How to Construct Pro Forma Financials
Pro Forma financial statements are prepared to project potential future financial results of a new business venture or major business transaction. They help managers and potential investors evaluate new business ventures or new strategic initiatives as potential investments. The pro forma financial statements are meant to simulate results and although a lot of speculation goes into there creation, they should be based on reliable and quantifiable facts and estimates. The proforma financial statements are usually made for several years (five) into the future to show potential growth of the business over time.
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Instructions
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Build your pro forma financial statements from the ground up beginning with a market analysis. This will tell you if there is a market for your product worth pursuing, how large the market is, who your competition is, how to compete in the market and how much of the market you can expect to capture for your business. Once you have the market information and decide to go forward, you can start to develop your pro forma numbers.
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Project your sales volume first, then determine the costs of providing your product or service. Next, determine the price you will charge for the product or service. The price must be high enough to cover the costs and generate a profit, but it also must be competitive. Once you have determined your price, return to the market analysis and verify that you can compete at that price. If yes and you decide to move forward, it is time to start building your pro forma financial statements. If no and you are unable to cut your price to a competitive level because of cost constraints, you will be wasting your time moving forward.
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Project sales revenue for the next five years using an assumption of a percentage growth derived from the market analysis. For example, your market research may indicate a 10 percent growth in sales volume per year for the next five years, and other research shows that costs will increase 7 percent per year over the next five years, giving you a bottom line increase of 3 percent per year for the next five years. You know what your costs are from earlier planning and research, so now you can prepare your pro forma financial statements.
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Begin setting up the pro forma financial statements with the income statements, then the statements of cash flows and then the balance sheets (remember you are preparing them for five years into the future). The statement of cash flows will be most important to potential investors; it ties the balance sheet and the income statement together, but more importantly, it shows the cash coming into and going out of the business, and how it is being used.
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Set up your pro forma financial statements in an Excel workbook or something similar so that different business scenarios can be tested by changing some of the numbers. Remember that potential investors will be most interested in earnings before interest, taxes, depreciation and amortization (EBITDA). EBITDA provides a clearer picture of the core business and how the business functions internally. Potential investors want to make sure that the core business is sound and that you have a thorough understanding of how that core business should function.
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