Pro Forma Financial Statements

Proforma financial statements are financial statements which provide information about a company’s expected financial performance and financial position in future.

Proforma financial statements are also called forecasted/projected financial statements. They differ from historical financial statements in that they present a scenario in future which is prepared by making certain assumptions regarding business growth, capital structure, taxes, etc.

Pro forma financial statements typically include pro forma income statement, which provides information about future profitability of a business, and pro forma balance sheet, which provides a snapshot of a business’s financial position in future.

Preparation Procedure

Following are the most important steps in the preparation of pro forma financial statements:

1. Obtain historical financial statements, if available, and determine internal relationships.
2. Determine the growth rate of business and prepare pro forma income statement.
3. Identify other assumptions, limiting factors such as loan covenants, capital structure, taxes, etc.
4. Prepare pro forma balance sheet by projecting assets, liabilities, determine equity and identify any external financing needed.
5. Prepare pro forma statement of cash flows by projecting cash inflows and outflows or by adjusting proforma income statement.
6. Audit the financial planning process and incorporate any feedback.

In many cases, historical financial statements function as a good starting point for preparation of projected financial statements because they provide information about most recent performance and position of a business and the relationships between different financial and non-financial items such as sales and assets, profit and sales, sales and headcount, etc.

For example, a business’s capital intensity ratio, the ratio of its assets to sales is important in determining the increase in assets needed per $1 increase in sales. Similarly, the number of marketing and business development staff can be related to sales growth target.

Pro Forma Income Statement

The single most important step in preparation of pro forma financial statements is determination of expected growth rate.

Growth Rate

In many cases, the growth rate is arrived at by considering the following factors:

• Major economic indicators such as GDP growth rate, inflation rate, demographic changes, etc.
• Competitive position and strategy of the business in the context of its industry
• Availability of capital, both internal (in the form of retained earnings) and external (in the form of equity and debt capital).

It is useful to work out sustainable growth rate and internal growth rate because they can act as an upper limit on the potential growth in sales.

Sales Forecast

Once the expected growth rate g is worked out, expected sales next year S1 can be forecasted using the following equation:

$$ \text{S} _ \text{1}=\text{S} _ \text{0}\times(\text{1}\ +\ \text{g}) $$

Where S₀ is the current sales.

Instead of applying a blanket sales growth to last year sales, it might make sense to conduct marketing surveys or ask your sales staff to arrive at a sales forecast. If a company has more than one product, separate sales forecasts should be made for each product.

Projecting Expenses

Forecast of expenses depends on whether they are variable or fixed. Variable expenses such as cost of goods sold (or just the direct materials and direct labor) often grow linearly with sales and fixed expenses such as rent, property taxes, etc. remain constant regardless of sales level.

Some expenses such as depreciation, repair and maintenance expenses depend on fixed assets balance, so it would make sense to forecast them in relation to fixed assets or total assets. Similarly, interest expense and investment income grow in line with debt and investments, respectively.

Once we have projected revenue and projected expenses, we can arrive at projected net income by subtracting the expenses from revenue. The pro forma income statement can be prepared by presenting expenses based on nature or function.

Pro Forma Balance Sheet

It is reasonable to assume that with increase in sales, a company would need to increase its investment in fixed assets. Similarly, an increase in sales increases inventories and accounts receivable. Hence, it is useful to find the ratio of assets to sales from historical financial statements and multiply it with current year sales S₁ to work out current year assets A₁.

$$ \text{Projected Assets}\ (\text{A} _ \text{1})=\frac{\text{A} _ \text{0}}{\text{S} _ \text{0}}\times \text{S} _ \text{1} $$

The same approach can be used to project liabilities. It is because with increase in sales, cost of goods sold, and other expenses increase which results in increase in accounts payable and other liabilities. Hence, it is reasonable to project liabilities L₁ using the following equation:

$$ \text{Projected Liabilities} (\text{L} _ \text{1}) =\frac{\text{L} _ \text{0}}{\text{S} _ \text{0}}\times \text{S} _ \text{1} $$

However, this approach does not work in case of shareholders equity. It is because common stock remains constant and retained earnings depend on projected net income and projected dividends. This is why the pro-forma income statement is prepared before a pro forma balance sheet can be prepared.

The following equation shows the relationship between opening retained earnings (RE₀) and closing retained earnings (RE₁)

RE₁ = RE₀ + Net Income – Dividends

This can cause the sum of projected liabilities and projected shareholders equity to differ from projected assets. But since the accounting equation (assets = liabilities + equity) must hold, we insert a plug figure which represents net external financing needed.

Projected Assets (A₁) = Project Liabilities (L₁) + Common Stock + Projected Retained Earnings (RE₁) + Plug

If we assume that a business wants to grow at the sustainable growth rate, a rate at which it is not required to raise any new equity, the plug represents an increase or decrease in debt and should be adjusted by increasing or decreasing projected liabilities such as the accounting equation holds.

by Obaidullah Jan, ACA, CFA and last modified on Jun 2, 2019