Pro forma cash flow statement: definition, purpose, and examples
Learn how to create a pro forma cash flow statement and why the report is an important financial planning tool.
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1 minute
September 27, 2024
Successful SMBs invest time to perform financial analysis and to forecast business performance based on assumptions.
This post defines the pro forma cash flow statement and the common assumptions used. You’ll learn the best practices for generating the template and how this tool can improve a financial forecast.
Key highlights:
A pro forma cash flow statement projects cash inflows and outflows. Cash flows are categorized as operating, financing, or investing activities. Owners may use Excel or another software product to create pro forma statements.
Business owners create the statement to forecast cash balances in future periods. If the forecast predicts a negative cash balance, management must consider borrowing funds or an equity capital investment.
Pro forma is a Latin word meaning “as a matter of form” and refers to a set form or procedure performed in a particular manner. In business, pro forma financial statements are produced based on assumptions.
The statement of cash flows details the inflows and outflows of cash and cash equivalents for a specific period. Cash equivalents are securities that earn interest and are easily converted into cash, such as money market securities.
Each cash transaction is related to an operating, investing, or financing activity. The beginning cash balance plus the net change in cash is the ending cash balance.
The accounting standards used to create the statement of cash flows do not use the assumptions applied to a pro forma cash flow statement. The Securities and Exchange Commission has strict guidelines regarding pro forma financial information.
A pro forma financial statement is a projection created using assumptions. A budget is part of an overall business plan.
The budgeted cash flow statement uses actual data to determine cash inflows and outflows. Payments for budgeted lease expenses are based on a lease agreement, and IT consulting costs are determined by a contract with an IT vendor.
Budgets may also include assumptions from the pro forma financial statements.
The pro forma cash flow statement is created to perform several types of analysis. The statements are used for risk analysis, business valuations, and to make informed decisions.
When a business considers launching a new product, management will assess the impact on cash flow. Each new product requires cash outflows to manufacture a product or to purchase inventory. Cash inflows depend on the product’s price, and how quickly customers pay.
New products may be bundled and sold with related products. A grocery store, for example, will bundle hot dogs, buns, and picnic supplies and market the bundle during the summer months. The store owner can analyze cash flows for a group of products.
Pro forma statements reveal the financial impact of different scenarios. For example, a company produces two sets of pro forma statements. One scenario assumes that a company purchases a competitor, and the other does not.
The buyer takes on more debt to finance the company purchase, changing the firm’s capital structure. A business plan that adds more debt may reduce the company’s financial health, and potential investors may question management’s financial decisions.
Management must determine if the additional cash outflows to finance debt are offset by cash inflows from the acquired business.
Every business operates with limited resources and successful companies perform analysis to determine the best use of assets.
A manufacturer can make a component part, or outsource the process to a third party. When the product is outsourced, the manufacturer must pay cash to the vendor. If the vendor can produce the part at a lower total cost, the manufacturer spends less cash on production.
Pro forma financial statements are also used to assess worst-case financial decisions.
If a company division loses money, pro forma financial reports can estimate the cost of restructuring and closing the division. Management may decide to operate at a loss until long-term liabilities, such as lease agreements, are paid in full.
Cash inflows may not cover cash outflows, but continuing operations may be more attractive than closing the division, losing all cash inflows from sales, and paying cash on a long-term lease.
The 3-statement financial model integrates three financial statements: the income statement, the balance sheet, and the statement of cash flows. The statements are used to forecast business performance using various assumptions.
Managers create pro forma statements for all three financial statements to see the full picture of a particular decision.
A business can change variables in the financial statements and assess the impact. What if the 10% increase in sales is a 5% decline? If customers pay at a slower rate than forecasted, what is the impact on cash flow?
The pro forma cash flow statement includes three categories:
The cash inflows and outflows are added to compute the net change in cash. The formula for the statement of cash flows is:
Depreciation and amortization are non-cash transactions that do not impact cash flow. If planning includes a large capital expenditure (CapEx) budget and more spending on property, plant, and equipment (PP&E), the higher depreciation expense does not impact cash.
The pro forma cash flow statement is generated using pro forma data and assumptions from the income statement and balance sheet.
The income statement and balance sheet formulas reveal how the three financial statements are connected.
The income statement is generated using this formula:
The income statement is produced for a specific period (month, quarter, etc.), and the matching accounting principle matches revenue earned with expenses incurred to grow revenue.
A multi-step income statement includes additional line items for operating expenses and cost of goods sold (COGS).
Businesses produce the balance sheet (or statement of financial position) using this formula:
The balance sheet is created on a specific date, not for a particular period. Here are the components of the balance sheet:
Note that the equity section of the balance sheet includes shareholder’s equity and retained earnings.
Here are two important connections between the financial statements:
Select ratios and statistics that you frequently use to monitor business performance. The steps below explain how the analysis moves from the income statement to the balance sheet and the statement of cash flows.
Start the process by evaluating historical financial results, and using the data from pro forma financial statements. For example, a SaaS business dependent on subscription revenue will make assumptions about churn rate and customer retention.
Assume that an owner computes the average income statement account balances for the past three years and then calculates each account balance as a percentage of total sales. For example, the cost of goods sold (cost of sales) is 30% of sales.
The owner projects $1,400,000 in annual sales, a 5% increase over the three-year average. $1,400,000 in sales is multiplied by each account’s percentage of total sales. The pro forma cost of goods sold is $1,400,000 X 30%, or $420,000.
Note that the income tax account is projected based on an expected tax rate, not as a percentage of sales.
The business owner reviews the year-end balance sheet for the last three years, and considers other factors that impact the balance sheet:
A pro forma balance sheet presents the balance sheet based on historical data next to the projected balance sheet. The cash flow statement is created using the four rules of money and the differences in balance sheet accounts (historical balance sheet vs. pro forma balance sheet):
A company eventually pays cash for an asset. The business may pay for the asset in cash at the sale or repay a loan using cash over time. If the inventory balance increased by $40,000 from the prior year, the asset account increase is recorded as a cash outflow in the statement of cash flows.
When an asset is sold, cash is received immediately after the sale is closed. If the seller allows the buyer to finance the purchase, loan payments increase the seller’s cash balance.
A new loan or issuing common stock to shareholders both produce cash inflows. When a company receives $100,000 from issuing new shares of common stock, the increase in equity is posted as a cash inflow in the statement of cash flows.
Repaying a loan or retiring common stock shares both create a cash outflow.
Each cash flow is posted as an operating, financing, or investing activity. Most cash flow statements use the indirect method to determine cash flow for operating activities.
The indirect method starts with net income and ends with cash flow from operating activities. Here’s an example:
Depreciation expense is a non-cash item, and the balance is added back to the cash flow analysis. Accounts receivable, inventory, and accounts payable are all day-to-day operating activities. The rules of money determine the dollar amounts in the cash flow statement.
Financing and investing activities use the direct method to post cash inflows and outflows. Here is a completed cash flow statement:
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The change in cash is the sum of the three cash flow activities ($12,000). The $42,000 ending cash balance is posted on the balance sheet.
Owners create business plans using different time horizons. Accountants generally define “current” as one year or less and long-term is any time period beyond one year. Financial statements record assets and liabilities as either current or long-term.
Pro forma cash flow statements are created for different purposes, depending on the period.
Cash flow statements help businesses evaluate liquidity, or the ability to generate sufficient current assets to pay all current liabilities.
Current assets include cash and other assets that convert into cash within a year. Accounts receivable balances are collected and inventory is expected to be sold within a year (in most cases). Current liabilities, such as accounts payable, must be paid within a year.
A monthly cash flow statement for the next 12 months is a useful report for liquidity. If a particular month ends with a negative cash balance, the firm must plan for a loan or some other source of capital.
Management defines medium-term and long-term financial periods.
Assume that a commercial builder is bidding on a three-year project to construct an office building. The business produces a pro forma cash flow statement based on project costs and progress payments made by the customer.
For example, assume that the customer pays 20% of the total cost when the building’s foundation is completed and inspected. The builder’s cash outflows for labor and materials are compared to the cash inflow from the payment.
Does the business have to use excess cash to finance a cash flow deficit between payments?
Lease agreements and loans may have terms of ten years or longer. Businesses can generate a pro forma cash flow statement on a retail location to compare lease payments and other costs with cash inflows from sales.
Here are some uses of pro forma cash flow statements.
Managers often consider how company finances will look at the end of the fiscal year. This projection takes the year-to-date cash flow results and adds a cash flow forecast for the remainder of the year.
This projection is particularly useful for seasonal businesses. Assume that an e-commerce company generates 50% of sales in the last two months of the calendar year. The business must spend large amounts of cash in September and October for inventory purchases.
The projection starts with year-to-date cash flows from January 1st to August 31st (the current date). Managers then project cash activity for the last four months of the year to assess cash needs.
Startups often have to raise additional capital to fund business expansion, and investors need financial statements to evaluate the company. These financial projections include cash inflows from additional capital, and cash outflows for interest payments (if funds are raised using debt).
The projections show the financial impact of raising capital.
Business owners assess a potential business purchase by reviewing the combined financial statements of both businesses. The combined cash flow statements will reveal if the acquired business increases net cash flows, or is a drain on cash balances.
Pro forma income statements have limitations, and business owners need other financial reports to make fully informed business decisions.
Pro forma cash flow statements may not be created using historical financial data. Financial information posted in the cash flow statement may be excluded in a pro forma statement. For example, a cash flow projection may reduce cash outflows for a loan, assuming that the loan can be refinanced at a lower interest rate.
Pro forma income statements do not comply with Generally Accepted Accounting Principles (GAAP). Investors, lenders, and other stakeholders rely on GAAP-based financial statements.
GAAP requires businesses to conform to the matching principle and record revenue when earned and expenses when incurred to produce income. The cash basis is a financial accounting method that posts revenue when cash is received and expenses when cash is paid.
A pro forma statement generated using cash basis accounting does not conform with GAAP.
Pro forma cash flow statements may exclude important transactions that impact company profitability. To illustrate, assume a business is closing a division and expects to pay $1 million in severance to former employees.
The pro forma cash flow statement excludes the $1 million cash outflow, assuming that the workers can be transferred to other positions in the company. If that assumption isn’t realistic, the cash flow statement is misleading.
Pro forma statements are based on assumptions, and incorrect assumptions generate misleading financial statements. The company’s 35% gross margin assumption may be too optimistic, or the tax rate assumed in the analysis is much lower than the actual tax rate.
Two factors may have a large impact on pro forma cash flow statements:
Conditions can change and make pro forma statements less useful. A weaker-than-expected economy may make a 12% sales increase unrealistic. When customer preferences change, a new product line may no longer be attractive. Higher interest rates increase borrowing costs.
As time goes on, the initial cash flow forecast may no longer be useful, due to internal and external factors. Managers can quickly update business plans using software to keep the analysis current.
Here are two additional analysis methods that may use a pro forma cash flow statement:
Managers often plan using best-case scenarios, worst-case scenarios, and other assumptions. For example, the best-case sales forecast is a 12% increase over the next year, and the worst-case is a 5% decline.
These scenarios can be run through the model to assess the impact on cash flows.
Sensitivity analysis determines how a change in one variable impacts other variables.
For example, net present value (NPV) compares the present value of cash inflows and cash outflows for a particular project or investment. If the NPV (the sum of all cash amounts) is a cash inflow, the business may decide to implement the project.
One scenario discounts cash flows at 5%, and the second scenario uses 8% for discounted cash flows. The NPV may be a net cash inflow at 5% and a net cash outflow at 8%.
The pro forma cash flow statement helps you make informed forecasting, cash management, and financing decisions. Successfully generating these models necessitates clean data; however, obtaining this level of data can require numerous hours. Leverage technology to save time.
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