What Is a Pro Forma Income Statement? - The Full Guide

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No matter what your business is, there are going to be some technical and confusing aspects to it. Normally, these come up in what your business actually does, for example, if you were an engineering firm, you would need to know about the machinery you use and the safest way to use it.

However, there is one area where all businesses need to have a level of expertise, even if it comes from hiring someone not affiliated with your business's industry whatsoever. We are talking about accounting. If you have a business, you need someone to manage its finances.

The financial aspect of any business is a bit of a quagmire, and there are terms and forms that seem necessary and incomprehensible at the same time. Like a pro forma income statement. Most people know what an income statement is, but what is a pro forma income statement? Is it incredibly different? Is it even necessary to my business?

In this article, we seek to find this out.

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What Is a Pro Forma Income Statement?

While an income statement is normally a financial statement that serves as a baseline for your company’s performance, a pro forma income statement is slightly different. It is a potential income statement, otherwise known as a ‘projected income statement’, that removes several financial aspects or inputs to see what the business’ adjusted income would be without them.

A normal income statement will give you an idea of the revenue and expenses your company has had in the past year, while a pro forma income statement will give you an idea of the effect those revenues and expenses are having on your business.

For example, if you are a large food distribution service to supermarkets that is using contracted HGVs to deliver your product, you may draw up a pro forma income statement to determine how much more or less it would cost your business to just employ salaried HGV drivers with your own trucks.

It isn’t foolproof, but pro forma income statements can really help determine the impact something may have on your business before you make a critical decision.

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Why Would You Need a Pro Forma Income Statement?

A pro forma income statement is incredibly important and is used when a business needs to make sound financial decisions. These decisions can be due to external pressures, such as debts being called upon, or internal pressures, such as a slowing down of growth, but once a pressure has exerted itself upon your business, it needs to be dealt with.

Dealing with it quickly without consideration is a risky move that could destroy a business, as such a pro forma statement is normally drawn up to make calculated decisions or risks.

In these situations, you will want to know if you’re on track to meet your financial goals for a certain period of time and the risks you take from not meeting them, as well as areas that need higher budgets in your business and those that need to have their budget cut.

These statements don’t just cover the basics of potential finances, they go in depth as well. Let’s take that food delivery business idea again. The pro forma wouldn’t just consider the cost in breaking the contract with the HGVs and hiring of new drivers. It would take into account the cost of the trucks, their maintenance, food storage within the trucks, food storage within your business, the hiring of HGV managers and logicians, and so on. It would consider every possible avenue and how it would cost you.

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Who Uses Pro Forma Income Statements?

Pro forma income statements can be used by any business, but it is mostly used by business owners, accountants within the business, and hired outside consultants. These groups use these statements normally for four different reasons:

- Give the calculated potential income to creditors and investors in said business.

- Inform employees and prospective employees of the potential health and future of the business.

- Inform and warn management of potential financial situations that may occur.

- Calculate the risks and benefits of acquiring another company.

So, as you can see, all round these statements are useful to everyone involved in the company.

 

Types of Pro Forma Income Statements

There are generally two types of pro forma statements: historical pro forma statements and projected pro forma statements.

Historical pro forma statements act basically like company hindsight. When a company makes a decision and the long term effects are only seen and felt when they occur much later, the company’s accountants may be tasked with looking back and adjusting statements to see what could have occurred if they had done things differently.

It may seem a little late to do this, but it can help companies in making informed decisions in the future and seeing that they don’t make the same mistakes that they once did.

Projected pro forma statements are statements that aid in future financial decisions. These are the most common pro forma statements and the ones we have spent the majority of this article talking about. They help the company decide which direction to take while minimizing losses.

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Cons of Pro Forma Income Statements

Pro forma income statements can be very useful in showing you how profitable your company is. This can help you decide if you need to increase salaries or invest in new equipment. They can also help with understanding which direction a market is heading in and so a company can adjust accordingly.

However, pro forma income statements are not perfect, and there are some factors that can make them inaccurate. The main problem is that a company might not have the same revenue and expenses in each period. The problem with this is that you have no way of knowing if your company is expanding, decreasing, or staying the same.

Another problem is that if the management is under pressure or unwilling to divulge their data, the data may be manipulated in order to make it appear appealing to investors. Eventually, the truth will be revealed to those investors and trust in the company will plummet.

Finally, a pro forma income statement is weak to fads. If something is taking off now, then a pro forma will show this and the company may align their financial future with this information. However, if this turns out to be a fad that lasts a year, it may mean that a company's finances become ruined thanks to following this informational red herring.

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Conclusion

In this article, we have tried to explain what is a pro forma income statement and why you would need it. We have also discussed the types of pro forma income statements and their cons. We hope that after reading this article, you will have a better understanding of what a pro forma income statement is.

You can also use pay stubs to help evaluate and assess your total income and revenue.

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What Is a Pro Forma Income Statement? - The Full Guide
James Wilson

After graduating from McCombs School of Business in Texas, James joined ThePayStubs as a CPA to make sure the numbers we provide our clients are correct. Read More

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