Creating 5-Year Pro Forma Financial Statements: A Step-By-Step Guide
Money talks, but numbers tell stories. In the case of 5-year pro forma financial statements, those numbers spin a tale of your business’s potential growth, challenges, and triumphs.
A 5-year pro forma is a financial forecast that shows how a business might perform over the next few years, in terms of future sales and cash flows. It’s a way to peek into your company’s future, plan for what’s ahead, and show investors your company’s potential.
In this guide, you’ll learn all about 5-year pro forma financial statements. We’ll cover what they are, why they’re important, and how to create one for your business to give you the tools to map the company’s future.
What Does “Pro Forma” Mean?
“Pro forma,” meaning “for the sake of form” or “as a matter of form” in Latin, applies to financial statements and numbers based on assumptions or projections about the future.
Regular financial statements show what actually happened in the past. They’re based on historical data: real numbers from your business’s past performance. Pro forma statements look ahead. They use educated guesses about what might happen in the future. These guesses are based on trends, plans, and expert knowledge about the business and your industry.
5-Year Pro Forma Use Cases
Pro forma statements come in handy for a variety of reasons. Let’s take a look at five of the most common use cases:
- Pro Forma Budget. A pro forma budget shows your predictions for cash inflows and outflows over a set period of time—in this case, 5 years.
- Pro Forma Earnings Projections. When a business wants to show investors how financial changes might play out, they use pro forma earnings projections. Financial changes might include expanding into a new market or investing in new equipment.
- Pro Forma Financial Accounting. Sometimes, businesses want to show their earnings without including less common or one-off events. Pro forma financial accounting leaves these events out to paint a clearer picture of the company’s regular, day-to-day financials.
- Pro Forma Managerial Accounting. Before making a big move like opening a new store or launching a new product, managers use pro forma statements to predict what might happen if the change goes through.
- Pro Forma Financial Statements. These are the big picture pro forma documents. They include things like income statements, balance sheets, and cash flow statements. They differ from standard financial statements by projecting into the future instead of investigating the past.
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Reasons To Use Pro Forma Financial Statements
Here are some of the key reasons why you might want to create these forward-looking financial snapshots:
- Attracting Investors. Pro forma statements show potential investors what your business might look like in the future. Investors get a sneak peek of your business’s potential, which helps them decide whether they want to invest.
- Preparing for the Future. These statements help you plan ahead. For example, if you’re thinking about opening a second location or launching a new product line, 5-year pro forma statements can help you see how these changes might affect your finances.
- Making Smarter Business Decisions. By creating different “what if” scenarios, you can compare potential outcomes of different business moves. This helps you choose the path that’s best for your business.
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Limitations of Pro Forma Financial Statements
Pro forma statements can be powerful for planning, but there are some drawbacks to keep in mind. These include:
- Not GAAP Compliant. Pro forma statements don’t follow Generally Accepted Accounting Principles (GAAP), the standard rules for financial reporting. This means they vary widely from one business to another, making them harder to compare.
- Based on Assumptions. These statements rely on educated guesses about the future. If these assumptions turn out to be wrong, the pro forma statements won’t be accurate.
- Potential To Mislead. Some businesses might be tempted to paint an overly rosy picture of their financial future. That’s why it’s critical to be realistic and honest when creating these statements. If you’re too optimistic with these, you won’t be prepared for the future.
- Management Bias. It’s easy for your own hopes or fears about your business’s future to influence the numbers. This can lead to overly optimistic or pessimistic financial projections.
How To Create a Pro Forma Income Statement
A pro forma income statement projects your business’s future earnings. It shows potential income based on anticipated changes. These include things like revenue, expenses, and other factors.
Here are the steps:
- Set a Sales Goal. Decide how much you want to sell in the future. For example, imagine you own a bakery aiming to sell $5,000 worth of vegan products in the first month.
- Plan Your Production. Figure out how much you need to make to reach your sales goal. The bakery might need to bake 1,000 vegan items to hit your $5,000 target.
- Develop Your Strategy. Think about what you need to do to meet your production goals. The bakery might need to buy new equipment or hire a part-time baker.
- Calculate Your Costs. Estimate how much it will cost to make your products. This is called the “cost of goods sold.” For the bakery, this might include the added cost of vegan ingredients and packaging.
- Prepare the Statement. Put all this information together into a 5-year pro forma income statement. Show your expected sales, subtract your costs, and you’ll see your projected profit for the term.
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How To Create a Pro Forma Balance Sheet
A balance sheet shows how much your business owns, owes, and has invested into it. A 5-year pro forma balance sheet projects these figures into the future, helping your business plan for growth or major changes.
Here’s how to create one:
- Project Assets. Estimate what your business will own in the future. For example, let’s say you own a local coffee shop planning to open a second location. You might project increased cash from sales, spending on new equipment for the second location, and more inventory.
- Estimate Liabilities. Forecast what your business will owe. This might include a new loan for the second location and increased accounts payable for more supplies.
- Update Equity. Show changes in the owners’ stake in the business. This might include investing more money or retaining some profits in the business for growth.
- Balance the Sheet. Make sure your projected assets equal your liabilities plus equity. If they don’t balance, double-check your numbers.
- Prepare the Statement. Combine your projections into a 5-year pro forma balance sheet. For the coffee shop, this would show the increased assets from the new location. It would also show any new liabilities and changes in equity.
How To Create a Pro Forma Cash Flow Statement
A standard cash flow statement shows how money moves in and out of a business. A pro forma cash flow statement predicts these money movements for the future. This helps businesses plan for upcoming expenses and investments.
Here’s how to put a pro forma cash flow statement together:
- Estimate Cash Inflows. Project money coming into the business. For example, suppose you own a small landscaping company planning to buy new equipment for snow removal services. You can expect increased revenue from these additional services. But you might also need to factor in a small business loan for the new equipment.
- Estimate Cash Outflows. Forecast money going out. This might include loan payments, extra wages for winter staff, and ongoing expenses like fuel and maintenance.
- Calculate Net Cash Flow. Subtract the money going out from the money coming in. This shows whether your company will have extra cash or you’ll be short.
- Break Down Cash Flow by Activities. Separate your cash flows into three types: operating, investing, and financing. Operating cash flow includes money from your daily business activities, like landscaping service fees and regular expenses. Investing cash flow covers long-term purchases, like the new snow removal equipment. Financing cash flow involves money from loans or investments, like the small business loan for the new equipment.
- Prepare the Statement. Create your 5-year pro forma cash flow statement using all your projections. For the landscaping company, this would show expected cash from the new snow removal service, money spent on new equipment, and cash from the business loan. This statement gives you a clear picture of how cash might move through your business five years out.
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3 Tips for Creating Pro Forma Financial Statements
Creating useful pro forma financial statements takes skill and experience, but these tips will help you make more accurate projections right off the bat:
- Set Clear Goals. Know what you’re trying to achieve with your projections. Are you planning for growth, considering a new product, or preparing for a loan application? Your goals will guide your estimates and the types of financial statements you create.
- Use Realistic Estimates. Be honest about your business’s potential. It’s tempting to be optimistic, but unrealistic financial projections lead to poor decisions. Base your estimates on past performance and solid market research.
- Stay Up-to-Date. Your projections aren’t set in stone. Review and update them regularly as you get new information or your business situation changes.
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