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A pro forma income statement is a financial report that projects a company’s future income, expenses, and profitability based on specific assumptions or hypothetical scenarios. Unlike traditional income statements, which reflect historical data, pro forma statements provide a forward-looking view. This helps businesses evaluate the potential impact of decisions such as mergers, product launches, or expansion.
Understanding how to create and analyze pro forma income statements is crucial for making informed strategic decisions and managing financial risk effectively. Keep reading to learn more on what a pro forma income statement is, some pros and cons of using them, how to create them, and more.
Key Points
• Pro forma income statements project future revenues, expenses, and profits based on hypothetical scenarios or planned events.
• These statements help businesses evaluate the financial impact of strategic decisions, such as cost-cutting measures or new investments.
• The projections are based on assumptions about sales, costs, and market conditions, making it flexible for different scenarios.
• Benefits of pro forma income statements include helping with financial planning and strategy and showing what-if scenarios for your business.
• Pro forma statements are often used to attract investors by showing potential growth and profitability under favorable conditions.
What Is Pro Forma?
The phrase “pro forma,” derived from Latin, signifies that something is being done for the sake of courtesy or as a matter of convention. In business, a “pro forma” is an example document that doesn’t reflect the current reality of a company’s finances. Instead, the information and projections in the statement are assumptions and estimates rather than actual data.
What Is a Pro Forma Financial Statement?
Generally there are three types of pro forma financial statements. These are:
• Pro forma income statements (also known as profit and loss statements)
• Pro forma balance sheets
• Pro forma cash flow statements
What Are Pro Forma Income Statements?
Before we look at the pro forma income statement definition, let’s first look at what a traditional income statement is. An income statement shows a company’s income and expenses over a given period. It’s used to determine whether a company was profitable or not over that time.
The problem is: Not every period is the rule. There are always exceptions, like when you purchase another business or have to liquidate a large amount of inventory. In these exceptions, a traditional income statement won’t accurately reflect the financial health of your business. That’s where a pro forma income statement is more useful.
How Do Pro Forma Income Statements Work?
Just like you would with a traditional income statement, with a pro forma statement, you’ll include both the income and expenses of your business. The caveat is that you factor in whatever scenario you’ve got that will skew the income statement. In our example above, you might remove the investment cost of the business you acquired, since that large investment would make it look like your business operated at a loss.
Pro forma income statements can also be used to forecast potential revenues based on a particular scenario. Let’s say you take out a small business loan, which will take a toll on cash flow in the short term. If you use the loan to expand or bring new products to market, that could create a boost in revenues down the road, and you can calculate this potential increase in revenues in your pro forma statement.
It’s important to note that pro forma financials aren’t approved for Generally Accepted Accounting Principles. So they should only be used internally to better understand income and expenses over a period with unusual activity.
Recommended: Small Business Balance Sheets
When Do Businesses Use Pro Forma Income Statements?
Under normal conditions where you have no unusual expenses or revenues, you would use a traditional income statement. But if something out of the ordinary occurs, such as purchasing another company, upgrading equipment, or liquidating inventory that hasn’t sold, it might be better to compile a pro forma income statement.
Keep in mind that sometimes when you use pro forma financials, you’re basing your numbers on a hypothetical situation. By removing the manufacturing costs for a product you might decide to stop selling, you’re making assumptions that you’ll sell all the assets involved with that previous product and get revenue numbers back up to what they were.
Because this is a bit of speculation, you can’t share this pro forma statement with investors or shareholders. It’s better used internally to understand how your finances would look if a certain situation occurred.
How to Create a Pro Forma Income Statement
On the surface, the pro forma income statement format looks like a traditional income statement. It includes both revenues and expenses. The difference is that it also factors in the scenario you’re calculating for.
As suggested above, a pro forma income statement might factor in:
• A large investment for acquiring a business or purchasing high-cost equipment
• A forecast for a sudden increase in annual business revenues due to a new client
• The loss of revenue from stopping a product line and liquidating assets
1. Establish Baseline Numbers
You can start with the information recorded in your traditional income statement. You’ll likely alter it for this pro forma project, based on your chosen scenario, but it’s important to know your starting position.
2. Identify Major Changes
Say you were forecasting the impact of stopping a product line. In that scenario, your pro forma statement would show different numbers because you’d get less sales revenue, while also paying out less for raw material and labor. Various other aspects would be affected too. Having projected those effects, you’d see new numbers and then figure out what additional outcomes might follow.
3. Calculate Financial Impact
To continue with this example, if you discontinued a line of products, you’d run the numbers to see the outcome. For example:
• There’d be a decline in sales revenue — but if you were selling those products at a loss, there might actually be a positive impact on your bottom line.
• You might anticipate a one-time cash bump from liquidating related equipment. How much tax would you have to pay on the gain from that sale?
Some additional decisions you could make:
• If there’s less revenue coming in, would you lay off some workers and reduce your payroll? Would you rent a smaller, less expensive office space?
• Would you take out a loan to help you pay the bills while your business is regrouping? If that’s part of your scenario, remember that cash from small business loans is usually not considered income, while the loan interest is generally a deductible business expense.
4. Account for Multiple Scenarios
You can create as many pro forma income statements as you like; they’re meant to be helpful in making decisions. So if there are different scenarios you’d like to explore, such as different price points for products, these statements can give you a sense of what each potential possibility would bring.
Tools and Templates for Forecasting
Many accounting platforms and software packages now offer tools and templates for pro forma financials. Some allow you to create these documents with your existing accounting software; for example, QuickBooks can generate your documents in pro forma income statement format. You can also get spreadsheet templates from enterprises designed to help small business, such as Score and the Corporate Finance Institute.
Recommended: Small Business Financial Software
Pros and Cons of Using Pro Forma Income Statements
So is it worth it to use pro forma income statements? Here are some benefits and drawbacks.
| Pros | Cons |
|---|---|
| Show you a what-if scenario | May not accurately depict your company’s financial situation |
| Can help with financial strategy and planning | Not GAAP compliant |
Because the pro forma income statement is based on a possible scenario, you can use it to make informed financial decisions for your business, such as whether or not to take out a business expansion loan. Just be aware that it won’t accurately depict what’s actually going on with your company, but rather only one possibility. And, again, you won’t be able to use these statements anywhere you’re required to provide GAAP reports.
Pro Forma Income Statement vs. Income Statement
As mentioned, there are similarities and differences between traditional income statements and pro forma statements.
| Traditional Income Statement | Pro Forma Income Statement |
|---|---|
| Calculates based on actual numbers | Considers scenarios and possibilities |
| Based on past financial activity | Projections for future based on past |
A traditional income statement uses actual numbers for profit and loss based on what has happened in the past. A pro forma income statement looks at different possibilities based on certain scenarios and may use past data to create future projections for profit and loss.
The Takeaway
If your company has unusual activity coming up that can significantly alter a traditional income statement, consider using a pro forma statement to get a better sense of your profits and losses. Likewise, if you’re considering a certain action, such as buying another company, a pro forma income statement can help you make an informed decision.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
What’s the difference between a pro forma income statement and an income statement?
A traditional income statement is based on actual numbers, while a pro forma income statement may use projected or hypothetical numbers based on certain scenarios.
What should be included in a pro forma income statement?
A pro forma income statement includes projected revenues, cost of goods sold (COGS), operating expenses, and taxes. It also forecasts gross profit, operating income, and net income based on assumptions about future performance.
What items are excluded from a pro forma income statement?
A pro forma income statement typically excludes non-recurring items like one-time expenses (e.g., restructuring costs, legal settlements) or unusual gains (e.g., asset sales).
How far into the future should a pro forma income statement project?
It’s typical to present three years of pro forma data for readers, investors, and lenders. In general, as the time frame for the pro forma projections gets longer, the predictions are more and more likely to prove inaccurate.
Can pro forma income statements be used for budgeting purposes?
They definitely can. Budgeting is one common reason for generating pro forma income statements, often as part of broader business planning. A pro forma income statement can guide businesses in setting realistic commercial goals and identifying areas for improvement.
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