Understanding Pro Forma Financial Statements

School: Colorado Technical University - Course: FINC 225 - Subject: Accounting

Introduction Pro forma financial statementsare forward-looking or projected income statements and balance sheets. These projections are forecasted based on the assumption that key financial items will grow proportionately to projected sales. Pro forma statements are used by managers and external users (e.g., creditors, investors, employees, and competitors) to gauge a company's future financial health. This lesson discusses the purpose of pro forma statements and examines an example of a pro forma income statement and a pro forma balance sheet. Learn: Pro Forma Financial Statement Analysis Learning Materials What is a pro forma financial statement? As the word implies,pro formais an anticipation of efforts or results of pending activities. Items on apro forma financial statementare based on projected net revenues, cash flows, and liabilities. Reviewmore information about pro forma. Purpose of Pro Forma Statements Pro forma impacts a company's financial condition by providing projected performance, causing management to strive to meet expectations subconsciously, which in normalcy can have positive outcomes. It is used by managers and external users, such as creditors, investors, employees, and competitors. Informed stakeholders know that the most reliable reports for making investment or business decisions are the audited reports of certified public accountants (such as balance sheets, income statements, cash flow analysis, and statements of retained earnings). However, these reports are not readily available. Therefore, in lieu of audited financial statements, the closest

alternative is a pro forma statement. Although audited financial statements are widely accepted and encouraged, pro forma financial statements are preferred over a letter of credit or other noncertified documents. It is not the actual document but a commitment for future actions or obligations. Pro Forma Income Statement Apro forma income statementis a prediction of a company's net income. This is usually based on forecasted sales. Understanding future sales is an important element to determine a pro forma income statement. This is because many of the line items in an income statement are directly related to sales; that is, as sales increase, these items also increase proportionately. These items include cost of goods sold, advertising expenses, operation expenses, and administration expenses. Forecasting future sales can be determined by examining past changes in sales, such as the annual percentage change in sales over the past 3 years. For example, if sales have increased by 10% annually over the past 3 years and there is no anticipated disruption in the market, then the sales forecast may be a 10% growth per year for the next 3 years. Preparing a Pro Forma Income Statement To prepare a pro forma income statement, the ratios of the various line items to past sales need to be determined. For example, if the cost of goods sold over the past 3 years is about 40% of sales, then this can be applied to the pro forma or projected cost of goods sold using the forecasted sales. The same can be applied to the other expense items. As an example, this lesson shows a simple 4-year pro forma income statement for XYZ, Inc. (see Table 1)