Pro forma financial statements and projections

Learning outcome statements

The learning outcome statements relevant for this section are:

1. define the purpose of a pro forma income statement, a pro forma balance sheet, and a pro forma statement of cash flows, and demonstrate an understanding of the relationship among these statements and all other budgets
2. prepare pro forma income statements based on several revenue and cost assumptions
3. evaluate whether a company has achieved strategic objectives based on pro forma income statements
4. use financial projections to prepare a pro forma balance sheet and a pro forma statement of cash flows

Purpose of pro forma financial statements

Definitions

Pro forma financial statements

These are projected financial reports used by organizations to assess future financial performance, strategize growth, and evaluate the impact of specific plans or transactions.

While similar to budgeted financial statements, pro forma financial statements differ by focusing on “what-if” scenarios and providing insights into the financial impact of strategic decisions, such as new investments, mergers, or changes in capital structure.

The purposes of the key pro forma financial statements are:

1. Pro forma income statement: This statement projects future revenues, expenses, and net income under specific assumptions, enabling management to assess profitability, forecast the impact of strategic initiatives, and evaluate performance relative to the company’s financial goals.
2. Pro forma balance sheet: This projection estimates the company’s future asset, liability, and equity positions. It helps management understand how planned activities may influence the company’s liquidity, solvency, and capital structure over time.
3. Pro forma statement of cash flows: This statement forecasts cash inflows and outflows based on anticipated activities, assisting management in planning cash needs, evaluating financing requirements, and ensuring sufficient liquidity to support operations and growth.

Relationship between pro forma financial statements and other budgets

Pro forma financial statements are closely tied to the organization’s underlying budgets, as each budget contributes to the data that forms the basis of these financial projections. Key relationships include:

• Sales and expense budgets: The sales forecast and expense projections are integrated into the pro forma income statement, forming the basis for revenue and cost estimates.
• Cash and capital budgets: Cash flow projections and capital expenditure forecasts are incorporated into the pro forma cash flow statement and balance sheet, respectively, reflecting the company’s expected cash movements and capital investments.
• Production and inventory budgets: These budgets impact the cost of goods sold and inventory levels, influencing the pro forma income statement, balance sheet, and cash flows through adjustments in production-related cash requirements.

Pro forma financial statements vs. budgeted financial statements

The master budget culminates in budgeted financial statements, which are often called pro forma statements. When the two terms are distinguished:

Budgeted financial statements

Budgeted statements are based on fixed assumptions for the budgeting period and serve as the financial representation of an annual operating plan. They provide a benchmark for comparing actual results to the budgeted expectations and are primarily used for internal planning, performance measurement, and operational alignment.

Pro forma financial statements

Pro forma statements emphasize projecting the effect of a specific what-if scenario - such as an acquisition, a new product line, or a financing change - rather than representing the approved operating plan itself.

Evaluating strategic objectives using pro forma income statements

Pro forma income statements allow management to assess whether projected revenues and expenses align with strategic objectives. Evaluating a pro forma projection means comparing its results against a specific, quantified objective, not just checking whether a number went up from the prior year.

For example, suppose Sunrise Co.'s objective is a net profit margin of at least 12%. A pro forma projecting 10% sales growth with COGS held at 60% of sales yields a 12.95% margin, meeting the goal. A second scenario - same sales growth, but COGS rising to 62% of sales - still grows net income (from $112,500 to $126,000, up 12.0%), yet its 11.45% margin misses the target. Net income growth alone doesn’t mean a strategy succeeded; the projection has to be measured against the stated objective.

Preparation of pro forma financial statements

The preparation of pro forma financial statements typically begins with the budgeted financial statements, as they provide a foundational forecast based on the company’s expected operational activities. To create pro forma statements, adjustments are made to reflect specific hypothetical scenarios or strategic plans. For example, if a company is considering a new product line, the budgeted income statement may be adjusted to include anticipated revenues and costs for that product, giving management insight into its potential impact.

Example: Pro forma income statement under different assumptions

Sunrise Co.'s current-year income statement shows sales of $1,000,000, COGS at 60% of sales, fixed operating expenses of $250,000, and a 25% tax rate. Management tests a 10% sales increase under two cost assumptions: COGS held at 60% of sales (scenario A), or COGS rising to 62% (scenario B).

Line item	Current year	Scenario A	Scenario B
Sales	$1,000,000	$1,100,000	$1,100,000
COGS	$600,000 (60%)	$660,000 (60%)	$682,000 (62%)
Gross profit	$400,000	$440,000	$418,000
Fixed operating expenses	$250,000	$250,000	$250,000
Operating income	$150,000	$190,000	$168,000
Tax (25%)	$37,500	$47,500	$42,000
Net income	$112,500	$142,500	$126,000

Answer: Scenario A nets $142,500 (12.95% margin); scenario B nets $126,000 (11.45% margin).

Example: Pro forma balance sheet and external financing needed

Continuing scenario A, Sunrise Co. projects its balance sheet with the percent-of-sales method: assets and spontaneous liabilities (payables, accrued liabilities) stay at their current-year percentage of sales. Common stock is fixed; retained earnings rolls forward as beginning retained earnings plus net income minus an $85,500 dividend (60% of net income).

Account	Current year	% of sales	Pro forma (+10% sales)
Cash	$50,000	5%	$55,000
Accounts receivable	$150,000	15%	$165,000
Inventory	$250,000	25%	$275,000
PP&E	$250,000	25%	$275,000
Total assets	$700,000	70%	$770,000
Accounts payable	$80,000	8%	$88,000
Accrued liabilities	$20,000	2%	$22,000
Common stock	$150,000	-	$150,000
Retained earnings	$450,000	-	$507,000
Total before financing	$700,000	-	$767,000

Projected assets ($770,000) exceed the $767,000 generated internally, so Sunrise Co. needs external financing needed (EFN) of $3,000 to make the balance sheet balance.

These same changes, net of the $25,000 PP&E purchase, the $85,500 dividend, and the $3,000 new financing, produce a $5,000 net increase in cash, matching the $55,000 − $50,000 change in the cash account above. The indirect method for building a full cash flow statement is covered in Indirect method for operating activities.

Answer: Sunrise Co. needs $3,000 of external financing; the $5,000 projected cash increase reconciles across all three pro forma statements.

Pitfall: Net income isn’t cash. A pro forma cash flow statement adjusts for non-cash items and working-capital changes, and a pro forma balance sheet only works once assets actually equal liabilities plus equity.