What is the Pro Forma Income Statement?
Pro Forma Income Statement (also known as pro forma profit and loss) means how the adjusted income statement will look like when certain assumptions like non-recurring items, restructuring costs etc were excluded or if a loss-making unit is discontinued. When used in the context of a business plan, it represents financial forecasts based on managers or analysts’ assumptions about the company.
Two types of Pro Forma Income Statement
Pro forma income statement is the statement prepared by the business entity to prepare the projections of income and expenses which they expect to have in the future by following certain assumptions such as competition level in the market, size of the market, growth rate, etc.
#1 – Pro Forma of Historical Profit and Loss Statement
Below is an example of Amazon. As we note from below, Amazon removed its non-recurring charges including restructuring costs and stock-based compensation in order to correctly represent its Net Income.
source: Amazon SEC Filings
#2 – Pro forma projections of Income
Below is the Pro Forma projections of the Income Statement of Alibaba. Projection of revenues is based on many assumptions including growth rate, competition, market size, etc.
Uses of Pro Forma Income Statement
- Forecasting revenues are the most difficult part of any business plan. The assumptions have to be realistic and should be able to support the forecast. It is used to produce the Cash Flow Statements and Balance Sheets, all of which are important components of a business plan.
- It may be prepared in advance of a transaction to project the future status of the company. For example, if a company is planning to acquire another company, it may prepare a pro forma financial statement to estimate what effect the acquisition would have on its own finances.
- Pro forma profit and loss statements can also be used to calculate the financial ratios.
- If a company has a one-time expense, it may drastically bring down its net income in that particular year. This cost is irrelevant in subsequent years. Hence companies exclude such costs while making the pro forma profit and loss to give investors and analysts a better picture of the company’s financial position.
- For some companies, the pro forma profit and loss statements provide a clear and accurate view of its performance given the nature of their business. Example: telephone and cable companies
Drawbacks
- One of the major drawbacks is that it is just a mere projection, the future of which is uncertain. The basis of any pro forma is the assumptions made. If the assumptions are inaccurate, it may lead to inaccurate planning and execution. Past data may not always help to paint the correct picture in a dynamic and ever-changing business environment.
- Since there are no set rules while making such a pro forma, companies tend to manipulate the financial earnings. Companies can exclude anything it believes that conceals the true financial performance.
- Some firms exclude unsold inventory of their statements, which in a way portrays inefficient management to produce inventory which cannot be sold.
- Obviously, this does not mean that every firm manipulates their earnings. Hence while evaluating, investors and analysts should pay attention to what is and what is not included while preparing the pro forma income statements.
Conclusion
Although the pro forma profit and loss statements provide a better picture, it is prudent for the investor to dip deep and analyze what is included/excluded and why so? It also advised comparing the pro forma statements with the actual statements to get a better understanding.
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