Proforma Financial Statements
In Ralph Estes's Dictionary of Accounting (MIT, Cambridge, 1981, p. 105), a proforma financial statement is defined as "a financial statement prepared on the basis of some assumed events and transactions that have not yet occurred." Historical financial statements are used to measure an organization's past financial performance and condition. Without historical financial statements, financial analysis and evaluation would not be possible and management, board members, investors, and customers would be largely in the dark about how well an organization has done. Proforma financial statements are similar to historical financial statements in appearance and use, except that they focus on the future instead of the past and are based upon assumptions rather than hard fact. Historical statements should be real, solid, and scientific, while proforma statements allow management to exercise a certain amount of creativity and flexibility. Proforma statements reflect a dynamic environment in which change is still possible and a variety of different alternatives can be followed. They take the same forms as historical statements, the most common being the income statement, the balance sheet, and the statement of changes in financial position.
Proforma statements are used for a full range of financial analysis and should be created at the beginning of every financial planning cycle or whenever an organization is considering a step that could have a significant financial impact. They are often examined when a company is contemplating a merger, new financing (debt, stock, institutional subsidy, or external grant), capital investment in plant or other fixed assets, expanding production, launching a new product line, or any other situation with important financial implications. A university press most often uses proforma statements in connection with its annual operating budget and long-term financial planning process. Budgets and multiyear financial plans usually contain proforma income statements and balance sheets to summarize financial performance for given time periods and financial conditions for given dates.
The construction of proforma statements is based upon detailed financial projections and the historical relationships between different income statements and balance sheet accounts. A set of current financials serve as the foundation on which the proforma will be built. Alongside proforma statements, actual statements from previous periods will often be shown for easier comparison and analysis. The current financials are used as a starting point to which adjustments are made to reflect the financial transactions forecast for the time covered by the proforma. Before putting together a proforma income statement, it is important to have complete sales and other income forecasts as well as complete projections of manufacturing costs, royalties, freight-in, title subsidies, salaries and benefits, operating expenses, interest expense, etc. After completing the proforma income statement and its supporting forecasts (including a cash flow projection), it becomes possible to construct the balance sheet. To do this, forecast activity for the period is added or subtracted to the current account balances. For instance, to calculate proforma end-of-the-year balances for accounts receivable, inventory, and fixed assets, the following adjustments are made:
Actual inventory 6/30/1996 $1,000,000
+ Projected manufacturing purchases 1,200,000
- Projected inventory writedown (150,000)
- Projected manufacturing cost of sales (750,000)
- Projected manufacturing cost of frees (50,000)
Projected inventory 6/30/1997 $1,250,000
Actual accounts receivable 6/30/1996 $500,000
+ projected billings 2,500,000
- projected payments against AR (2,350,000)
Projected accounts receivable 6/30/1997 $650,000
Actual furniture and equipment 6/30/1996 $350,000
+ Projected F & E purchases 45,000
- Projected depreciation $(35,000)
Projected furniture and equipment 6/30/1997 $360,000
In this way, all of the accounts of the proforma balance sheet can be estimated with the exception of cash, which becomes the final and forced or balancing entry.
A quicker but often less accurate method of projecting a proforma balance sheet involves using the historical relationships between different financial statement items to calculate the proforma account balances. For example, if accounts receivable at year-end are typically 20 percent of annual sales billings and the new fiscal year's forecast of invoiced sales is $2,500,000, then the projected fiscal year-end accounts receivable balance is $500,000. The problem with this approach is that it ignores timing differences. If you are going to have a very late list or plan to publish a blockbuster just before year-end, then the normal year-end historical relationship between annual sales volume and accounts receivable will not hold. Accounts receivable will be higher than normal as a percent of sales billings. A complete balance sheet can be put together using this method, but you should be aware of its shortfalls.
Once the proforma balance sheet is completed, it becomes possible to make a proforma statement of changes in financial position by calculating the changes in specific balance sheet accounts, considering the effects of proforma income statement items that will not use cash (for example, depreciation), and taking into account uses of cash that are not reflected in the income statement (for example, repayment of debt).
Remember, proforma income statements are active planning tools. If analysis of your proformas indicates that problems lie ahead, there should still be time to make adjustments and to improve your press's financial performance.