No one likes to imagine the worst-case scenario. But if you are planning a new product or service in your business, forecasting failure is necessary to demonstrate your firm can withstand a slower than projected start or an unanticipated hiccup. This is where pro forma financial statements - or financial projections - come in.
WHAT ARE PRO FORMA FINANCIAL STATEMENTS?
In Latin, pro forma means “for the sake of form.” Pro forma financial statements are financial reports prepared for the sake of illustrating the future financial state of a business with certain assumptions.
WHY ARE THEY IMPORTANT?
To an entrepreneur with a dream, pro forma financial statements are a dose of reality. This is a good thing. The act of preparing projections forces a business owner to consider all of the expenses associated with a new venture (e.g., space, personnel, start-up costs) and the impact the additional costs will have on their current business.
More importantly, pro forma financials present an opportunity to quantify not only the "home run" scenario, but also potential setbacks in the venture. They should include best, average and worst-case scenarios. Many owners take the easy road and focus exclusively on the most optimistic potential outcome. However, doing so is a lost opportunity because quantifying a worst case scenario presents a fantastic opportunity to itemize and study potential challenges and how to minimize their impact. In short, your pro forma financial statements allow you to play out the “what if” scenarios.
Pro forma financial statements should also answer the vital question - can the company absorb the financial losses if the new offering fails? Investors and potential lenders need to know the answer to that question as well. If there's one thing these stakeholders appreciate, it's forethought; so it actually instills confidence in them when a business owner acknowledges the worst can happens. If you are trying to raise capital for a new offering, a bank's confidence is the difference between acceptance or rejection.
What Should They Include?
Your financial projections should ideally include an income statement, balance sheet and statement of cash flows. While the projected timeline can vary widely depending on the circumstances, traditional approaches - such as the one detailed in this Harvard Business Review article - suggest it should include the first five-year period. The projections should include monthly income and cost estimates for the first three years, then quarterly or yearly for years four and five.
PRO FORMA FINANCIAL STATEMENTS HELP MINIMIZE RISK
Despite the best intentions, new offerings can fail for a number of reasons. “The problem is when you become so married to your idea that you keep throwing money at it and you don’t know when to back off,” says Paul DelFino in this Inc Magazine article.
Pro forma financial statements help a business owner understand, ahead of time, the point at which an idea is no longer feasible and when it’s time to stop investing in it. After all, as exciting as a new venture is, it’s not worth risking your company. On a positive note, they can also highlight areas in your plans that warrant adjustments which could result in a more favorable outcome.
Help with your crystal ball
At Driven Insights, pro forma financial statements are just one of the services we offer. We specialize in outsourced accounting and assume day-to-day responsibility of our finance function on an ongoing basis.
Reach out 888-631-1124 / firstname.lastname@example.org to see how we can not only help project your financial future, but also give you valuable insights to help you reach your business goals along the way.