When it comes to making business decisions, so much relies on numbers. To get sign-off from key stakeholders, win investors, and strategically plan, you need to demonstrate that your ideas make financial sense.
While certain financial statements—such as balance sheets, income statements, cash flow statements, and annual reports—help provide a historical snapshot of a business’s performance, they often lack the ability to provide foresight when planning for the future. For this reason, professionals typically turn to forecasts and financial projections to guide their plans and answer critical “what if” questions. Pro forma financial statements are a common type of forecast that can be useful in these situations.
Here’s a closer look at what pro forma financial statements are, how they’re created, and why they’re a key aspect of financial decision-making.
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A pro forma financial statement leverages hypothetical data or assumptions about future values to project performance over a period that hasn’t yet occurred.
In the online course Financial Accounting, pro forma financial statements are defined as “financial statements forecasted for future periods. They may also be referred to as a financial forecast or financial projection.”
The course notes that these projections can be used “as a depiction of what the financial statements for the business will look like over a certain period of time, if the assumptions made when preparing them hold true.”
Since the term “pro forma” refers to projections or forecasts, it can apply to a variety of financial statements, including:
- Income statements
- Balance sheets
- Cash flow statements
Whether you’re trying to interpret pro forma financial statements or prepare them, these projections can be useful in guiding important business decisions. In fact, business owners, investors, creditors, and other key decision-makers all use pro forma financial statements to measure the potential impact of business decisions.
How Are Pro Forma Financial Statements Used?
Traditionally, financial statement analysis is used to better understand a company’s performance over a specified period. While this provides insight into a company’s historical health, creating pro forma financial statements focuses on its future. For this reason, these reports can be leveraged in several ways, including analyzing risk, projecting investments, and showing expected results before the end of a reporting period.
One of the most important uses of pro forma reports is related to decision-making and strategic planning efforts. For example, you might create pro forma financial statements to reflect the outcomes of three investment scenarios for your business. Doing so can allow you to conduct a side-by-side comparison of possible outcomes to determine which is favorable and guide your planning process.
Creating Pro Forma Financial Statements
Keep in mind that the general process of creating pro forma financial statements isn’t significantly different from that of creating traditional statements. The difference lies in the assumptions and adjustments made about various inputs, while the format and calculations remain the same.
There are, however, specific methods used for these forecasts. The percent of a sales forecasting method, for example, involves determining future expected sales and finding trends across accounts in statements. This is typically used when creating pro formas internally.
Other individual line items can also be easily forecasted, such as the cost of goods sold, since it can be assumed it will proportionally grow with sales. Line items like income tax expense, on the other hand, typically don’t change directly with sales. Stable businesses can generally estimate income tax expense as a percentage of income before taxes.
All in all, the process of preparing a pro forma balance sheet is much the same as preparing a normal balance sheet. The same holds true for the process of preparing income statements and cash flow statements. It differs when you begin forecasting various line items and calculating how those projections impact your bottom line.
Beyond the Numbers
The true value of pro forma statements goes beyond the numbers they show. These reports provide key stakeholders, investors, and creditors the foresight needed to make decisions and strategically plan. Managers and individual contributors can also benefit from creating pro forma statements, enabling them to understand different factors impacting business units.
Remember: There are limitations to pro forma financial statements. Since these documents are based on assumptions, they shouldn’t be taken as fact. Rather, they can inform decisions using hypothetical data based on historical trends.
Taking an online course like Financial Accounting can help you understand how to create and interpret different kinds of financial statements so you can find meaning in them. Learners enrolled in the course learn the language of accounting and how to create financial statements and forecasts to make strategic decisions.
Do you want to learn more about what's behind the numbers on financial statements? Explore Financial Accounting, one of three courses comprising our Credential of Readiness (CORe) program, to discover how you can develop an intuitive knowledge of financial principles and statements to unlock critical insights into performance and potential.
