Question
What is pro forma Financial Statements?
Why is it important?
How to apply it in a corporation?
Answer
Contents
Application to a Corporation. 3
Introduction
A pro forma financial statement is a statement of a firm’s projected or estimated income statements, balance sheets, and cash flow statements. It evaluates and reasonably predicts the future financial situation of the firm provided that the present trends remain the same during the projected time frame. Companies use them for resource allocation, internal decision making, and general planning in addition to external reporting to owners and shareholders. They can be used for new business and/or an existing one. In the vital process of creating a business plan, a new firm must implement pro forma statements for proper planning and the minimization of risks associated with new businesses.[1] These projections should be based on accurate and reliable facts, and updates should be made frequently on the statements. Additionally, they are crucial for a young company trying to find investors and creditors for the business. This paper explores the meaning of pro forma financial statements, their importance, and their application in a corporation.
Meaning
As previously noted, pro forma financial statements provide information on projected income of a business through an analysis of estimated income statements, balance sheets, and cash-flow statements. Well-established firms implement them as a reference for their growth and planning processes. They use both external and internal information from past records to accurately project the position of the firm over short-term and long-term periods.
The process of creating a pro forma statements for a firmbegins with the creation of revenue projections. At this stage, relevant market information is used to determine an average revenue stream within the industry of operation, followed by a thorough estimation of liabilities such as loans and costs such as insurance, salaries, and licenses. These first parts create a visual demonstration of money flow in the firm, and are then used to estimate projected cash flows. Finally, this information is merged into data illustrations of projections over a three to five year period. The first year is mostly broken down into monthly statements for close monitoring. Subsequent years may be divided quarterly and then annually depending on growth.
Importance
There are five major uses of pro forma financial statements, and they include business planning, external reporting, financial modeling, evaluating effect of organizational change, and calculating ratios. To begin with, they are useful in management of employees and general organizational activities.During business planning, these statements are used to compare the strength and weaknesses of different business plans, thereby allowing for assumptions that are vital in managing competition and for the firm’s budgeting processes.
To support external reporting, pro forma statements are prepared with investors, creditors, and business owners in mind. Firms are also expected to prepare new pro forma statements when essential organizational changes occur, for example, in terms of accounting principles and strategies and acquisition or disposition of assets. On the other hand, financial modeling examines the factors that affect the assumptions used in proposed plans. Some of these factors include interest rates, labor, resources, and inventory. In this case, both manual and computer-based modeling can be used to provide accurate projections.[2]
Moreover, the statements are increasingly being used to evaluate the effects of organizational change that is mostly significant for the outlook and operations of a firm such as mergers and acquisitions. These processes come with significant changes such as new strategies, new management, and even the issuance of new financial instruments. Therefore, pro forma statements are prepared to measure the effect of a potential merger or acquisition before it happens in order to decide on finalizing the process and to prepare for all resulting changes beforehand.
Additionally, financial ratios are often made between income statements and balance sheets as a method of measuring a business’s performance against that of other firms.[3]Thus, ratios are used to calculate and measure competition and business liquidity level and rank it under various categories, thus allowing for the identification of weak and strong points to be used in future planning. In addition, fiscal ratios are being used by comparing actual tax statements to the projected ones.
Application to a Corporation
The structure of pro forma Statements is regulated by accounting bodies such as the Securities and Exchange Commission (SEC) and various national institutes of Certified Public Accountants. Since the statements are often fully based on assumptions and evaluations, it means they are inaccurate and prone to exaggeration especially during external reporting. For this reason, they are prepared using Generally Accepted Accounting Principles (GAAP).
The use of various agencies and regulatory bodies has proved useful in directing the form, content, and procedures for creating the statements.[4] This is revealed in the SEC guidelines and outline indicating the basic components of a pro forma statement. In the process of going public, a sole proprietorship or partnership restructures itself as a corporation. This re-organization is a complex process that requires new systems in crucial functions of management, taxation, salaries, and inventory. Often, a business will slowly transition into the space of a corporation by implementing new systems and measuring their performance while creating pro forma statements in most of these stages.[5]Moreover, legal adjustments should also be made during this process due to the resulting organizational and financial implications.
Conclusion
Thus, pro forma Statements are therefore greatly valuable for both external and internal aspects of a firm. If properly done in line with the laid out procedures and corporate ethics, their construction can be an invaluable tool of measurement and growth determination for both established businesses and startups.
References
Benninga, Simon. Financial Modeling. Cambridge: MIT Press, 2008.
Elliot, Barry and Jamie Elliot. Financial Accounting and Reporting. New York: Pearson, 2015.
Graham, Benjamin and Spencer. B. Meredith. The Interpretation of Financial Statements. New York: Harper Business, 1998.
Sangter, Alan and Frank Wood. Frank Wood’s Business Accounting: Volume 1. New York: Pearson, 2015.
[1]Alan Sangter and Frank Wood. Frank Wood’s Business Accounting: Volume 1 (New York: Pearson, 2015), 30.
[2]Simon Benninga, Financial Modeling (Cambridge: MIT Press, 2008), 21.
[3]Barry Elliot and Jamie Elliot, Financial Accounting and Reporting (New York: Pearson, 2015), 83.
[4]BenjaminGraham and Spencer. B. Meredith, The Interpretation of Financial Statements (New York: Harper Business, 1998), 108.
[5]Sangterand Wood. Frank Wood’s Business Accounting, 36.
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