Pro forma budgets are used by most businesses and many conscientious individuals. These calculations project the income and outflow for the coming month, quarter or year. At times, conditions recommend creating multiple pro forma budgets based on potential revenue increases or decreases and/or possible changes in expenses. All projections should be based on a combination of historical information, current expectations and answers to "what if" questions.
How Are They Used?
Businesses use pro forma budgets to project the results of and "test" their plans for future periods. For example, ABC Company wants to introduce a new product next year. Based on estimated cost, selling price, number of units sold, and selling expenses, a pro forma budget based on just this product's expectations can help make go/no go and marketing decisions. Start-up businesses always need one or more pro forma budgets, income statements, balance sheets and cash flow statements to project how they might fare in the first one, two, three and five years. If new or mature businesses need loans or investment, they use pro forma budgets to justify their requests.
When Actual Results Don't Mirror Pro Forma Projections
Deviations of 10 to 15 percent, up or down in any category, should generate pro forma budget re-examination to see if changes are required. These deviations indicate that economic conditions have changed, projections were based on flawed data, or a combination of internal and external factors changed the financial landscape. When this occurs, businesses examine individual projections to update and modify their former projections. This often improves the accuracy of future projected results, helping owners to better manage the companies.
When Financing or Investment Is Desired
When a business needs additional monies from loans or investors, it injects an added element into its pro forma budget. Prior to applying to banks, credit unions or commercial lenders, the business owner estimates a monthly cost for "debt service," required interest and principal payments. If reasonable, this helps lenders look favorably on loan requests, as the pro forma budget displays sufficient cash to make monthly payments as agreed. Prospective investors have no interest in debt service. Since they are not "lending" you money, no monthly payments are needed. However, they want to learn if the projected business profit is sufficient to pay them "earnings" on their investments in the form of dividends or profit distributions. A projected reasonable return should be included in an investor-targeted pro forma budget.
Allowance for Estimated Income Taxes
A good pro forma budget should also include a reasonable "allowance" or projection of estimated income tax cost. In business accounting, "net profit before taxes" should first be projected, based on expected revenue and expenses. Estimating the applicable tax bracket for this net income level, the business can then estimate the cost of income tax liability. You can subtract the projected tax cost from before-tax net income to calculate estimated "after-tax net income." The pro forma budget is now complete, subject to possible modifications during the year to create a more accurate projection.
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