The Small Business Owner’s Guide To Understanding Pro Forma Budgets
The Bank of America 2021 Small Business Owner Report reveals that 60% of smaller companies expect their revenues to increase in 2021. The nationwide financial institution’s findings came from a March 2021 survey of almost 1,000 business owners across the United States.
Pro forma budgets and pro forma financial statements are important planning tools that can help business owners prepare for future growth. These statements enable business owners to make decisions based on “what if” scenarios. Owners can compare the financial predictions in their pro forma statements with actual results.
In this article, we’ll take a look at what pro format budgets and financial statements are and how they can benefit your small business.
Let’s dive in.
What Does Pro Forma Mean?
The phrase “pro forma” is a Latin term that literally means “as a matter of form.” The phrase “sake of form” also means the same thing. Pro forma financial projections show how specific conditions can affect a small business during a certain period.
Businesses often utilize pro forma statements as internal decision-making tools. These statements also provide useful financial information to shareholders, creditors, and investors.
Pro forma statements do not utilize Generally Accepted Accounting Principles (or GAAP) in their computations. These financial statements often delete one-time expenses not incurred in standard company operations.
Because of these discrepancies, the Securities and Exchange Commission (or SEC) requires that pro forma statements utilize standard creation and reporting formats. The SEC also requires businesses to present the most comparable financial statement based on GAAP.
What Are Pro Forma Financial Statements?
Pro forma financial statements are targeted financial reports based on certain assumptions. A business owner may create a pro forma income statement, a pro forma cash flow statement, or a pro forma balance sheet. Often shown on an Excel spreadsheet, each financial forecast measures the company’s predicted financial health differently.
Functions of Pro Forma Financial Statements
Business owners utilize pro forma financial statements to gauge a product’s profitability. This financial modeling vehicle also shows how major business decisions can affect the company’s bottom line.
Commercial lenders make loan decisions based on past years’ financial statements and pro forma financial reports. Potential investors often require a pro forma income statement to evaluate a company’s ability to produce higher sales and profits.
A new business should generate an initial set of pro forma financial statements. Looking ahead, the small business owner should prepare monthly and annual financial projections. The reports should correspond to the company’s fiscal year or calendar year accounting structure.
What Is a Pro Forma Budget?
A pro forma budget is a projected budget based on “what if” scenarios. Maybe your company is considering changes to its operating structure. Or perhaps, an economic downturn is predicted to reduce demand for your leading product. A pro forma budget will show how each change can affect your company’s financial results.
Pro forma budgets also demonstrate the financial effects of revised operational variables. A pro forma budget can reflect changes to your company’s revenues, operating expenses, or profits.
Finally, your company may be planning to obtain a loan, make a capital investment, or purchase a real estate property. Perhaps you want to attract potential investors or complete a merger. A pro forma budget will demonstrate each action’s expected financial effects.
Benefits of Pro Forma Budgets
A pro forma budget provides business owners with three major benefits. By making financial projections about market or product demand, you can better plan for your company’s future. Lenders may also require a pro forma budget as documentation for a loan or line of credit.
Maybe you are considering a merger, acquisition, or sale. A pro forma budget will show how that change can affect your company’s financial picture.
The accuracy of a pro forma budget may be affected by new technology, sudden labor market changes, or other external factors. Despite these unexpected disruptions, a pro forma budget can help you make operational decisions. The pro forma budget can also serve as a longer-term business plan tool.
Pro Forma Budget vs Pro Forma Financial Statement
Businesses frequently create financial statements showing monthly, quarterly, or yearly operational results. Based on this financial accounting data, the company formulates its operational budgets.
Pro forma financial statements and pro forma budgets are similar. First, the company generates projected financial statements based on certain assumptions. Next, the business creates budgets based on those projections.
Actual results may be better or worse than the projections. There’s even a chance that worst-case scenarios can occur.
Common Pro Forma Financial Statements
Companies commonly utilize three types of pro forma financial statements. Each statement resembles its standard financial statement counterpart.
1. Pro Forma Income Statements
A pro forma income statement shows how profitable a company expects to be over the next year. The report displays the business’ projected sales (or gross income) minus the cost of goods sold and operating expenses. The company’s net income is the result of this calculation.
Following are five common pro forma income statement categories. Changing each category’s data produces a different overall result:
- Sales
- Cost of goods sold (materials and labor costs)
- Gross profit (sales minus cost of goods sold)
- Operating expenses (overhead expenses)
- Net income (gross profit minus operating expenses)
2. Pro Forma Cash Flow Statements
A pro forma cash flow statement shows the amount of cash you predict to have on hand during a future period. Along with a standard cash flow statement, these statements are useful if your company uses the accrual accounting method.
In an accrual accounting structure, you record income and expenses when you incur them. Conversely, a cash-based accounting system records these items only when you receive income or pay money to other entities.
3. Pro Forma Balance Sheets
A pro forma balance sheet provides a projected snapshot of your company’s financial position at a future point. This financial statement resembles a standard balance sheet containing actual values of the major categories.
A pro forma balance sheet and standard balance sheet are based on a central equation:
Assets = Liabilities + Owner’s Equity
- Assets (items the company owns, including accounts receivable)
- Liabilities (total liabilities or debts, including interest payments)
- Owner’s equity (funds remaining after subtracting liabilities from assets)
How to Create Pro Forma Financial Statements Using a Template
You can create each pro forma financial statement with a template. Before you begin, gather all documentation to save time and avoid confusion.
Pro Forma Income Statement
Create a pro forma income statement by following five steps. Review the United States Small Business Administration’s income statement template for guidance.
- Analyze your previous year’s business income statement.
- Compare this year’s to-date sales with last year’s total sales. Determine the percentage change of this year’s sales compared to the previous year’s revenue.
- Use the percentage change in sales to create a pro forma income statement.
- Review the pro forma statement to test your assumptions. Adjust specific variables if necessary.
- Create a new pro forma income statement for each assumption.
Pro Forma Cash Flow Statement
Prepare your pro forma cash flow statement the same way you would prepare a standard cash flow statement. The pro forma cash flow statement will show how you plan to use the funds.
This statement will also show how much money you expect to have on hand at any time. A negative cash flow means you’ll lack the funds needed to operate your business. A positive cash flow shows a monetary surplus.
Follow these steps to create a pro forma cash flow statement. View the template for a sample cash flow statement.
- Obtain relevant data from your income statement.
- Choose the indirect method or the direct method based on your needs. The indirect method is usually simpler and faster. However, the direct method provides more important details about your business’ cash situation.
- Follow the steps of your chosen method to create the pro forma cash flow statement.
Pro Forma Balance Sheet
To create a pro forma balance sheet, extract relevant data from your income statement and cash flow statement. Refer to previous balance sheets for a more complete picture of your business operations. View the template for a sample pro forma balance sheet.
- Determine your current cash assets and the accounts receivable.
- Add your long-term assets.
- Calculate your total assets by adding the numbers from Step 1 and Step 2.
- Record each of your business liabilities.
- Determine your total liabilities by adding all your liabilities together.
Subtract the liabilities from the assets. This figure summarizes your business’ financial health.
Moving Toward Cost-Effective Business Operations
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FAQs About Pro Forma Budgets
Q: What is a pro forma budget?
A pro forma budget is a financial forecast or projection that estimates future income, expenses, and cash flows. It serves as a planning tool to anticipate and evaluate the financial performance of a business or project. It provides a forward-looking view to aid in decision-making and setting financial goals.
Q: Why is a pro forma budget important?
A pro forma budget is important because it helps businesses and individuals anticipate and plan for future financial outcomes. It allows for strategic decision-making, identifies potential financial gaps or risks, and provides a benchmark for tracking actual performance against projected goals.
Q: How do I create a pro forma budget?
To create a pro forma budget, start by gathering historical financial data, such as past income statements and cash flow statements. Then, make assumptions and projections for future revenues and expenses based on factors like market trends, sales forecasts, cost estimates, and anticipated changes. Use financial modeling techniques or spreadsheet software to organize and calculate the projected figures.
Q: What should I include in a pro forma budget?
A pro forma budget should include anticipated revenues, such as sales income or funding sources, as well as projected expenses, including operating costs, marketing expenses, and capital investments. It should also incorporate factors like taxes, interest, depreciation, and amortization. Additionally, consider including cash flow projections to assess the availability of funds over time.
Q: How often should I update my pro forma budget?
It is recommended to update your pro forma budget regularly to reflect changing circumstances and new information. The frequency of updates depends on the nature of your business or project. Generally, it is advisable to review and revise the budget on a monthly, quarterly, or annual basis, or whenever significant changes occur in the business environment.