Pro forma statements

What Are Pro forma statements?

Pro forma statements are financial reports prepared on a "what if" basis, projecting a company's financial results by making assumptions about future events or the impact of past events had they occurred earlier. These statements fall under the broader category of financial analysis and financial reporting, providing a hypothetical view of a company's financial position and performance. The term "pro forma" comes from Latin, meaning "for the sake of form," indicating that these statements are created to illustrate a specific scenario rather than to report historical actuals. Companies utilize pro forma statements to forecast the financial outcomes of various strategies or future scenarios, helping them to anticipate liquidity needs, profitability, and overall financial health under different conditions.³², ³³ They may adjust or omit certain costs to reflect a company's core business performance or to illustrate the impact of a specific transaction.

History and Origin

The practice of presenting pro forma financial information has evolved with the increasing complexity of corporate transactions and the need for forward-looking insights. While not having a single, definitive "invention" date, the use of pro forma figures became more prominent as businesses engaged in activities like mergers and acquisitions (M&A), divestitures, or significant capital expenditure projects. These events significantly alter a company's financial structure, making historical financial statements less indicative of future performance. Pro forma adjustments gained particular attention in the early 2000s, especially during periods of significant corporate restructuring and technological advancements, where companies frequently presented "adjusted" earnings to highlight what they considered their ongoing operational performance, often excluding one-time charges or non-cash expenses.³¹ The U.S. Securities and Exchange Commission (SEC) has since provided guidance on the presentation of pro forma financial information, particularly in the context of public filings for significant business acquisitions or dispositions.²⁸, ²⁹, ³⁰ This guidance aims to ensure transparency and comparability for investors.

Key Takeaways

Pro forma statements are hypothetical financial reports that project a company's financial performance under specific assumptions or scenarios.²⁷
They are crucial tools for forecasting, budgeting, and evaluating potential business decisions.²⁵, ²⁶
These statements include projected versions of the income statement, balance sheet, and cash flow statement.²², ²³, ²⁴
Pro forma statements are often used in contexts such as mergers, acquisitions, fundraising, and internal strategic planning.²¹
While useful, pro forma statements rely on assumptions and may exclude certain expenses, requiring careful interpretation by users.¹⁹, ²⁰

Interpreting the Pro forma statements

Interpreting pro forma statements requires understanding the underlying assumptions and the purpose for which they were created. Unlike historical financial statements, which report past actual results, pro forma statements reflect "what if" scenarios. They are forward-looking tools that provide insights into how a company's financial position and results of operations might look given a specific event or set of changes. When reviewing pro forma statements, it is important to scrutinize the adjustments made to historical data. These adjustments typically aim to show the impact of a transaction as if it had occurred at an earlier date, or to remove non-recurring items to highlight ongoing operations.¹⁸ Users should analyze the narrative accompanying the pro forma statements, which explains the assumptions and adjustments. This context is critical for evaluating the projected earnings per share, asset levels, and cash flows. Pro forma statements are best used as a tool for scenario analysis and decision-making, rather than as a definitive forecast of future performance.

Hypothetical Example

Consider "TechSolutions Inc.," a growing software company, planning to acquire "DataAnalytics Co.," a smaller competitor, for $50 million. To assess the potential financial impact of this acquisition, TechSolutions Inc. would prepare pro forma statements.

Assumptions: Management assumes the acquisition will close on January 1st of the next fiscal year. They project that DataAnalytics Co. will contribute an additional $10 million in revenue and $2 million in net income annually, net of integration costs. TechSolutions Inc. plans to finance the acquisition using $20 million from existing cash and $30 million from a new term loan with an annual interest rate of 5%.
Pro Forma Income Statement: TechSolutions Inc. would combine its own historical income statement with DataAnalytics Co.'s historical income, adjusting for projected synergies, the new interest expense from the loan, and any anticipated acquisition-related costs that will recur or are directly related to the combined entity's operations. The pro forma income statement would then show a combined projected revenue and net income for the next year, reflecting the acquisition as if it had occurred at the beginning of the current fiscal year.
Pro Forma Balance Sheet: The pro forma balance sheet would combine the assets and liabilities of both companies, adjusting for the cash used, the new debt, and the goodwill created from the acquisition. This would provide a snapshot of the combined entity's anticipated financial position immediately after the transaction.
Pro Forma Cash Flow Statement: This statement would project the combined cash inflows and outflows, reflecting the new operational cash flows from DataAnalytics Co., the debt service payments, and any cash movements related to the acquisition. This helps TechSolutions Inc. understand the future liquidity of the combined entity and ensure sufficient cash to manage operations and debt.

This exercise allows TechSolutions Inc. to evaluate the acquisition's impact on its financial health before making the final investment decisions.

Practical Applications

Pro forma statements are widely used across various financial and business contexts to gain forward-looking insights.

Mergers and Acquisitions (M&A): Companies preparing for or evaluating an acquisition use pro forma statements to understand the combined financial picture of the merged entity. This helps in assessing potential synergies, integration costs, and the overall impact on profitability and balance sheet strength. The SEC often requires pro forma financial information in public filings related to significant business acquisitions.¹⁶, ¹⁷
Fundraising and Debt Financing: Businesses seeking capital from investors or lenders often present pro forma statements to illustrate how new funding will impact future financial performance and to demonstrate their ability to generate sufficient cash flows to service debt or provide returns to shareholders.
Internal Strategic Planning: Management uses pro forma statements for internal budgeting, strategic planning, and assessing the financial viability of new projects, product launches, or expansion initiatives. This enables them to make informed resource allocation decisions.
Due diligence: During the due diligence phase of transactions, both buyers and sellers rely on pro forma statements to model different scenarios and evaluate financial risks and opportunities. A general overview from a major accounting firm can provide additional context on how pro forma information is used in professional practice.¹⁵

Limitations and Criticisms

Despite their utility, pro forma statements have significant limitations and have attracted criticism, primarily concerning their potential to present an overly optimistic or manipulated view of financial performance.

Reliance on Assumptions: Pro forma statements are inherently based on assumptions about future events, which may or may not materialize. Inaccurate or overly optimistic assumptions can lead to misleading projections.
Lack of Standardization: Unlike financial statements prepared under Generally Accepted Accounting Principles (GAAP), there are no universal standards for how pro forma statements are prepared, especially for non-GAAP measures. This lack of standardization means that companies can choose what to include or exclude, making comparisons between different companies or even different reporting periods of the same company difficult.¹², ¹³, ¹⁴
Potential for Manipulation: Critics argue that companies may selectively exclude certain expenses, such as restructuring charges, amortization of intangible assets, or stock-based compensation, to present a more favorable picture of profitability, often making losses appear as profits.¹⁰, ¹¹ The practice of emphasizing pro forma figures while de-emphasizing GAAP results has been a concern for regulators and investors.⁹ Research has indicated that excluded expenses from pro forma earnings can be far from one-time or unimportant, and higher levels of such exclusions may lead to lower future cash flows.⁸
Unaudited Nature: Pro forma statements are typically not subject to the same rigorous auditing scrutiny as GAAP financial statements, increasing the risk of errors or intentional misrepresentation.⁷
Investor Misinterpretation: While intended to provide useful insights, investors may misinterpret pro forma figures as actual results, leading to misinformed investment decisions.⁶

Pro forma statements vs. Actual financial statements

The primary distinction between pro forma statements and actual financial statements lies in their purpose and the data they represent.

Actual Financial Statements (also known as historical or GAAP financial statements) report a company's past financial performance and position based on recorded transactions. These include the income statement, balance sheet, and cash flow statement, prepared in accordance with established accounting principles (like GAAP in the U.S. or IFRS internationally). They are audited by independent accountants, providing a verifiable and objective view of a company's financial health during a specific historical period.

Pro forma statements, in contrast, are forward-looking or "as if" statements. They are created by adjusting actual historical data to reflect the impact of a hypothetical future event or a past event as if it had occurred at an earlier date. For example, after an acquisition, a pro forma statement might show what the combined company's revenues and expenses would have been if the acquisition had occurred at the beginning of the fiscal year. They serve as a planning and analytical tool, allowing management and external stakeholders to evaluate the potential financial implications of various scenarios, such as new projects, mergers, or changes in operational structure. While they provide flexibility to illustrate specific outcomes, they are not regulated to the same extent as actual financial statements and rely heavily on the assumptions made by their preparers.

The key difference is that actual financial statements reflect reality, while pro forma statements reflect a potential or assumed reality. Investors and analysts often examine both to gain a comprehensive understanding: the actual statements for a factual baseline and the pro forma statements for forward-looking insights under specific conditions.⁵

FAQs

What is the main purpose of pro forma statements?
The main purpose of pro forma statements is to project a company's financial future under various hypothetical scenarios or to illustrate the impact of a specific transaction as if it had occurred at an earlier time. They are essential tools for forecasting, strategic planning, and evaluating potential investment decisions.³, ⁴

Are pro forma statements audited?
Generally, pro forma statements are not subject to the same level of independent audit as a company's historical financial statements prepared under GAAP. While public companies must follow SEC guidelines for presenting pro forma information, especially in filings related to significant transactions, the assumptions and adjustments within these statements are largely management's responsibility and are not typically verified by external auditors to the same extent as actual financial results.²

Why do companies use pro forma statements if they can be misleading?
Companies use pro forma statements because they offer a flexible way to present the financial impact of specific events or strategies that historical statements cannot fully capture. For instance, in a mergers and acquisitions scenario, pro forma statements can show the combined entity's potential financial performance, which is invaluable for internal planning and communicating with stakeholders about future prospects. While there are risks of misuse, when prepared transparently and with clear disclosures of assumptions, they can provide valuable insights.¹