Learn the definition of pro forma and the basic steps to create a pro forma projection. Consider that the forecast is simply a prediction. You can change your forecast based on your best guess.
- What exactly is a pro forma statement? Well, it's essentially an estimate. An estimate of how well you think your company's going to do. An estimate of how many resources you may need. An estimate of future cash flows for the company. Okay, how official is it? Well, it's not the same thing as a report of GAAP net income but it can still be quite informative. There are no universal guidelines for pro forma statements. Basically, companies just use their own discretion when making these calculations.
That being said, they'll leave out things that are either one-time costs, or those that obscure projections for the future. For example, some companies will leave out amortization expense because it's not an item that's paid for as a part of cash flow. However, it is considered an expense under GAAP rules since it represents the lost value of an asset over time. Amortization directly reduces the asset amount on a balance sheet. Remember, the goal is to provide investors with outlooks that are as honest as possible.
The problem is that since there aren't regulations that govern pro forma statements, companies can bend or abuse rules to make things seem better than they actually are. Look, in general, companies aren't dishonest. But, you should always be skeptical when reading pro forma statements, especially if you happen to be an investor. As a business owner, you should be honest as possible. Think about it. If you embellish your statements and miss your predictions, you're going to look bad. In my opinion, better to give honest, reasonable predictions and then hit or exceed the mark that you set.
Then, your company's going to look successful. Here is a quick example of some manipulation that you might see. If you ever invest in real estate properties, specifically apartments, you may get a pro forma statement that reports high revenues in the future. But, this is pro forma, it's an estimate. That means that it isn't the actual GAAP reported income. There's no regulation here. It's what the current landlord estimates the rental income to be in the future. Where'd he or she get that number from? Who knows? Could be a simple percentage calculation.
Could be pulled from thin air. It's really hard to tell sometimes. In your statements, be sure your numbers are comprehensible. That they can be traced back. That your algorithm makes sense and is transparent. And most of all, that your investors can trust you. When creating pro forma financials internally, first consider the overall goals of the business. Then think about resource allocations. For your sporting goods business, your overall goal is to boost sales, grow your team, and expand your inventory.
So a lot of cash flow needs to go into operating and investing activities. Next, let's take a look at how we can build a simple pro forma statement with different components. We'll use a fictional income statement and balance sheet to guide our estimates.
- Explain the four different types of financial statements.
- Distinguish between the types of moving averages.
- Determine a seasonal adjusted trend.
- Break down pro-forma financial statements.
- Identify cash flows, and what increased liabilities and decreased earnings generally indicate.
- Tell what a regression is.
- Outline the naive approach.