Pro forma financial statements are valuable tools for managers to plan for the future, anticipate and control risks and assist in securing funding for the business. They’re not just for big corporations, but should be used by all small business owners as well.
What Is a Pro Forma Financial Statement?
While standard financial statements prepared by accountants are based on a company’s historical performance, pro forma financial statements look to the future. They are projections of what management expects to happen under a particular set of circumstances and assumptions.
Pro forma statements could include revenue projections, estimates of costs and expenses and expectations of cash flows, such as the result of a merger or the introduction of a new product. Managers can use pro forma statements to illustrate the effects of a variety of executive decisions.
Pro Formas to Secure Funding
As businesses grow, they will need to secure additional funding to finance the increase in current assets, purchases of fixed assets and equipment or, possibly, the acquisition of other companies. If outside funds are needed, pro forma statements will help present the expected future results to lenders and other investors.
Let’s suppose Blue Widget Corporation has introduced a new model widget and sales are skyrocketing, putting a strain on the company’s cash flow to finance the growth in inventory and receivables. Management prepares projections for the next several years of the expected revenue increase and the rise in costs of operations. These projections detail how much money the company will need to borrow and how the loan will be paid back.
Lenders like to know when and how their loans will be repaid. It gives them confidence that the company’s managers have a firm and clear understanding of their cash flow needs, and they have a plan on how to manage it.
The pro formas help the company and its lenders determine the most appropriate type of financing. It could be a working capital loan, a revolving line of credit or maybe even a long-term loan to finance equipment purchases.
Forecasts for Results of a Merger or Acquisition
Acquiring another corporation or merging with their operations can be complicated. Forecasts will clarify things when presenting these ideas to other partners, lenders or to a board of directors.
Managers have to make difficult decisions when assessing the effects of a merger or acquisition. Which offices and plants will be kept and which ones will be closed? Will departments be consolidated and employees laid off? How will new product lines affect revenues?
These questions can be answered with the preparation of pro forma financial statements.
What if Blue Widget Corporation wanted to introduce a new product line that would cost $1 million in a new plant expansion and equipment and another $1 million in marketing and promotion? What would be the effects on the financial health of the company if the project failed?
Pro forma projections could shed some light on the best-case and worst-case scenarios.
If the project is successful, the company would reap the benefits of profits and positive cash flows. But if not, the losses might deplete the company’s capital base and create financial hardships. The pro formas will reveal the company’s capacity to absorb a worst-case situation and be able to continue operating.
Management has to gauge the probability of success or failure and decide if the potential return is worth the risk. Pro formas are a way to examine the effects of different outcomes.
Pro Forma Modeling With Ratios
One tool that lenders use to evaluate the performance and financial health of a company is the calculation of financial ratios for various scenarios of revenues and expenses. Lenders use ratios to gauge a company’s liquidity, profit performance and debt-to-equity leverage.
Lenders want to feel comfortable that a business has sufficient working capital and liquidity to support its operations. For example, they will look at projections of changes in the current ratio, current assets divided by current liabilities, under different economic conditions to make sure that enough liquidity is being maintained.
Will the company be as profitable in the future as in past years? How profitable is the company compared to others in the same industry? Pro formas will show management’s expectations.
Prudent financial management requires a balance between the amount of debt a company owes compared to its equity base. Lenders will look at a company’s pro forma balance sheet to determine the debt-to-equity ratio for additional lending. If it’s too high, additional borrowing may not be available.
Company management should look at their pro forma financials to make sure their ratios comply with lenders’ guidelines.
Adjustments for Nonrecurring Items
Suppose a company has recently gone through a substantial restructuring program. Stores or plants were closed; employees were laid off and benefits paid; departments were combined. All of these events had one-time costs.
Under standard Generally Accepted Accounting Principles, these nonrecurring restructuring costs would get posted on the company’s income statement, substantially reducing profits or maybe even showing losses.
Management could prepare a set of pro forma statements to remove these extraordinary items and show the results of the company’s normal business operations. This would be helpful to lenders and partners who might otherwise be alarmed at such a negative performance. The more positive presentation from the pro formas could restore confidence that the restructuring was a correct decision and the company would continue to operate profitably.
Issues with Pro-Forma Financial Statements
While pro forma financials are useful for management to evaluate the consequences of various alternatives, they are sometimes used to present more optimistic pictures of future results. GAAP requirements are occasionally omitted from pro forma statements because they result in more negative reporting.
For example, GAAP requires deductions for such expenses as depreciation, amortization, restructuring expenses, one-time costs, stock payouts and employee stock options. Management, on the other hand, does not feel that some of these expenses affect cash flow or are not part of normal operating costs.
Litigation is another area of difference between GAAP and pro forma financials. Occasionally, a company may receive an adverse judgement in a lawsuit. GAAP would require that this expense be reported on the company’s income statement, but management would not consider this to be a recurring expense and may elect to prepare pro forma statements that reflect normal operating results.
However, ongoing litigation might be a regularly occurring cost in some businesses, such as medical devices, and should be reported as a normal cost of doing business.
Pro Forma Statements and Budgets
The preparation of pro forma statements in various economic environments is useful for management to examine the results of increases in revenues or the consequences of rises in expenses or economic downturns. With the best guesses of future results, managers can prepare budgets for all departments to deal with the expected conditions.
As an example, suppose sales for some reason are expected to be less in the coming summer months than previous years. Management could prepare for the coming downturn by ordering less inventory, reducing employee hours and cutting back on other variable expenses. With the preparation of departmental budgets, division managers would not be caught by surprise and would in better positions to deal with the anticipated adverse conditions.
The opposite is also true. Optimistic pro forma financials help managers prepare for increases in sales and profits. They may need to increase purchases of inventory, hire additional staff, lease more warehouse space and secure additional lending to finance the rise in current assets.
Management’s responsibility is to never get caught by surprise, anticipate changes and always be prepared for upcoming conditions. Pro forma financial statements are essential tools to meet those obligations.
Pro Forma Financial Statements: Essential “What If” Modeling Tools
Pro forma statements are versatile. Managers can use them to play with various “what if” scenarios. That might be the introduction of a new product, the acquisition of another company, the purchase of new equipment or the closing of a money-losing division. The objective is to examine various alternatives and determine the best course for the business.