What are Pro Forma Financial Statements?
Pro forma financial statements refer to the reporting of the companies current or projected financial statements based certain assumptions and hypothetical events that may have occurred or is likely to happen in the future. Thee company’s management can include or exclude line items which they feel may not accurately measure its estimates.
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For eg:
Source: Pro Forma Financial Statements (wallstreetmojo.com)
Types of Pro Forma Financial Statements
#1 – Projections
Full-year pro forma projects the Company’s financial statements and earnings potential based on year to date results and few assumptions. These statements are then presented to the management of the Company and to the investors and creditors.
As a financial analyst, you are expected to create these pro forma financial statement projections of companies. For example
#2 – Funding
Pro forma projection of the Company’s performance can be used to showcase to potential investors in case the Company is seeking new funds. The Company may or may not prepare different types of pro forma financial statements based on the funding needs and type of investors and funding channels used.
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#3 – M&A Analysis
The Company may create pro forma statements considering an acquisition/merger of another business/Company. The Company will create financial statements for the past 2-3 years, considering the acquisition and looking at its impact. This approach is useful to estimate the impact of an acquisition on the financials of the Company.
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The Company can make assumptions like the net costs of acquiring the business, positives from synergies and intellectual property gains, and estimate the total impact on the financial statements. This method can also be used for a shorter time period, like one-year giving details about the Company’s performance in case acquisition is made.
Such pro forma analysis and statements help the investors and shareholders of the Company to better understand the management strategy in running the business.
#4 – Risk Analysis
Pro forma statements can be used in risk analysisRisk AnalysisRisk analysis refers to the process of identifying, measuring, and mitigating the uncertainties involved in a project, investment, or business. There are two types of risk analysis - quantitative and qualitative risk analysis.read more. These statements perform analysis on the financials of the Company considering the best case and worst-case scenario so that the financial managers have a better outlook on how various decisions can impact the financial health of the Company.
Pro Forma vs. GAAP Financial Statement?
If a company had a one-time cost, it might not report such cost on pro forma financial statement considering it’s a one time cost and, if included, does not show the operational performance of the Company. However, under GAAP, it will have to report the one time cost and thus negatively impacting the net income of the Company.
Pro forma financial statements can be a good indicator for the Company to show the investors the typical earnings outlook, but removing the one time cost makes the Company appear profitable when maybe it is losing money.
An exhibit of Pro forma statement of operationsStatement Of OperationsStatement of Operations, also known as the income statement, displays a Company’s revenues & expenditures for a specified period, i.e., monthly, quarterly, or annually in a standard accounting format in accordance with the accounting policies suggested by the governing body.read more is shown below:
source: Amazon SEC Filings
Issues with using Pro Forma Financial Statements
Many Companies tend to manipulate these financial statements by including or excluding various items. Let us look at some examples:
- Companies generally do not include depreciation, amortization, restructuring costsRestructuring CostsRestructuring Cost is the one-time expense incurred by the company in the process of reorganizing its business operations. It is done to improve the long term profitability and working efficiency. This expenditure is treated as the non-operating expenses in the financial statements.read more or merger costs, one-time costs, employee stock optionsEmployee Stock OptionsEmployee stock option plan (ESOP) is an “option” granted to the company employee which carries the right, but not the obligation, to buy a promised number of shares at a pre-determined price (known as exercise price). read more, and stock payouts, etc. the Company feels that the depreciation and amortization are not actual expenses as there is no cash outflow for these line items. However, under GAAP financial statements, amortization and depreciation are considered as expenses because there is a loss in the value of the assets.
- One time expenses are also excluded from pro forma because they are not a regular part of operations and thus are irrelevant to the Company’s performance. However, such an expense is included in GAAP, as the Company has spent the amount and decreased its net profit.
- Some Companies exclude their unsold inventories from the pro forma balance sheet. This seems counterintuitive of why would a Company do so? Having too much-unsold inventory on the balance sheet shows bad management of the Company. Either the Company is not able to maintain demand-supply or is not able to sell its inventory amongst the consumers.
Conclusion
Pro forma financial statements are very informative to the investors as it shows the various assumptions and projections for the Company’s financials. However, such statements could vary substantially from actual events and may be inaccurate. Although, using these assumptions is not fraudulent in any way as pro forma earningsPro Forma EarningsPro-Forma Earnings are the company’s income determined in deviation from compliance with the Generally Accepted Accounting Principle. It does not consider non-recurring expenses like loss due to fire, restructuring expenses to create a relatively positive picture of its financial statement.read more are not regulated. The investors should be careful while using pro forma statements and should rely on the GAAP figures and financial statements for analyzing the Company’s performance. Analysts and investors should dig deep and should try to find the reasons for variance between the pro forma and GAAP financial statements.
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