Pro Forma Financial Statements

Pro forma financial statements refer to reporting the Company's current or projected financial statements based on certain assumptions and hypothetical events that may have occurred or are likely to happen. Accordingly, the Company's management can include or exclude line items that they feel may not accurately measure its estimates.

• Pro forma financial statements present the company's predicted or current financial information based on several assumptions and speculative circumstances that may or may not have transpired. 
• As a result, line items that the Company's management feels might not accurately measure its forecasts may be included or excluded.
• Risk analysis can make use of pro forma statements. The company's financials are analyzed in these statements, considering the best-case and worst-case scenarios. It gives the financial managers a clearer picture of how various choices might affect the company's financial stability.
• Risk analysis may employ pro forma assertions. These statements analyze the Company's financials while considering the best-case and worst-case situations.

#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 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 if 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, type of investors, and funding channels used.

#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 its impact. This approach is useful for estimating the impact of an acquisition on the financials of the Company.

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 period, like one year, giving details about the Company's performance in case acquisition is made.

Such pro forma analysis and statements help the company's investors and shareholders better understand the management strategy in running the business.

#4 - Risk Analysis

Pro forma statements can be used in risk analysis. These statements perform an analysis of the financials of the Company, considering the best case and worst-case scenarios so that the financial managers have a better outlook on how various decisions can impact the Company's financial health.

If a company had a one-time cost, it might not report such cost on a pro forma financial statement, considering it's a one-time cost and, if included, does not show the Company's operational performance. However, under GAAP, it will have to report the one-time cost and thus negatively impact the Company's net income.

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 the Pro forma statement of operations is shown below:

source: Amazon SEC Filings

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 costs or merger costs, one-time costs, employee stock options, 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 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: 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.

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 as pro forma earnings are not regulated. The investors should be careful while using pro forma statements and rely on the GAAP figures and financial statements to analyze the Company's performance. Analysts and investors should dig deep and try to find the reasons for the variance between the pro forma and GAAP financial statements.

This has been a guide to what are Pro Forma Financial Statements. Here we discuss the top 4 types, practical examples, and crucial issues with using such statements. You may learn more about Financial Statements from the following articles –

• Pro Forma Income Statement
• Pro Forma Cash Flow Statement
• Amalgamation vs Merger
• What is Financial Modeling?