Simple Explanation of Pro Forma Financial Statement
Overview
When a user looks at the pro forma documents, it is basically like looking into the future. The proforma is a projection where you make an assessment of future financial data and try to do your best to guess what will happen with your company in the future. Accordingly, a pro forma financial statement is a projected future financial statement.
Obviously, no one can predict the future and there is a good chance that unexpected events will happen and the actual performance of your company will not match your financial projections. Nonetheless, thoroughly investigating future trends and making good assumptions about those future trends is important for a couple of reasons.
- A good prediction of the future will improve the change of success for your business;
- Banks and other interested parties are going to ask the business for pro forma financial statements and review each number very closely.
You need to plan ahead for where your revenue is coming from, how much of it, and what you will be spending your money on. Without financial projections, you really have no idea if your business will be making or losing money. Thus, pro forma financial statements are essential for proper business planning.
Tips for Creating Pro Forma Financial Statement
To help you, as an entrepreneur make better assumptions, you can do a feasibility analysis. This is a combination of survey and open-ended interviewing technique where you want to get feedback from the actual potential customers. You can also do a latent need analysis and see if your product or service is something people need but they just do not know it yet, before they get what you have to offer.
There are many other ways to make these projections more accurate. If you have a more mature business, making predictions can be easier as you can base the data you already have for the previous periods of operations. Alternatively, you can look at your competitors and use their income, cost of goods sold, cash flows, and other financial information to have something to base your pro forma financial statement on.
Here are some more tips that you might find helpful when creating a pro forma financial statement for your business:
- You cannot create financial projections without knowing your business model in and out and knowing where your money is coming from and how much it cost you to bring it in.
- You should account for every single possible expense you might incur. It is easy to have things that are going to cost you money slip through when projecting. This is partially the reason why many pro forma financial statements have overstated income and cash flows.
- This type of document involves many assumptions. Thus, these assumptions must be clearly defined for you and the investors who are going to be looking for information about the basis for the numbers in your report.
- Although the majority of the numbers in the pro forma financial statement are simply guesses, it does not mean that you should not back them up. As mentioned before, evaluate your and your competitors’ previous financial reports and do additional research if necessary.
- Finally, it is very helpful to create several scenarios of future business outcomes. For instance, it is helpful to have values for the worst-case scenario and the maximum outcomes you expect to receive in the future. You can also create different reports to compare various investment opportunities and so on.
As you can see, just like any financial report, every pro forma financial statement requires that you do some work. Nonetheless, this work is going to pay you off in the future as you are going to be able to know the trajectory your business is moving in and can effectively make your plans and other business decisions.