Pro formas aid startups, investors, and established businesses by modeling the what-if scenarios of the business and the potential profitability. Pro forma financial statements are made up of the three main accounting reports: balance sheet, income statement, and a statement of cash flows. A pro forma creates the “what could be” vision of the business and are constructed using industry averages, accepted accounting principles, estimated tax rate, and the sales and budget predictions of the business owner. A pro forma and its statements are an essential part of a business plan.
Pro forma financial statements are sought after by investors and entrepreneurs for different reasons. Investors most often use them to determine their potential return on investment. A strategic business owner can use a pro forma in the following ways:
- Long-term financial planning
- Investor relations
- Cash flow predictions
- Planning staffing and operating expenses
- Revenue forecasting
- Planning capital needs (debt and/or equity)
A well-crafted pro forma is just as invaluable for small businesses looking for more or first-time funding as it is for the investor. From it, an investor or owner should be able to perform what-if scenario analysis, calculate financial ratios, potential profit after taxes, and determine future financial health.
When should you use pro forma financial statements?
If you are a business owner, inventor, entrepreneur, or investor who is researching this, the answer is now. The information gathered from a pro forma and supporting schedules are relevant to you and your future decisions.
Existing businesses use pro formas that project 5 years into the future as the crystal ball to determine Pivot/New product line profitability, Long-term growth planning, and sales and budget projections.
How do you create pro forma statements?
Pro forma statements are created with the three critical accounting statements: balance sheet, income statement and statement of cash flows. Before starting, you will want to assess your skills in financial modeling. If you are not feeling confident, seek out professional CFO services to create a pro forma so you can focus on growing.
If you are willing to try to model on your own, focus on the goals of your operation and ask yourself where it will be in 5 years. You need to link where the company is now to where you want it to be. If you want to sell your company for $10 million in 5 years, then build the bridge to that exit via your pro forma, the projected financial statements.
Look at balance sheets for an established firm in your industry as an example. Take notice of all the main elements: detailed assets, liabilities, and equity for 12 months. Your pro forma balance sheet will have the same with another 4 years, for a total of 5 years of projected information.
Make sure the balance sheet balances! We are amazed how many people lose investors because of such a simple error.
The income statement, also referred to as a profit and loss statement, will detail the following:
- Revenue Streams
- Cost of Goods Sold
- Costs that go into your product or service
- Sales, General, and Administrative Expenses
- Payroll, Marketing, professional services, sales
- Overhead costs
- Net Profit or Net Income
You will need to think of all the ways that your organization will generate income and what costs you will need to incur to generate that income. Notice how the two reports, balance sheet and income statement, link together. Your pro forma income statement will need to do the same.
Statement of Cash Flows
Once the balance sheet and income statement are created and detailed, the final step is to create your statement of cash flows. The statement of cash flows consists of:
- Operating cash flows
- Investing cash flows
- Financing cash flows
The statement of cash flows is the only page where you do not need to make assumptions. If you have completed your income statement and balance sheet correctly, then the statement of cash flows solves like a sudoku.
Outside of the main accounting schedules you will also want to consider including:
- Revenue and Cost of Goods Projections
- Headcount/Staffing and Operational Costs
- Capital Expenditures
Including these will help you add depth to you model that will aid in your predictability of the future of the business.
If you are feeling overwhelmed by the idea of tackling this yourself and have a budget, there are professionals, like CFOshare, out there that can help. Certified public accountants are not typically skilled or trained in financial modeling. Instead, using skilled CFO services will save you time.