Pro forma income statement: definition, purpose, and examples
Learn how to create a pro forma income statement and why the report is an important financial planning tool.
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1 minute
August 5, 2024
Successful SMBs use financial tools to forecast business performance based on assumptions.
This post defines the pro forma income statement and the common assumptions used. You’ll learn the best practices for generating the statement and how this financial tool can improve business forecasting.
Key highlights:
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A pro forma income statement is a projection of an income statement based on historical data and performance assumptions. Startups, small businesses, and large companies can all benefit from generating pro forma reports for decision-making.
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 income statement is 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).
An income statement is based on actual company data, and a pro forma income statement is based on assumptions. When businesses close the month-end books, each revenue and expense account is reconciled, and the account balance is posted to the income statement.
Businesses also create a pro forma balance sheet and a pro forma cash flow statement. These three types of pro forma financial statements are used to generate financial projections and make business decisions regarding future periods.
A pro forma balance sheet presents total assets, total liabilities, and equity balances. A pro forma projection for cash flows lists cash transactions for operations, financing, and investing activities.
Standard 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.
Pro forma statements are created using Excel or other financial software tools.
Standard 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 $1,400,000.
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.
Gross profit can also be calculated as $1,400,000 X 69.2% = $968,333
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.
Net income before interest and taxes (EBIT) is calculated as gross profit less operating expenses and depreciation and amortization expenses:
The tax rate is 30% and is not stated as a percentage of sales.
Taxes = $448,000 earnings before taxes X 30% = $134,400
Net income after taxes = $448,000 earnings before taxes - $134,400 taxes = $313,600
Pro forma income statements are a useful tool for financial analysis. Here are several reasons why:
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.
Pro forma income 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.
Pro forma financial statements may also be used for these scenarios:
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.
Businesses should use current assets to launch a product line, and inventory and accounts receivable balances may increase. The financial information should determine the time period required to recover the product launch cost.
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.
The Securities and Exchange Commission (SEC) has specific disclosure requirements for businesses that issue securities to the public, including pro forma financial statements.
Companies should follow disclosure requirements for financial reports, financial ratio analysis, and templates used in the company’s annual report.
Pro forma income statements have limitations, and business owners need other financial tools to make fully informed decisions.
Pro forma income statements are not created using historical financial data. Information posted in the income statement may be excluded in a pro forma statement. For example, a pro forma report does not include an accounting adjustment posted to correct a prior period error.
A business valuation analysis should clearly state if pro forma financial statements are used.
Pro forma income statements do not comply with Generally Accepted Accounting Principles (GAAP). Investors, lenders, and other stakeholders rely on GAAP financial statements.
GAAP requires businesses to conform to the matching principle and record revenue when earned and expenses when incurred to produce income. A pro forma statement may not follow the matching principle and post revenue and expenses based on cash flow changes.
Pro forma income statements may exclude important transactions that impact company profitability. Here are two examples:
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 expense over time. A pro forma statement may not include amortization 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 must be recorded on the income statement.
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.
Here are some key points regarding the pro forma income statement.
Pro forma statements are not created using actual accounting data. The statements do not comply with GAAP accounting standards and may exclude transactions posted to the income statement.
A pro forma income statement is a projection based on historical data and performance assumptions. Pro forma statements are often generated based on an account’s percentage of prior year sales or revenue.
Pro forma income statements are not used to report actual financial performance. Pro forma statements are not audited.
Pro forma income statements are not required. They are used by management to project financial results based on assumptions.
The pro forma income 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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