Using Pro Forma Financial Statements In Financial Modeling

Introduction

A Pro Forma Financial Statement is an analysis tool used to assess a company’s current and future financial performance. This statement typically applies company data such as profit, revenue, cash flow and other relevant variables to provide insight into a company’s performance. They can also be used to compare a company’s current and future performance as well as to compare the company’s financial performance to that of its competitors.

Pro Forma Statements play an important role in financial modeling. Financial modeling is the process of forecasting a company’s financial performance in order to better understand its current and future financial health. Pro Forma Statements provide a useful tool for measuring a company’s financial performance in the face of changing market conditions, industry trends, and competitive dynamics. By leveraging Pro Forma Statements, financial models can provide more accurate forecasts for companies.

Content of Pro Forma Statements

Pro forma statements target financial reports in the context of extraordinary events such as mergers and acquisitions. These reports help guide investors on the impacts of extraordinary events have on financial performance, decision-making and performance metrics. While pro forma financial statements are not in line with Generally Accepted Accounting Principles (GAAP), they provide an estimate of future cash flows and reconciled revenue. In this section, we take a closer look at different types of pro forma statements and their uses.

Overview of Pro Forma Statements

A pro forma statement provides an analysis of how a company's financial performance is expected to look given certain factors. A pro forma statement provides a ‘viewer’s’ guide to forecasting and future of the company. This statement is based on the existing financial condition of the company, with certain modifications. It looks into the future and helps the management make decisions accordingly. Pro forma statements are prepared to inform investors, lenders, board of directors and other stakeholders about the projected financial results. Pro forma statements also help explain the potential financial implications for mergers, acquisitions and new operational activities such as launching new products.

Types of Pro Forma Statements

The types of pro forma statements vary depending on the company and the context in which they are being used. Common pro forma statements include:

• Income Statement: This statement projects the income and expenses for a specific timeframe.
• Cash Flow Statement: This statement outlines the projected cash flows for a specific timeframe.
• Balance Sheet: This statement projects the assets, liabilities and capital of a company over a specific timeframe.

These statements provide investors and other stakeholders a highly accurate picture of how the company will do financially in the future, with certain pre-determined factors and assumptions. Pro forma statements can be updated with the help of a financial modeller to give a deeper view into the company. The combination of pro forma statements and financial modelling provides the best result in terms of estimating future cash flows and profits.

Uses of Pro Forma Statement in Financial Modeling

Pro forma financial statements help to analyze the financial state and potential of a business or corporation. A pro forma statement is a financial document that is specially designed to portray a picture of what the future finances of a business or corporate entity may look like, by forecasting estimated financial results by taking current information into account and then making predictions based on what could potentially happen in the future.

In financial modeling, pro forma statements have numerous uses. The following outlines a few examples of how pro forma statements can be used.

Budget Forecasting

Forecasting an accurate budget is an important part of the financial modeling process. The pro forma statement can be used to project estimated future income and expenses, giving financial stakeholders a more accurate view of what their future budget could potentially look like.

Valuation of a Business

Pro forma financial statements may also be used to ascertain the current market value of a business. Knowing the value of a business is important for a range of reasons, from helping when making decisions regarding mergers and acquisitions, to being able to set the proper expectations when raising capital.

Adjusting Historical Financial Statements

Pro forma statements can also be used to adjust current and past financial statements to reflect expected changes. This can help to create a more accurate picture of a company's future financial state and better inform decisions that need to be made.

• Accounting adjustments can be made to current financial statements that take into account capital expenditures and other non-operating assets or expenses.
• Income statements and balance sheets can be adjusted to make future earnings estimates.
• Cash flows can be adjusted from current to expected future cash flows.

Example of Pro Forma Forecast

A pro forma forecast is a prediction of financial results, often represented in the form of a provisional balance sheet or income statement. It is used to project the potential financial outcomes of a certain decision or event and can be used to assess the viability of a business plan, or to help inform the decision-making process. The following will illustrate a pro forma forecast using a hypothetical example.

Revenue Forecast

The first step in generating a pro forma forecast is to determine the forecasted revenue. This is often the most difficult task as it involves making assumptions for the prices of products or services, the volume of sales, and the market size. For instance, if the organization is projecting to double revenues from the previous year, then the difference between current and projected sales would need to be factored into the forecast along with estimates of the breakdown of sales into different products or services.

Cost of Goods Sold and Expenses

The cost of goods sold (Cost of Sales) and expenses are then determined. This process involves creating an estimate of the cost associated with running the business. Some of the typical expenses would include things like labor costs, materials, and other costs associated with producing the product or service that is being sold. In addition, any outside costs that are required to run the business such as office rents, professional fees, and advertising costs would be taken into account to generate a comprehensive estimate of the cost of goods sold and operational expenses.

Forecasted Cash Flow

The forecasted cash flow is then calculated. This includes the cash coming in from sales, any investments made in the business, and expected expenses. It is essential to account for these projected expenses in order to accurately estimate the cash flow that will be available for the business going forward. When the cash in and out of the business are accounted for, the forecasted cash flow for the upcoming period can be estimated.

Forecasted Balance Sheet and Income Statement

The forecasted balance sheet and income statement can then be produced. This involves taking the forecasted cash flow, projecting the assets and liabilities of the business, and calculating the expected net income and other related financial metrics. The result is the final pro forma forecast which can be used to assess the potential viability of a business plan or to inform the decision-making process.

Benefits of Pro Forma Forecasts

Pro forma financial statements provide users with a tool that allows them to project future financial results based on specific scenarios. As such, by utilizing pro forma forecasting techniques and incorporating financial information, stakeholders can make more informed decisions and more accurately project future results.

Improved Accuracy for Projections

One of the main benefits of incorporating pro forma forecasts into financial modeling is improved accuracy for financial projections. Pro forma statements are widely used to project forward-looking values such as sales, operating expenses, and cash flows. As such, users can effectively adjust assumptions to determine future performance and make more effective decisions.

More Effective Decision Making

Another benefit of utilizing pro forma financial forecasts is improved decision making. Utilizing pro forma forecasting techniques allows users to evaluate various assumptions and adjust accordingly. By incorporating financial data into a forecast and adjusting assumptions as needed, users can effectively adjust their strategy in order to maximize their future performance and achieve their objectives.

Pro forma financial statements provide users with a tool to project future financial results based on specific scenarios. By using pro forma forecasting techniques, users can make more accurate projections and more effective decisions. This improved accuracy and more effective decision making can help stakeholders to maximize their future performance and achieve their goals.

Challenges of Pro Forma Analysis

Pro Forma analysis is a useful tool to evaluate a company’s operations and financial performance, but there are several challenges that can arise when preparing and analyzing pro forma statements. These challenges can create responsibility and accuracy issues, making it important to understand the potential pitfalls of pro forma analysis.

Difficult to Gather Accurate Data

Collecting consistent and accurate data from different sources to prepare pro forma financial statements can be difficult. Companies need to be diligent in verifying the retrieved data, as even the smallest mistakes can lead to serious reporting errors. Additionally, companies should pay attention to the assumptions and estimates used in the pro forma analysis, as they need to be as accurate as possible to obtain reliable results.

Need for Expertise

Another challenge is the need for expertise in order to prepare a comprehensive and accurate pro forma analysis. A financial analyst should possess strong skills in accounting and financial analysis, as well as a thorough understanding of the industry and the company in order to identify any potential issues. Without the necessary expertise, the results of the pro forma analysis could be unreliable, leading to inaccurate decision-making.

Pro Forma analysis is an invaluable tool for financial decision-making, but it is important to understand and be aware of the potential challenges associated with its use. Companies need to be diligent in collecting and verifying accurate data, and should ensure that the analyst in charge of the preparation is knowledgeable and experienced. With the proper preparation and necessary caution, pro forma analysis can help companies make informed and strategic decisions.

Conclusion

Pro forma financial statements are an integral part of financial modeling. They provide a framework for project projections, the benchmark for evaluating a company's performance, and the foundation of an investment thesis. They are an invaluable tool for investors, business owners, and financial analysts alike.

To make the most of pro forma financial statements, it is essential to understand their key components and how they are constructed. It is also important to recognize the limitations and potential inaccuracies of these documents, as well as the various industry guidelines related to their use. By adopting best practices and leveraging the right tools, an investor or business owner will be able to gain a comprehensive view of their financial performance.

Pro forma financial statements provide a powerful resource for evaluating business performance, but they should be used as just one part of an overall financial analysis and modeling process. By combining pro forma statements with non-financial metrics and other financial statements, investors and business owners can gain a more complete picture of their current and future business performance.