Pro forma financials

What Are Pro Forma Financials?

Pro forma financials are financial statements that present a company's financial position, operating results, and cash flows under hypothetical scenarios or assumed conditions. The term "pro forma" is Latin for "as a matter of form" or "for the sake of form," indicating these statements illustrate "what if" situations rather than actual historical outcomes. These documents are a critical tool within financial reporting and financial analysis, allowing businesses to anticipate the financial impact of various potential events or decisions. Unlike standard financial statements prepared according to Generally Accepted Accounting Principles (GAAP), pro forma financials are forward-looking and based on a set of projections and estimates. They typically include a pro forma income statement, balance sheet, and cash flow statement.

History and Origin

The practice of preparing pro forma financial information has long been integral to financial planning and corporate transactions. Historically, businesses used pro forma statements to adjust prior-period financials to reflect a significant event as if it had occurred earlier, aiding comparability. For instance, after a merger, historical statements of the combined entity could be restated as if the merger had taken place a year earlier.⁸

However, the late 1990s saw a significant increase in the use of pro forma reporting, particularly among dot-com companies. Many companies began excluding "unusual and nonrecurring transactions" from their stated earnings to present a more favorable financial picture, sometimes even turning GAAP losses into pro forma profits. This trend raised concerns among regulators and investors, leading the U.S. Securities and Exchange Commission (SEC) to issue cautionary advice and eventually more stringent guidance on the use of non-GAAP financial measures, under which pro forma financials often fall.⁷, The SEC's actions aimed to ensure that pro forma results did not mislead investors or obscure GAAP-compliant reporting.

Key Takeaways

Pro forma financials are forward-looking financial statements that project outcomes based on hypothetical scenarios or proposed events.
They are commonly used for internal strategic planning, budgeting, evaluating potential transactions like mergers and acquisitions, and external communication to stakeholders.
Unlike GAAP financial statements, pro forma financials rely on assumptions and may exclude certain expenses or gains to highlight core operational performance or the impact of specific events.
Regulators, such as the SEC, require publicly traded companies to present GAAP financial statements alongside any pro forma figures to prevent misleading investors and ensure transparency.
While useful for analysis and decision-making, pro forma financials should be viewed as estimates and not guarantees, given their reliance on assumptions.

Interpreting Pro Forma Financials

Interpreting pro forma financials involves understanding the underlying assumptions and the specific events or scenarios they aim to illustrate. Since these statements are by nature speculative, their value lies in the clarity of the assumptions made and their relevance to the decision at hand. Users should assess whether the adjustments made are reasonable and whether the pro forma financials provide a more insightful view of a company's potential future performance or the impact of a significant transaction. For example, in the context of a potential acquisition, pro forma financials would combine the revenue and expenses of both entities, adjust for anticipated synergies or acquisition-related costs, and present the projected combined financial health. Analysts often perform due diligence on the assumptions to ensure the pro forma statements offer a credible outlook.

Hypothetical Example

Imagine "TechSolutions Inc." is considering acquiring "Software Innovations LLC" for $50 million. To assess the potential impact of this acquisition, TechSolutions' finance team would create pro forma financials.

Scenario: TechSolutions wants to see how the combined company's financials would look for the upcoming fiscal year if the acquisition occurs on January 1.

Steps:

Gather Historical Data: TechSolutions collects its own historical financial statements and those of Software Innovations.
Identify Acquisition Adjustments:
- Revenue: Software Innovations projects $10 million in revenue for the next year. TechSolutions believes it can achieve $2 million in cross-selling synergies.
- Operating Expenses: Software Innovations has $6 million in operating expenses. TechSolutions anticipates reducing these by $1 million through consolidating redundant roles.
- Financing Costs: TechSolutions plans to finance the $50 million acquisition with a loan at a 5% interest rate, adding $2.5 million in annual interest expenses.
- Goodwill & Amortization: The acquisition is expected to create $20 million in goodwill (the excess of purchase price over the fair value of identifiable net assets), which will not be amortized but will be subject to impairment testing. TechSolutions also identifies $5 million in acquired intangible assets that will be amortized over 5 years, adding $1 million in annual amortization expense.
Construct Pro Forma Income Statement:
- Combine historical revenue from both companies.
- Add projected synergy revenue ($2 million).
- Combine historical operating expenses.
- Subtract anticipated cost savings ($1 million).
- Add new interest expense ($2.5 million) and amortization expense ($1 million).
- Calculate pro forma net income.

This exercise provides TechSolutions a clear, albeit hypothetical, picture of the combined entity's projected profitability, helping them make an informed investment decision.

Practical Applications

Pro forma financials are employed across various financial contexts:

Mergers and Acquisitions (M&A): Companies frequently use pro forma financials to model the combined entity's financial performance post-acquisition, assessing potential synergies, integration costs, and the overall impact on profitability and valuation. This is often required in SEC filings related to such transactions.⁶
Capital Investment Decisions: Before undertaking significant capital expenditures, such as building a new factory or launching a new product line, businesses prepare pro forma statements to project the financial returns and risks associated with these investments.
Loan Applications and Fundraising: Businesses seeking external financing often provide pro forma statements to lenders or investors, demonstrating their projected ability to generate sufficient cash flows to repay debt or provide investor returns.
Budgeting and Forecasting: While not strictly historical, pro forma techniques inform annual budgeting processes and multi-year financial forecasting, helping management set realistic goals and allocate resources.⁵
Corporate Restructuring: In cases of restructuring, such as spinning off a division or selling a major asset, pro forma financials can show the financial state of the remaining entity or the new standalone business.

Limitations and Criticisms

Despite their utility, pro forma financials have significant limitations and have faced criticism. The primary concern stems from their reliance on assumptions, which can be subjective and may not materialize as planned. Since companies can select which items to include or exclude, there is a risk of presenting an overly optimistic picture of financial performance. Critics argue that management may strategically omit "non-recurring" charges that are, in fact, regular operating expenses (e.g., restructuring costs or stock-based compensation), thereby inflating pro forma earnings compared to GAAP results.⁴,³

The lack of standardized definitions for pro forma adjustments means that comparisons between different companies, or even different periods for the same company, can be challenging. The SEC has repeatedly issued guidance and warnings regarding the potential for pro forma and other non-GAAP measures to mislead investors, emphasizing that GAAP financial statements must always be presented with equal or greater prominence.² Studies have shown that higher levels of excluded expenses in pro forma reports can correlate with lower future cash flows and negatively impact stock returns, suggesting that investors may be "fooled" by these adjusted figures.¹ Therefore, while pro forma financials can offer valuable insights, they should always be scrutinized in conjunction with a company's comprehensive, GAAP-compliant financial statements.

Pro Forma Financials vs. Actual Financials

The key distinction between pro forma financials and actual financials lies in their basis and purpose.

Actual Financials (also known as historical financials) are prepared based on past transactions and events, adhering strictly to Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). They provide a verifiable, objective record of a company's past performance and financial position, typically for a completed reporting period. These statements are audited and are the foundation for regulatory filings and external reporting.

Pro Forma Financials, conversely, are forward-looking and hypothetical. They are constructed by taking historical financial data and adjusting it to reflect the impact of anticipated future events or "what-if" scenarios, such as acquisitions, new investments, or changes in operations. Their purpose is to project potential outcomes, aid in strategic planning, and evaluate the financial implications of specific actions before they occur. While they start with a historical basis, the significant adjustments and assumptions made render them speculative rather than factual records of past performance. Confusion can arise when pro forma figures are presented without adequate context or reconciliation to their GAAP counterparts, potentially leading investors to misinterpret projected performance as current reality.

FAQs

What is the main purpose of pro forma financials?

The main purpose of pro forma financials is to project a company's financial performance and position under specific hypothetical scenarios or proposed events. They help management, investors, and lenders evaluate potential outcomes of decisions like acquisitions, new projects, or financing changes before they happen.

Are pro forma financials audited?

No, pro forma financials are typically not audited. Unlike historical financial statements which are subject to external audits to ensure accuracy and compliance with accounting standards, pro forma statements are forward-looking projections based on assumptions. While the underlying historical data might be audited, the pro forma adjustments and resulting figures are management's estimates.

Why do companies use pro forma financials if they are not based on actual results?

Companies use pro forma financials because they provide valuable insights into future possibilities that historical data alone cannot capture. They are essential for strategic planning, forecasting the impact of significant transactions like mergers and acquisitions, and communicating potential financial outcomes to stakeholders who need to understand the implications of future events.

What kind of events typically trigger the creation of pro forma financials?

Common events that lead to the creation of pro forma financials include anticipated mergers and acquisitions, significant new capital expenditures, major financing initiatives (e.g., issuing new debt or equity), corporate restructuring, and the launch of new products or business lines that are expected to significantly alter a company's financial profile.

How should investors use pro forma financials?

Investors should use pro forma financials as a supplementary tool to understand potential future scenarios, but always in conjunction with, and subordinate to, a company's actual, GAAP-compliant financial statements. It is crucial to critically examine the assumptions underlying the pro forma figures and to be aware that they are projections, not guarantees of future performance. Investors should look for clear reconciliations to GAAP measures and consider how transparently the company explains its pro forma adjustments.