For business owners, making decisions about business operations and the company’s trajectory can be exciting, but it also comes with uncertainty. For example, say your company wants to expand and is considering purchasing land for a new manufacturing facility. Or your company is considering refinancing debt in response to low interest rates. Whatever the business transaction, some uncertainty can be mitigated by preparing a hypothetical future budget, or pro forma financial statement. A pro forma is a financial statement written as you anticipate things will look at some point in the future. Unlike a typical financial statement that is based on actual past transactions, a pro forma is based on real information as well as good faith assumptions and projections. A well-prepared pro forma provides guidance and helps business owners avoid risky transactions that could land the company in the red. It can also show the likely results of expanding into new markets or reducing expenses by even just one percent.
Preparing a Pro Forma
Preparing a pro forma consists of two general steps. First, the company’s previous year’s actual revenue serves as a benchmark for projecting each of the next, say, three years of revenue. The projected changes in revenue are based on factors like market demand, changes in prices, or expanding locations to reach more customers. Next, expenses such as loans, employee compensation, overhead, taxes, and raw materials are projected for those three years as well. If the purpose of the forma is to determine whether adding a second retail location pencils out, for example, expenses such as hiring new employees along with the cost of the lease would be added here. The expenses are then deducted from the revenue to show the projected profit or loss. With this information at your fingertips, you can play out various hypotheticals on paper before actually moving forward with any real changes. Perhaps the numbers reveal that adding two locations is more profitable than just one, due to economies of scale. Or perhaps the numbers reveal it doesn’t make financial sense to add any new locations until the cost of raw materials goes down. This illustrates how valuable preparing a pro forma in advance of a financial transaction really is.
Due Diligence
Maybe you’re on the other side of the table and are considering a merger or acquisition of a company. How can you be sure that company’s pro forma follows generally accepted accounting principles (GAAP) and is based on accurate assumptions and projections? The U.S. Securities and Exchange Commission requires publicly-traded companies to adhere to GAAP accounting methods in preparing financial documents, but privately-held companies are not held to those same standards. Involving an attorney during the due diligence phase of a large transaction such as an acquisition is crucial to ensuring the entity’s pro forma is accurate and compliant.
Leading a company inevitably involves taking risks, but those risks can be mitigated in part by careful preparation or review (depending on which side of the transaction you fall) of pro forma financial statements. Let us ensure your projections are both compliant and as accurate as possible so you can move forward with confidence with your informed business strategy.
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