Pro forma, a Latin term meaning "as a matter of form," is applied to the process of presenting financial projections for a specific time period in a standardized format. Businesses use pro forma statements for decision-making in planning and control, and for external reporting to owners, investors, and creditors. Pro forma statements can be used as the basis of comparison and analysis to provide management, investment analysts, and credit officers with a feel for the particular nature of a business's financial structure under various conditions. Both the American Institute of Certified Public Accountants (AICPA) and the Securities and Exchange Commission (SEC) require standard formats for businesses in constructing and presenting pro forma statements; new SEC rules require that, to avoid misrepresentation, companies issuing pro forma statements must also show the most comparable statement on the company's finances, prepared using Generally Accepted Accounting Principles (GAAP), alongside the pro forma statement.
As a vital part of the planning process, pro forma statements can help minimize the risks associated with starting and running a new business. They can also help convince lenders and investors to provide financing for a start-up firm. But pro forma statements must be based upon objective and reliable information in order to create an accurate projection of a small business's profits and financial needs for its first year and beyond. After preparing initial pro forma statements and getting the business off the ground, the small business owner should update the projections monthly and annually.
USES OF PRO FORMA STATEMENTS
Business Planning
A company uses pro forma statements in the process of business planning and control. Because pro forma statements are presented in a standardized, columnar format, management employs them to compare and contrast alternative business plans. By arranging the data for the operating and financial statements side-by-side, management analyzes the projected results of competing plans in order to decide which best serves the interests of the business.
In constructing pro forma statements, a company recognizes the uniqueness and distinct financial characteristics of each proposed plan or project. Pro forma statements allow management to:
- Identify the assumptions about the financial and operating characteristics that generate the scenarios.
- Develop the various sales and budget (revenue and expense) projections.
- Assemble the results in profit and loss projections.
- Translate these data into cash-flow projections.
- Compare the resulting balance sheets.
- Perform ratio analysis to compare projections against each other and against those of similar companies.
- Review proposed decisions in marketing, production, research and development, etc., and assess their impact on profitability and liquidity.
Simulating competing plans can be quite useful in evaluating the financial effects of the different alternatives under consideration. Based on different sets of assumptions, these plans propose various scenarios of sales, production costs, profitability, and viability. Pro forma statements for each plan provide important information about future expectations, including sales and earnings forecasts, cash flows, balance sheets, proposed capitalization, and income statements.
Management also uses this procedure in choosing among budget alternatives. Planners present sales revenues, production expenses, balance sheet and cash flow statements for competing plans with the underlying assumptions explained. Based on an analysis of these figures, management selects an annual budget. After choosing a course of action, it is common for management to examine variations within the plan.
If management considers a flexible budget most appropriate for its company, it would establish a range of possible outcomes generally categorized as normal (expected results), above normal (best case), and below normal (worst case). Management examines contingency plans for the possible outcomes at input/output levels specified within the operating range. Since these three budgets are projections appearing in a standardized, columnar format and for a specified time period, they are pro forma.
During the course of the fiscal period, management evaluates its performance by comparing actual results to the expectations of the accepted plan using a similar pro forma format. Management's appraisal consists of testing and re-testing the assumptions upon which management based its plans. In this way pro forma statements are indispensable to the control process.
Financial Modeling
Pro forma statements provide data for calculating financial ratios and for performing other mathematical calculations. Financial models built on pro forma projections contribute to the achievement of corporate goals if they: 1) test the goals of the plans; 2) furnish findings that are readily understandable; and 3) provide time, quality, and cost advantages over other methods.
Financial modeling tests the assumptions and relationships of proposed plans by studying the impact of variables in the prices of labor, materials, and overhead; cost of goods sold; cost of borrowing money; sales volume; and inventory valuation on the company in question. Computer-assisted modeling has made assumption testing more efficient. The use of powerful processors permits online, real-time decision making through immediate calculations of alternative cash flow statements, balance sheets, and income statements.
Assessing the Impact of Changes
A company prepares pro forma financial statements when it expects to experience or has just experienced significant financial changes. The pro forma financial statements present the impact of these changes on the company's financial position as depicted in the income statement, balance sheet, and the cash-flow statement. For example, management might prepare pro forma statements to gauge the effects of a potential merger or joint venture. It also might prepare pro forma statements to evaluate the consequences of refinancing debt through issuance of preferred stock, common stock, or other debt.
