Reviewed by Oct 05, 2020| Updated on
Pro forma refers to a Latin term denoting "for the sake of form" or "as a matter of form". It is a method of calculating financial results using some projections or presumptions.
Presumptions surrounding hypothetical events that have existed in the past and may occur in the future are used to estimate the most likely organisational result and present it as pro forma financial statements.
For instance, a budget is a modification of a pro forma financial statement. It is because it anticipates the inflow of expected revenues and the outflow of funds for a given future date, usually a fiscal year, based on certain assumptions. Pro forma statements mainly present expected corporate outcomes to external stakeholders and are often used in investment proposals.
A pro forma income statement uses the method of calculating pro forma, for preparing the financial statement. It is often designed to draw the focus of potential investors to specific figures when a company announces earnings. Companies may also develop statements pro forma to assess the potential earnings value of a proposed change in business, such as an acquisition or a merger.
Investors should be aware that the pro forma financial statements of a company may depict figures or calculations which do not conform to the Generally Accepted Accounting Principles (GAAP).
Pro forma figures sometimes differ significantly from those generated within a GAAP framework. It is because the results of pro forma will make adjustments to GAAP numbers to highlight important aspects of the company's operating performance.
The following are the steps to create a pro forma income statement:
Step 1: Calculate your business's future sales estimates (pro forma forecasting). You may use market expectations that are practical and not just figures that make you or your investors feel confident.
Step 2: Estimate the gross assets and liabilities. Your obligations include credit lines and loans. Items, such as your lease price, electricity, employee compensation, insurance, licenses, permits, supplies, taxes, etc., will be your costs.
*Step 3: *You will be using the sales figures from Step 1, and the overall costs arrived at in Step 2 to build the first portion of your pro forma. The section of the pro forma statement will estimate your Net Income (NI) for the future.
*Step 4: *Estimate the future cash flows. This section of the pro forma statement will identify the net cash effect if the proposed change to the business is implemented. Cash flow varies from net profit, as all revenue and expenditures are recorded before or after cash changes hands under accrual accounting.