As business owners, we have many unique skills and talents. But did you know you also have the ability to tell the future? Okay, so, you’re not likely to predict the next winning lottery numbers. However, you can predict (or project) your company’s financials over the next few years with pro forma. You see, knowing what the future could bring, empowers you to take immediate action that can hasten or prevent certain scenarios from taking place. That’s exactly what pro forma statements can do for your business. Think of them like the Polaroid photo in the film, Back to the Future. Just like Marty McFly, you can use that snapshot (pro forma) to see how the actions taken today will affect the future. In this entry, I want to dig deep into the power and value of pro forma.
Follow Along With The Financially Simple Podcast!
This week on The Financially Simple Podcast:
- (1:48) What is Pro Forma?
- (2:35) Pro Forma calculation
- (5:03) Budget documents
- (5:24) Company income statements
- (6:24) Earnings projections
- (10:53) Secure funding
- (11:51) Inspire confidence in prospective buyers
- (13:38) Assessing M&A and risk analysis
Tapping into the Future of Your Business with Pro Forma
Before we dig in to the heart of the subject, let’s get the academics out of the way. What is pro forma? Put simply, it’s a Latin term meaning, “for the sake of form” or “as a matter of form.” Investopedia describes it as “A method of calculating financial results using certain projections or presumptions.” However, it’s important to note that they aren’t always calculated using generally accepted accounting principles (GAAP). They could contain adjustments to emphasize important factors of the company’s operating performance. So, how are pro forma statements calculated?
Calculating pro forma statements is similar to calculating your current financial statements. However, you’re not simply looking at current and historical data, Instead, you’re using that data to make reasonable projections about where your business will be within a given period. Fortunately, there are a number of pro forma templates available online or you can create your own if you prefer. Once you’ve got your template, input the data into each field to easily create a variety of pro forma documents.
To make your calculations, follow these steps:
- Pro Forma Forecasting. Estimate your total monthly income. You can adjust this for seasonal sales cycles (i.e. higher or lower sales volumes). Remember, it’s best to be conservative with these estimates.
- Estimate expenses based on industry-specific ratios, then multiply your sales total by the percentage of sales for each expense category. This will yield your future net income (NI).
- Review each line and determine how many transactions you would need to execute to achieve your projected numbers. Repeat this process until the numbers make sense for your business.
Types of Pro Forma Documents
There are several types of Pro Forma documents. Each one can tell a different story and provide unique benefits. These common types can help you get a crystal clear look at your business.
Budgets aren’t anything new. The principles remain the same regardless of the type of budget you’re creating. Start with a set amount of funds and direct them where to go. It really is as simple as that. However, you can create pro forma budget documents to help you plan for specific projects or departments. The only real difference is that you’ll use some hypothetical scenarios when creating your budget.
While based on some assumptions, pro forma budgets also look at past expenses and revenue to inform your company’s fiscal plans for the year.
Company Income Statements
Company income statements are another area where pro forma can help. If you’re trying to attract potential investors with your growth, you could use pro forma to show how you’re poised to increase revenues. Typically, you would use the pro forma calculation method and draw their attention to specific numbers. For example, you might report your actual numbers from the previous quarter while also highlighting your projections for the current quarter.
You can also use pro forma to inform your investors of how changes to the business are expected to impact its earnings and expenses. This is especially useful when you’re considering a merger, acquisition, or making a change to the leadership in your company. Forecasting your earnings will show you and investors how the business could benefit from such a move. Conversely, if you find that it could negatively impact the business, you can make an informed decision to back out of the deal.
But what is the real power of pro forma in your business?
Additional Benefits to Your Business
It may seem obvious that pro forma statements can provide the necessary data for planning, but they can impact your business in much larger ways. Let’s look at some of the potential benefits of pro forma.
Through the pro forma calculation, you’re able to make realistic projections surrounding the potential growth of the organization. Potential investors will pay close attention to your pro forma numbers to get an idea of your business’s trajectory. If you use correct assumptions in creating your pro forma, you can demonstrate viable growth, making your business attractive to investors. Pro forma statements are often required by banks because they show that you have a keen understanding of the operations of your business, as well as provide crucial information about your ability to make payments while running the business.
A well-done pro forma also inspires confidence in prospective buyers. As you probably know, I sold my business recently. As the buyers examined my financials, they keyed in on my five-year pro forma projections. I had accurately projected the business’s growth and revenue to within $30K. As a result, the buyers were extremely confident that the company could reach its future growth goals. In fact, they thought it was funny to see that I was upset about my projections being off by a “meager” $30K.
Making Sound Decisions
Similarly, pro forma statements can help you determine when a merger or acquisition makes sense. If you’re considering a strategic M&A, pro forma can help you identify redundancies and additions that will need to be made. For example, you probably won’t need two HR departments. But pro forma can also show you what a merger might look like from a financial perspective, therefore, allowing you to proactively develop solutions to problems that could arise from combining the two entities.
Finally, pro forma statements are a powerful tool in risk analysis. Because pro forma deals with some hypothetical (yet well-informed) situations, it gives you the unique ability to test different scenarios. By changing a few key factors, you can identify risks in your planning well before they have the chance to be realized. This enables you to come up with best and worst-case scenarios for your business. Likewise, you can apply your findings to your strategic plans to mitigate potential risks or even turn them into opportunities.
Friends, I bet you didn’t know you could see the future! With the power of pro forma, you can. As you can see, taking stock of your historical financial data to project the trajectory of your business can help in many ways. If you haven’t used pro forma in your business, there’s no better time than now. Using the principles of the pro forma calculation method, you can take a glimpse into the future and create or adjust plans to reach your business goals.
Look, life is hard but it’s still so good. Tracking the future of your business can be frustrating but it doesn’t have to be. With the power of pro forma, we can at least make forecasting at least, financially simple. Let’s go out and make it a great day!
Do you have questions about this or other business and financial topics? Could you benefit from an expert review of your pro forma calculations? Reach out to our team. We’re here to help.