & Company CPAs.
How Can a Small Business Use a Pro Forma Statement?
If you’re a small business who is just starting out, you may not have enough historical info to put together a traditional business plan.
That’s when a pro forma financial statement can be important, and used in the following ways:
As a key part of business planning is constructing a budget and predict outcomes based on assumptions.
These flexible financial statements enable a company to create alternative plans and then compare them next to each other.
A company can play around with different scenarios when it comes to sales, profit, and costs.
In making such predictions, it ultimately gives a company more control over their business.
“Once a decision has been made regarding an assumption, then those pertinent pro forma statements can be a valuable tool to create a budget,” says Broyles.
“The budget will be used to measure variances, favorable and unfavorable, to actual results.
This allows the small business owner to monitor, measure and adapt as needed in a timely manner to make data-driven decisions to achieve desired outcomes.”
Financial Modeling with Pro Forma Ratios
Ratios can be an important component to the notes by quantifying the assumption within historical financial statements in the following three categories:
- Liquidity: Measures the small business’ ability to meet its current financial obligations;
- Profitability: Measures the owner’s ability to control expenses and to earn a return on investment (ROI);
- Leverage: Measures the small business’ ability to raise additional debt and its ability to pay its liabilities on time.
“If a small business owner needs to obtain a loan, oftentimes the lending institution or investor will ask for both historical financial statements and pro forma financial statements as part of their due diligence process in making a lending decision,” explains Broyles.
Because lenders and investors want to make a return on the borrowed money, either through interest or equity, they are most curious to see a new small businesses’ anticipated income and cash flows.
“This often helps the lender understand the assumptions in greater detail and provides insight that the pro forma financial statements alone cannot provide,” adds Broyles.
Therefore, small business owners who include a detailed, thorough, and well-researched pro forma may have an easier time obtaining financing for their enterprising ventures.
Pro Forma for New Businesses
While a small business with a track record may create such a statement based on their company’s prior financial info, a startup or entrepreneur in the initial stages of forming a company may find it challenging.
In order to do so, the small business owner can perform a detailed marketplace analysis that reviews similar companies in the same industry.
From there, estimates of profitability can be made.
A budding entrepreneur may also show how their company made provide something different and stand out from companies offering similar products or services.
“The benefits include the opportunity to present a more accurate picture of a company’s finances by excluding one-time charges,” explains Leffler.
“However, the downsides are the time and expense needed to prepare such statements, and the possibility, whether intentional or not, to mislead people.”
While there is quite a bit of research and work in creating them, pro forma financial statements are a key tool for small businesses to lower their risks and have more control over their business.
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