Pro forma cash flow statement refers to the cash flow statement prepared by the business entity to prepare the projections of the amount of cash inflow and amount of cash outflow which they expect to have in future from the different activities which include operating activities, investing activities and financing activities.
What is Pro Forma Cash Flow Statement?
Pro Forma Cash Flow Statement is a popular accounting practice that reports a voluntary statement prepared by a firm for presenting financial projections. It can be defined as the probable amount of cash inflows and outflows expected in future periods for a specific duration of time.
- Pro-forma Cash Flow Statement can be developed as part of the annual budgeting or forecasting process, or it may be created as part of a specific request for cash flow information, as required by prospective investors or company management for future decision making.
- It also plays a vital role in new business, startups, or SMEs in the planning stage as they provide a possible representation of the future running a business. It can help credit lenders in identifying and provide financing to such business, which might not be operational today, but in the future might be the next growth story.
- Pro forma cash flow statement must be based upon objective and reliable information to create an accurate projection of financial needs and status that can help convince the investors.
Example of Pro Forma Cash Flow Statement
For example, consider the following financial numbers of a hypothetical firm
As per the given scenario, estimated earnings after-tax on sales should be 23.31%, which is an average of the last five years. It is an ideal representation of estimates as per pro forma cash flow statement.
Similarly, depreciation on sales can be estimated at 4.49% and net-working capital on sales 7.08% as per previous year trends. Based on these estimations following Pro forma cash flow statement can be prepared for analysis of the year 2018
Based on these figures, the firm can ascertain the cash flow available with it at the end of the current financial year.
Types of Pro Forma Cash Flow Statement
It can be prepared for a short term, medium-term and long term based on the requirement from the management.
#1 – Short term
The preparation of short term statements is on a monthly, weekly, or daily basis. The use of these is to make short-term decisions. I.e., for day to day, operating decisions like budgetingBudgetingBudgeting is a method used by businesses to make precise projections of revenues and expenditure for a future specific period of time while taking into account various internal and external factors prevailing at that time. for an expense, planning for temporary cash deficits, etc.
#2 – Medium-term
The preparation of Medium-term statements is for a period not exceeding a year. The use of these statements is to make decisions for the financial year under consideration, like an estimation of revenuesRevenuesRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions., profits, etc. The purpose of these types of statements is to satisfy medium-term objectives.
#3 – Long-term
The preparation of Long-term statements is for durations exceeding a year. The use of these statements is for taking long-term investing and strategic decisions by management and investors. A decision of capital funding, the establishment of new ventures, etc. are based on long-term pro forma cash flow statements.
Following are some crucial advantages of pro forma cash flow statement
#1 – Business planning
Pro forma cash flow statements help in business planning and control. These statements help management in comparing their business strategies and alternative business plans. Analyzing projected numbers, help in deciding what serves the company best as It is useful in the estimation of cash shortages soon.
- It helps plan for the reduction of avoidable expenditure.
- Taking future investment decisions in cases of excess cash availability;
- It is useful in planning a firm’s operations and in anticipating the company’s financial position.
- Identifying inorganic growth prospects and their impacts like mergers, acquisitions, or joint venturesJoint VenturesA joint venture is a commercial arrangement between two or more parties in which the parties pool their assets with the goal of performing a specific task, and each party has joint ownership of the entity and is accountable for the costs, losses, or profits that arise out of the venture.;
#2 – Financial Modeling
Pro forma cash flow statements help perform mathematical calculations and create financial models. The what-if scenarios thus created help in:
- Testing different assumptions that can provide different scenarios of sales and production costs.
- Quantifying the future business plans and impact on future valuations;
- Studying the impact of variables in prices of labor, materials, and overhead costsOverhead CostsOverhead cost are those cost that is not related directly on the production activity and are therefore considered as indirect costs that have to be paid even if there is no production. Examples include rent payable, utilities payable, insurance payable, salaries payable to office staff, office supplies, etc.;
The following are some limitations of this mechanism.
- It may not target the effects of external market forces. Since these statements are based on estimations, it may not capture external forces affecting the financials of the company. There are various such external factors that effects organization like changes in the tax rate structure, changes in raw material prices dues to market conditions, inflation, recession, interest rate changes, technological changes, etc. These aspects largely influence the financials of the company.
- Sometimes, it may present misleading results due to incorrect estimations. Since pro forma cash flow statement is based on past performance estimation of the company, it may not provide a perfect future picture, thus resulting in estimations that might be incorrect. In such kind of situations, pro forma cash flow can give misleading and unreliable results.
It is an integral part of financial planningFinancial PlanningFinancial planning and analysis (FP&A) is budgeting, analyzing, and forecasting the financial data to align with its financial objectives and support its strategic decisions. It helps investors to know if the company is stable and profitable for investment. and forecasting. Management used these to quantify the strategic initiatives irrespective of the size of the firm or its subsidiary. While a pro forma offers no guarantee, when done right, it demonstrates that management has done its homework with accurate assumptions based on industry standards. Since pro forma cash flow statements are estimates, they are flexible, and adjustments are made as and when required. It cannot be ascertained whether the suggestions are made by investors or other ideas that adjust costs, thus representing a dynamic nature.
This article has been a guide to what is Proforma Cash Flow Statement. Here we discuss examples of pro forma cash flow statements, its types, advantages, and limitations. You may learn more about cash flows from the following articles –