Pro forma financial statements: definition, purpose, and examples

Many SMBs use financial tools to forecast business performance based on assumptions.

This post discusses pro forma financial statements and the common assumptions used to create the reports. You’ll learn some of the best practices for generating the statements and how the financial documents can improve business planning and forecasting.

Key highlights: 

• Pro forma financial statements project three different statements based on historical data and performance assumptions.
• Companies, and public companies in particular, may have to comply with regulatory requirements for pro forma statements, such as requirements from the U.S. Securities and Exchange Commission.
• Pro forma statements may exclude one-time historical transactions from the analysis, so that stakeholders can review the impact.

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Ken Boyd is a guest contributor. The views expressed are his and do not necessarily reflect the views of Rho.

What are pro forma financial statements?

Pro forma financial statements project three different statements based on historical data and performance assumptions: 

• Balance sheet
• Income statement
• Statement of cash flows

Startups, small businesses, and large companies can all benefit from generating pro forma reports for decision-making. 

In many instances, pro forma statements are for management’s internal use and do not need to conform to accounting standards. Certain companies, such as public companies, however, may have to comply with regulatory requirements (e.g., requirements from the U.S. Securities and Exchange Commission (SEC)) for pro forma statements. Make sure to check with an attorney or expert to determine if any regulatory or other requirements may apply to your business (e.g., Regulation S-X Article 11).

Pro forma statements allow management to perform a “what-if” analysis by removing one-time transactions in order to assess the financial impact. When one-time transactions are removed, financial performance trends are easier to identify.

What does "pro forma" mean?

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 regarding future periods.

Which industries use pro forma statements?

Here are several industries that generate pro forma financial statements:

Accounting

Accountants may produce both pro forma financial statements and financial statements that comply with Generally Accepted Accounting Principles (GAAP). As explained above, the pro forma statements may exclude one-time transactions from the analysis, so that stakeholders can review the impact.

Businesses 

Pro forma statements are an effective tool to analyze the effect of a large transaction. Businesses that are considering a merger, company acquisition, or raising more capital generate pro forma statements. 

Pro forma financial statements report on the balance sheet structure, profitability, and cash flow changes that a large transaction may produce. A business valuation may be based, in part, on pro forma statements.

What are the types of pro forma financial statements?

Pro forma financial statements differ, based on the time period used and the data reported in each statement.

Annual vs. interim pro forma statements

Annual pro forma statements project data for an entire year and pro forma interim financial statements are issued for a period shorter than a financial year. An interim period can be a month, a quarter, or any other period. 

Full-year pro forma projection

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.

The 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 should 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.

Pro forma income statements

Pro forma income statements are generated using this formula:

• Revenue - expenses = net income (loss) 

The income statement is produced for a specific period (month, quarter, etc.), and the matching 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). The example below includes a multi-step income statement.

Pro forma balance sheets

Businesses can produce a basic balance sheet (or statement of financial position) using this formula:

• Total assets - total liabilities = equity

The balance sheet is created on a specific date, not for a particular period. Here are the components of the balance sheet:

• Assets are resources used to generate income and sales. 
• Liabilities are amounts owed to third parties (vendors, creditors). 
• Equity is the true value of the business. If the owner sells all assets for cash and uses the cash proceeds to pay off all liabilities, any cash remaining is equity.

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:

• Cash balance: The ending cash balance in the statement of cash flows (discussed below) is equal to the cash balance in the balance sheet. 
• Net income: Net income in the income statement is posted as an increase to equity in the balance sheet. At the end of each month, all revenue and expense accounts in the income statement are adjusted to zero. The net balance after all accounts are closed is net income.

Pro forma statements of cash flow

A pro forma cash flow statement includes three categories:

• Cash flow from operating activities: Inflows and outflows from day-to-day operations, including customer payments, purchasing inventory, and processing payroll.

• Cash flow from investing activities: When the business buys or sells an asset, the cash inflow or outflow is posted as an investing activity.

• Cash flow from financing activities: This section includes cash inflows from raising capital by issuing equity or debt and cash outflows when investors are repaid.

The cash inflows and outflows are added to compute the net change in cash. The formula for the statement of cash flows is:

• The beginning cash balance plus or minus the net change in cash equals the ending cash balance.

Pro forma budget documents

A budget combines assumptions regarding revenue, expenses, and cash flows for the upcoming fiscal year. The budget also includes assumptions regarding capital expenditures, equity, and debt.

Pro forma earnings projections

Mergers, acquisitions, and other large transactions impact company earnings. A pro forma earnings projection calculates the earnings impact of a particular transaction.

Pro forma statements before a change in capital structure

Startups often have to raise additional capital to fund business expansion, and investors need financial reporting 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).

To illustrate, assume that a business takes on $5 million in long-term debt to purchase a competitor. The competitor’s high profit margins increase earnings for the combined businesses. The higher earnings more than offset the interest expense on the new long-term debt.

Pro forma invoice

Businesses that ship goods internationally should disclose details about shipments to customs officials. A pro forma invoice describes the items shipped, the shipping weight, and transport charges. 

The invoice is sent to the buyer before goods are shipped, so that customs officials can determine the duties that should be paid. A final invoice is provided to the buyer when goods are delivered.

Short-term vs. medium-term vs. long-term pro forma financial statements

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 financial statements are created for different purposes, depending on the period.

Short-term

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, should be paid within a year.

A monthly cash flow statement for the next 12 months is a useful report for liquidity analysis. If a particular month ends with a negative cash balance, the firm should plan for a loan or some other source of capital.

A short-term pro forma income statement can report on company profitability during a specific time period. 

Assume, for example, that a seasonal business decides to promote discounts on certain products to drive higher customer traffic. A pro forma income statement will report the change in profitability.

Medium-term

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. 

In this 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?

Long-term

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.

The pro forma balance sheet will post lease agreements and loans as long-term liabilities. Management can compare the debt section of the balance sheet to the total assets and total equity. 

If debt is increasing at a much faster rate than assets and equity, the company may be too heavily leveraged.

What's the purpose of a pro forma financial statement?

Managers use pro forma financial statements for a number of reasons.

Analyzing risk

Every business decision produces some level of company risk. 

Assume, for example, that an online retailer purchases a competitor based on a set of assumptions. A weaker-than-expected economy may make the sales assumptions unrealistic. If customer preferences change, the competitor’s biggest product line may no longer be attractive. 

Managers can perform “what-if” analysis using pro forma financial statements and evaluate risks.

Projecting cash flow

Revenue generates cash inflows, and expenses produce cash outflows. A pro forma income statement helps an owner with financial modeling on the cash flow statement. 

Assume a new product launch will increase revenue by 15% in the next fiscal year. Pricing is based on high demand for the product, and if the cost of sales is controlled, the company’s profitability moves higher.

The financial forecast also impacts the balance sheet and the cash flow statement. Due to higher sales, accounts receivable will increase, and cash inflows will increase as customer payments are processed. With higher cash inflows, decision-makers can avoid borrowing from a line of credit.

Scenario analysis for future planning

Pro forma financial 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 can assess the impact on revenues and expenses and decide which decision makes the most financial sense. Managers can also make assumptions about cash payments and collections to determine the impact on the monthly cash balance.

Helps with decision-making and strategic financial planning

Pro forma financial statements may also be used for these scenarios:

Adding a product line

Business owners evaluate the financial accounting impact of adding a product line. A pro forma balance sheet projects the new financial position of the company, including assets, liabilities, equity, and the required capital investment. 

When the product line is launched, inventory and accounts receivable balances will both increase. The financial information should determine the time required to recover the cash invested in additional inventory and higher accounts receivable. 

Business restructuring

Pro forma financial statements are also used to assess worst-case financial decisions. 

If a company division is losing money, pro forma reports can estimate the cost of closing the division completely. Management may decide to operate at a loss until long-term liabilities, such as lease agreements, are paid in full.

Asset and liability management

Every business operates with limited resources and successful companies perform analyses 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 should pay cash to the vendor. If the vendor can produce the part at a lower total cost, the manufacturer spends less cash on production.

Limitations of pro forma statements

Managers and other users of financial statement data need to understand the limitations of pro forma financial statements.

Not GAAP compliant

Pro forma financial statements do not comply with GAAP. Investors, lenders, and other stakeholders generally rely on GAAP financial statements, which are produced using actual financial transactions. 

For example, GAAP requires businesses to conform to the matching principle and record revenue when earned and expenses when incurred. A pro forma statement may not follow the matching principle and instead post revenue and expenses based on cash inflows and outflows.

Excludes critical information

Pro forma financial statements may exclude important transactions that impact financial results. Here are two examples:

Goodwill amortization

Goodwill is recorded when a business purchases an intangible asset or another company for more than the asset’s book value. Goodwill balances are reclassified to amortization expenses over time. A pro forma income statement may not include amortization expenses.

Stock-based compensation expenses

Businesses that provide stock-based compensation have to record expenses for the value of the compensation over time. 

Companies that provide large dollar amounts of stock-based compensation will incur expenses that should be recorded on GAAP-based income statements. Pro forma statements may exclude stock-based compensation transactions.

Based on assumptions, this includes a degree of inaccuracy by design.

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 income tax rate assumed in the analysis is much lower than the actual tax rate.

The SEC has restricted public companies from using pro forma statements due to the possibility of misleading investors

Pro forma income statements have limitations, and business owners need other financial tools to make fully informed decisions. Financial statement disclosure rules for public companies were changed after the dot-com stock declines in the late 1990s.

As tech stock prices increased in the mid to late 1990s, many investors relied on pro forma statements to make investment decisions. Among other things, the SEC has specific rules that govern how pro forma reports are created, and how they are presented to investors.

How to create the pro forma financial statements

Managers use historical financial data and assumptions to create the income statement, balance sheet, and the statement of cash flows. Pro forma statements may be created using an Excel template or other financial software tools.

Create a pro forma income statement using the percent of sales forecasting method

Modern Brands is a CPG company whose owner is building a pro forma income statement for 2025. Here are the steps required to create the pro forma statement using average income statement balances for the past three years.

1. Project the variables with a stable sales relationship

Modern computes the three-year average for the income statement balances listed below. 

The owner creates a column that lists the percentage of sales for all of the income statement balances except for taxes. The company knows it will pay a 30% tax rate on the average earnings; the 30% is not a percentage of sales. Finally, the owner estimates 2025 sales to be $1,350,000.

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2. Calculate pro forma gross profit

Gross profit is calculated as (sales less cost of goods sold). Cost of goods sold (COGS) includes costs directly related to producing the product or service. Direct labor and direct materials are posted to the cost of goods sold. 

• Cost of goods sold = $1,350,000 X 30.8% = $416,250
• Gross profit = $1,350,000 - $416,250 = $933,750

Gross profit can also be calculated as $1,350,000 X 69.2% = $933,750

3. Calculate pro forma total operating expenses

Operating expenses are costs that are not directly related to production. These costs include advertising and marketing costs, rent, utilities, and administrative costs. Depreciation and amortization are also operating expenses but are often separately listed in the income statement.

• Operating expenses = $1,350,000 X 31.7% = $427,500
• Depreciation and amortization expenses  = $1,350,000 X 3.8% = $50,625

4. Calculate pro forma net income before interest and taxes 

Net income before interest and taxes (EBIT) is calculated as gross profit less operating expenses and depreciation and amortization expenses:

• EBIT = $933,750 gross profit - $427,500 operating expenses - $50,625 depreciation and amortization expenses = $455,625

• Interest expense = $1,350,000 X 1.8% = $23,625

• Earnings before taxes = $455,625 EBIT - $23,625 interest expense = $432,000

5. Calculate pro forma taxes

The tax rate is 30% and is not stated as a percentage of sales.

Taxes = $432,000 earnings before taxes X 30% = $129,600

6. Calculate pro forma net income after taxes

Net income after taxes = $432,000 earnings before taxes - $129,600 taxes = $302,400

Forecasting the balance sheet

The business owner reviews the year-end balance sheet for the last three years, and considers other factors that impact the balance sheet:

• Higher cash balance: Due to higher projected sales, accounts receivable increase. Cash inflows will increase as more customer payments are processed. 

• Accounts receivable turnover: This ratio measures how quickly a small business collects cash from credit sales. The accounts receivable turnover ratio is (net credit sales) / (average accounts receivable), and is often used in pro forma analysis. This article explains why the ratio is important.

• Accounts payable turnover ratio: The AP turnover ratio measures how quickly a business pays for supplier purchases, and is also used to forecast the balance sheet. The accounts payable turnover ratio is (net credit purchases) / (average accounts payable). You can read more about the ratio in this article.

• Less short-term debt: With higher cash inflows, decision-makers can avoid borrowing from a line of credit (LOC). Loan payments due within a year are current liabilities, and higher cash collections can reduce short-term borrowing costs.

• Capital expenditures (CapX): If the business is expanding or needs to replace IT equipment and other fixed assets, the company makes assumptions about financing purchases. Fixed asset balances will increase in the balance sheet.

• Long-term debt: The firm may use a combination of available cash and debt financing for CapX. Businesses that need to conserve cash may finance all CapX purchases, increasing long-term debt.

Here is the pro forma balance sheet for 12/31/25:

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Generate the cash flow statement using the rules of money

The pro forma 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 above): 

An increase in assets generates a cash outflow

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.

A decrease in assets generates a cash inflow.

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. 

An increase in liabilities and equity generates a cash inflow

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.

A decrease in liabilities and equity generates a cash outflow

Repaying a loan and retiring common stock shares both create a cash outflow.

Each cash flow is posted as an operating, financing, or investing activity. Here is Modern Brands’ pro forma statement of cash flows:

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The change in cash is the sum of the three cash flow activities ($70,000). The $110,000 ending cash balance is posted on the balance sheet.

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What is a pro forma 3-statement financial model?

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 changed to a 5% decline? If customers pay at a slower rate than forecasted, what is the impact on cash flow? Pro forma statements reveal the financial impact.

How to use pro forma statements in financial analysis

Once the pro forma financial statements are created, managers can perform several types of financial analysis.

Scenario analysis

Managers often plan using best-case scenarios, worst-case scenarios, and other assumptions. For example, the best-case current asset 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 the financial statements. 

Sensitivity analysis

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 transactions) is a cash inflow, the business may decide to implement the project.

Assume that one scenario discounts cash flows at 5%, and the second scenario uses 8% for discounted cash flows. The discount rate has an impact on whether or not the project is implemented. The NPV may be a net cash inflow at 5% and a net cash outflow at 8%. 

Risk analysis

As mentioned above, pro forma financial statements are used to assess various types of risk. Will a company acquisition increase total profits and cash inflows? If the business takes on long-term debt to launch a new product line, can the firm cash flow the debt payments?

Wrap-Up: All about the pro forma cash flow statement

The pro forma financial statements help 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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Ken Boyd is a guest contributor. The views expressed are his and do not necessarily reflect the views of Rho.

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