PERFORMA FINANCIAL STATEMENT & RELEVANCE OF

FORECASTING September 22, 2019

Introduction

1. Pro forma is a Latin term that means “for the sake of form” or “as a matter of form.” In
the world of investing, pro forma refers to a method by which firms calculate financial results
using certain projections or presumptions. Financial statements that use the pro forma
calculation method are often designed to draw focus to specific figures when a company issues
an earnings announcement and makes it available to the public, particularly potential investors.
Companies may also design these pro forma statements to assess the potential value of a
proposed change, such as an acquisition or a merger. Investors should be aware that a
company’s pro forma financial statements may hold figures or calculations that are not in
compliance with Generally Accepted Accounting Principles. Sometimes, pro forma figures
differ vastly from those generated within a GAAP framework, as pro forma results will make
adjustments to GAAP numbers to highlight important aspects of the company's operating
performance. A pro forma financial statement is one based on certain assumptions and
projections. For example a corporation may want to see the effects of three possible financing
options. Therefore, it prepares a projected balance sheet, income statement, and statement of
cash flows for each of the three financing options. These projected financial statements are
referred to as pro forma financial statements. Financial performance is a subjective measure of
how well a firm can use assets from its primary mode of business and generate revenues. The
term is also used as a general measure of a firm's overall financial health over a given period.
Analysts and investors use financial performance to compare similar firms across the same
industry or to compare industries or sectors in aggregate. There are many ways to measure
financial performance, but all measures should be taken in aggregate. Line items, such as
revenue from operations, operating income, or cash flow from operations can be used, as well
as total unit sales. Furthermore, the analyst or investor may wish to look deeper into financial
statements and seek out margin growth rates or any declining debt. There are many
stakeholders in a company, including trade creditors, bondholders, investors, employees, and
management. Each group has its own interest in tracking the financial performance of a
company. Analysts learn about financial performance from data published by the company in
Form 10K, also known as the annual report. Public companies must publish the SEC required
10K form. The purpose of the report is to provide stakeholders with accurate and reliable
financial statements that provide an overview of the company's financial performance. In
addition, company leaders audit and sign these statements and other disclosure documents. In
this way, the 10K represents the most comprehensive source of information on financial
performance made available to investors annually. A statement of financial performance is an
accounting summary that details a business organization's revenues, expenses and net
income. Three financial statements comprise the statement of financial performance: income
statement, balance sheet and cash flow statement.

(a) Income statement. The income statement reflects a company’s revenues

and expenses. It shows the company’s bottom line so you can see how profitable your
company is during a certain period of time, such as quarterly or annually. The
statement of financial performance takes into account sales revenue, cost of goods
sold and other operating expenses and income.

(b) Balance sheet. The balance sheet reflects where your business stands
financially at a certain point in time. This statement of financial performance takes
into account assets, liabilities and shareholder equity to make sure assets are equal to

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the other two factors. The balance sheet incorporates the net income determined on
your income statement.

(c) Cash flow statement. The cash flow statement looks at how money
moves through your business. It shows increases and decreases in cash from
operations, investing and financing during a period of time. This statement of
financial performance shows the net change in cash balance using numbers from both
the income statement and the balance sheet.

2. These statements are prepared monthly, quarterly or annually, and give businesses a
big picture of there they stand financially. A corporation's accounting department may
prepare a statement of financial performance at any given point in time or throughout the
year, depending on business requirements. For example, you may ask your accounting
manager to prepare a statement of financial performance for the last two weeks of July and
the first three weeks of November to understand what factors affect sales and whether sales
are seasonal.

Financial Performance Factors for a Business

3. Preparing a statement of financial performance means knowing a lot of important

information about how money comes into your business and how it goes out. These financial
performance factors for a business should be tracked regularly :-

(a) Assets. An asset is anything your business owns or has that will be of value in
the future. This includes tangible assets such as products, buildings and equipment. It
also includes intangible assets such as contracts, marketing and consumer mailing
lists. These are all things that can be sold in the future that would add value to your
company.

(b) Liabilities. A liability is anything you might owe in the future and is often
based on a contract. For example, if one of your employees crashes the company car,
you may be liable for paying the car’s insurance deductible since you contract with
the insurance company.

(c) Equity. Equity is the value of your business that remains after deducting
liabilities from assets. In corporations, this value is known as the shareholder’s equity.

(d) Owner investment. Business owners typically invest their own cash and
resources into the business. This is known as the owner investment, which establishes
equity in the business. If future business partners want equity in your business, how
much they invest determines their equity share. For example, a limited liability
corporation, or LLC, with two equal partners who contributed 50 percent has an owner
investment of 50 percent of the business.

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(e) Owner distribution. If those partners later sell their shares, they would
receive an owner distribution. This results in decreased equity in the business.

(f) Revenue. Revenue represents income that a company earns during a

certain period. It includes sales, interest income and gains on short-term investments.
Revenue may be a short-term item if it is earned in a year or less or a long-term item
if it is earned after a year. For example, a business’ short-term revenues include sales
and interest income, while long-term revenues can include interest income, such as
from a corporate savings account, that is earned in two years.

(g) Expenses. Expenses represent costs that a company incurs during a certain
period. They include the cost of sales, interest expense, production or delivery costs,
as well as losses on short-term investments.

(h) Gains and losses. These are increases and decreases in equity that result
from transactions incidental to your business. For example, if your primary business
is book printing and distribution, you likely have machinery needed to bind books. If
you sell a book binder used to manufacture books, you would sell it either for more
than you paid for it (a gain) or less (a loss).
A statement of financial performance can also include comprehensive income, asset
use, market share and other factors that affect your business.

Why We Need a Statement of Financial Performance

4. There are many reasons why businesses need a statement of financial performance.
Generally, a statement of financial performance is important to understanding if your
business is profitable and, if not, where to make needed changes. It shows the current
financial status of your business, how cash is used and where the unnecessary costs are.
5. A statement of financial performance allows a company's top management to identify
major revenue and expense items that affect the company's bottom line, or net income. For
example, you can review your company’s statement of financial performance for the months
of June, September and November to understand and compare sales revenue levels and which
expense items increase based on seasonal business demands.
6. The statement of financial performance also helps management see which business
segments or products are worth investing more money in and which the company may need
to stop putting money into. If you're investing a lot of money in a product that historically
costs more to produce than it earns profit, you can make the best decision for your company
based on information learned from the statement of financial performance.
7. A statement of financial performance also provides significant insight into an
organization's overall profitability. It helps investors, lenders or regulators gauge a
corporation's economic standing. This comes into play in such situations as seeking a bank
loan. The bank's credit officer may review your statement of financial performance over a

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five-year period to gauge profitability levels or sales trends and ensure that you will have
available cash to repay the loan.
8. Potential investors look at your statement of financial performance to help them
decide if they want to invest in your company. Likewise, someone wanting to purchase or
acquire the business will use the statement of financial performance to help determine a
purchase price. When done properly, the statement of financial performance tells future
investors or purchasers everything they need to know about your company.
9. While only publicly traded companies are required to maintain statements of financial
performance, keeping track of your company’s finances will help you when it comes time to
file tax returns.

How to Improve Financial Performance

10. After all of the calculations are in, you may find that the statement of financial
performance isn’t showing the profits you expected. This can be disheartening to anyone who
invests a lot of time, energy and money into their business enterprise, but there are ways to
improve the financial performance of your company :-

(a) Maintain ongoing financial statements One of the best ways to improve
financial performance is to regularly review how your business is doing. Instead of
preparing the statement of financial performance annually, you may want to do it
quarterly, or even monthly, to see where improvements can be made. What you
don’t want to do is make rash decisions based on one bad month, so be sure to look
at financials month-to-month, quarter-to-quarter or year-to-year to make the most
informed decisions.
(b) Be proactive. With regular financial performance statements, you can see if
things are operating as efficiently as they should. With ongoing financial statements,
you can get a sense of what is currently happening in your company, what is going to
happen, and if any changes need to be made. Being proactive can save you a lot of
money and positively impact your bottom line.
(c) Have a realistic budget One of the quickest ways to improve financial
performance is to have a realistic budget. Don’t spend a lot of money in areas that
don’t make sense, since it will negatively affect your bottom line. Make sure you have
a budget that is realistic and in line with company goals. When you work within that
budget, you may see the financials move in the direction you want.
(d) Price your products correctly. Know how much your products are
actually worth on the market by doing competitor research. If you can increase the
price of your product or service, you may be able to see immediate improvements in
the company’s financial performance, especially if costs stay the same.
(e) Set achievable goals. In addition to a realistic budget, make sure your goals
are achievable. Don’t try to provide services you don’t have the resources for. Don’t
try to double your profits within one month. What you want to do is strategically plan

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where to invest resources and money, and then set goals that the company can actually
achieve. Meeting smaller goals helps improve financial performance in the short-
term, while ultimately meeting your long-term financial goals.
(f) Get everyone on board. Make sure your entire team is onboard with the
budget. This ensures they abide by how much to spend and when to cut their losses.
It also ensures that your team is engaged and committed to your company’s goals and
bottom line. Satisfied employees can boost your financial goals since they are more
likely to do what it takes to help your company succeed and stick around for the long-
term.
(g) Make sure your systems are current. The company is only as efficient
as the people and technology you employ. Outdated technology and systems can slow
things down so much that you waste both money and time. Periodically check in with
your staff to make sure they are making effective use of their time and efficiently
processing anything related to your company’s finances, such as invoices and
collecting overdue payments. Keeping the computers and software up to date will also
keep things operating more smoothly. Utilizing financial performance apps and newer
computer programs is key in today's fast-changing world.

How to Create a Pro Forma Income Statement

11. Today, there are several places where you can find a boilerplate template for generating
a pro forma financial statement, such as the income statement, including Excel spreadsheets
that will automatically populate and calculate the correct entries based on your inputs. Still,
you may want to know how to create a pro forma income statement by hand.

(a) Step 1. Calculate the estimated revenue projections for your business (this is
called pro forma forecasting). Use realistic market assumptions and not just numbers
that make you or your investors feel optimistic. Do your research and speak with experts
and accountants to determine what a normal annual revenue stream is, as well as cash
flow and asset accumulation assumptions. Your estimates should be conservative.

(b) Step 2. Estimate your total liabilities and costs. Your liabilities are loans and
lines of credit. Your costs will include items such as your lease, utilities, employee pay,
insurance, licenses, permits, materials, taxes, etc. To create the first part of your pro
forma, you’ll use the revenue projections from Step 1 and the total liabilities and costs
found here. Put in a great deal of thought into each expense and keep your estimates
realistic.

(c) Step 3. Estimate the cash flows. This portion of the pro forma statement will
project your future net income (NI), sale of assets, dividends, issuance of stocks, and
so on.

Pro-Forma Forecast
12. A pro-forma forecast is a financial forecast based on pro-forma income
statements, balance sheet, and statement of cash flows. Pro-forma forecasts are usually created
from pro-forma financial statements and are forecasted using basic forecasting procedures.

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When making these forecasts, revenues will usually provide the initial groundwork for the
forecast, and expenses and other items are calculated as a percentage of future sales.

13. Pro-forma financials used in the pro-forma forecast will usually reflect the predicted
state of the business after a large or important transaction has taken place. The inclusion of
anticipated future events in the pro-forma financial statements allows the company a unique
opportunity to sculpt the presentation of the company's financial situation in a way that
normally wouldn't be allowed under Generally Accepted Accounting Principles (GAAP) rules.
Often, events depicted in the pro-forma financial statements have yet to occur, so the actual
company financial picture may be very different than the picture presented. Forecasts made
from these financial statements may or may not contain an even higher degree of deviation
from the actual state of the company.

14. A pro-forma forecast, similar to any sort of pro-forma report, is not required to abide
by GAAP. As a result, they often reflect the best-case scenario, which the firm would like to
portray to investors. It takes a skilled analyst to unpack the marketing from the actual numbers.
Of course, the analyst can always just use the audited financial statements in their analysis as
opposed to pro-forma statements and forecasts. Although, these forecasts can be a valuable
clue as to how the subject company intends to increase its value and what type and nature of
growth they are aiming for.

15. Example of a Pro-Forma Forecast. For example, XYZ Company is a publicly-traded

maker of widget presses. After many years of research and development, they have applied for
a patent on a fantastic new type of widget press technology. If they are granted the patent, they
will be the only company who can use this fantastic new technology for 10 years. This new
technology will allow XYZ Company to manufacture widget presses at half their current cost
and several times more quickly. This could potentially make them the preferred provider in the
space and help them gain market share. To demonstrate this potential good fortune on the
company's financial statements, XYZ Company may draw up pro-forma financial statements
which show the predicted effects of lower costs and increased sales on the company's financial
situation. Pro-forma forecasts made off of the assumption that this patent will be granted might
show larger than normal yearly sales increases as XYZ Company steals market share from its
less technologically advanced and more expensive competitors. Of course, if the patent isn't
granted, all of this would be highly inaccurate.

Financial Forecasting in the Budget Preparation Process for existing & new Company

16. The purpose of the financial forecast is to evaluate current and future fiscal conditions
to guide policy and programmatic decisions in a company . A financial forecast is a fiscal
management tool that presents estimated information based on past, current, and projected
financial conditions. This will help identify future revenue and expenditure trends that may
have an immediate or long-term influence on government policies, strategic goals, or
community services. The forecast is an integral part of the annual budget process. An effective
forecast allows for improved decision-making in maintaining fiscal discipline and delivering
essential community services.

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17. Recommendation. The GFOA recommends that governments at all levels forecast
major revenues and expenditures. The forecast should extend several years into the future. The
forecast, along with its underlying assumptions and methodology, should be clearly stated and
made available to stakeholders in the budget process. It also should be concisely presented in
the final budget document. The forecast should be regularly monitored and periodically
updated. The key steps in a sound forecasting process include the following :-
(a) Define Assumptions. The first step in the forecasting process is to define the
fundamental issues impacting the forecast. The results of this initial step will provide
insight into which forecasting methods are most appropriate and will help create a
common understanding among the forecasters as to the goals of the forecasting process.
There are four key questions to consider when defining assumptions for the forecast :-
(i) What is the time horizon of the forecast ?
(ii) What is the objective of the government’s forecasting policy? For
example, a conservative forecast underestimates revenues and builds in a layer
of contingencies for expenditures. This might make it harder to balance the
budget, but reduces the risk of an actual shortfall. On the other hand, an
objective forecast seeks to estimate revenues and expenditures as accurately as
possible, making it easier to balance the budget, but increasing the risk of an
actual shortfall. Therefore, a government should be transparent concerning its
own forecasting policy and underlying assumptions.
(iii) What are the political/legal issues related to the forecast? Be aware of
current laws or expected changes in laws that affect forecasts.
(iv) What are the major revenues and expenditure categories?
(b) Gather Information. To support the forecasting process, use statistical data as
well as the accumulated judgment and expertise of individuals inside and perhaps also
outside the organization. For instance, department heads may have an insight into
activities within their own section. This step is designed to increase the forecaster’s
expert knowledge about the forces impacting revenues and expenditures. This would
also include events that could cause a disruption in the operating environment and in
prevailing trends. Both are important for forecasting because they allow the forecaster
to more intelligently build quantitative models and to make a forecast using his or her
own judgment. Assumptions should be documented for future reference, so the
financial forecasting process has some basis to start from at the beginning of each cycle.
Also, become familiar with other longer-term planning efforts of the organization or
other organizations that impact financial decisions and the fiscal environment. Such
plans might include comprehensive development and/or capital improvement
programs.
(c) Preliminary / Exploratory Analysis. The analysis should include an
examination of historical data and relevant economic conditions. This improves the
quality of the forecast both by giving the forecaster better insight into when and what
quantitative techniques might be appropriate and also is useful for supplementing

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forecasting methods. The forecaster is looking for consistent patterns or trends. In
particular, the forecaster should look for evidence related to :-
(i) Business cycles. Does the revenue (or expenditure) tend to vary with the
level of economic activity in the community or are they independent of cycles?
How do broader market forces impact key expenditures, such as pension
contributions affected by investment returns ?
(ii) Demographic trends. Are population changes affecting service
demands and/or revenues ?
(iii) Outliers and historical anomalies. Does the data contain any extreme
values that need to be explained? It could be that these represent highly
anomalous events that don’t add to the predictive power of the data set.
(iv) Relationships between variables. Are there important relationships
between variables that could aid in forecasting ?
(d) Select Methods. Determine the quantitative and/or qualitative forecasting
methods that will be used. Keep in mind that the chosen method for one program may
differ for another. While complex techniques may get more accurate answers in
particular cases, simpler techniques tend to perform just as well or better on average.
Also, simpler techniques require less data, less expertise on the part of the forecaster,
and less overall effort. Three basic models of forecasting to consider include :-
(i) Extrapolation. Extrapolation uses historical revenue data to predict
future behavior by projecting the trend forward. Trending is very easy to use
and is commonly employed by forecasters. Moving averages and single
exponential smoothing are somewhat more complex, but should be well within
the capabilities of most forecasters.
(ii) Regression/econometrics. Regression analysis is a statistical procedure
based on the relationship between independent variables (factors that have
predictive power for the revenue or expenditure source) and a dependent
variable (expenditure source being predicted). Assuming a linear relationship
exists between the independent and dependent variables, one or more
independent variables can be used to predict future revenues or expenditures.
(iii) Hybrid forecasting. Hybrid forecasting combines knowledge-based
forecasting (knowledge-based forecasting consists of using the forecaster’s own
knowledge and feel for the situation, rather than data and statistics, as the basis
for the forecast) with a quantitative method of forecasting. Hybrid forecasting
methods are very common in practice and can deliver superior results.
(e) Implement Methods. Making the forecast and using forecast ranges are
included within the implementation methods.
(i) Making the forecast. Put into practice one or more of the forecasting
methods described above.

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(ii) Forecast ranges. It may be wise to develop a range of possible forecast
outcomes, with the use of different scenarios. Multiple projections should be a
part of a well-planned and thoroughly discussed approach.
(f) Use Forecasts. The purpose of a forecast is to inform and assist in
decision-making. Three items that are essential to a compelling and informative
forecast presentation include :-
(i) Credibility of the forecaster. Credibility of the forecast’s presenters
is essential if a forecast is to be trusted. So have a transparent forecast process.
Address how the forecast compares to widely accepted economic or financial
forecasts from outside organizations. Describe forces acting on your revenues
or expenditures that might cause the actual results to be higher or lower than the
forecast. Stay within acceptable accuracy tolerances for forecasts. Avoid over
promising on the level of forecast accuracy to set appropriate expectations. Note
to the audience that years estimated farther out are less reliable and be careful
about using forecasts to raise an alarm about an impending crisis.
(ii) Presentation approach. A good forecast presentation revolves around
a clear message. A clear, simple, and reasoned statement of the forecast
message is vital. Build the message around a baseline set of assumptions that
represent a reasonable level of consistency with status quo conditions. An
exception to status quo conditions might be changes in the financial/economic
environment that are widely appreciated and / or assumptions about changes in
the environment. Such exceptions should be clearly stated. The assumptions
should be made very clear, and be supplemented with salient information. The
forecaster should explain how the assumptions lead to the forecast, without
delving into the details of the specific methods. The message should address the
implications of the forecast in terms of budget shortfalls or surpluses, changes
in reserve levels, and other metrics that would be meaningful to the audience.
Involving other staff in the forecasting process in these steps will also help
ensure that understanding of the method is shared by key potential supporters.
It may even prove possible to involve other staff directly in the presentation,
which may increase credibility.
(g) Linking forecast to decision-making. In order to maximize decision makers’
interest in the forecast, it will be important to emphasize the importance of the forecast
as a key factor in the planning and budgeting process. This means imparting a long term
perspective to the budgeting process and emphasizing financially sustainable decisions.
The following financial policies might be particularly helpful for promoting interest in
financial forecasting :-
(i) A reserve policy, which establishes the desired level of reserves to
maintain. A policy on reserves implies the need for forecasting tools to see if
reserve levels will remain within desired parameters given future spending and
revenues.

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(ii) A policy on maintaining structural balance, which requires recurring

expenditures to be covered by recurring revenues. A forecast is required to tell
if this will occur into the future, facilitating the considerations of long-term
implications of decisions.
(iii) A long-financial planning policy, which commits officials to
considering the long term implications of decisions made today. Capital
improvement plans should employ a long-term planning horizon.

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BIBLIOGRAPHY

1. https://www.accountingcoach.com/blog/pro-forma-financial-statements
2. https://bizfluent.com/about-6627481-definition-statement-financial-performance.html
3. https://www.investopedia.com/terms/f/financialperformance.asp
4. https://www.investopedia.com/terms/p/proforma.asp
5. https://www.investopedia.com/terms/p/pro-forma-forecast.asp
6. https://www.anaplan.com/blog/ten-steps-for-forecasting-demand-and-revenues-for-
new-products/
7. https://www.entrepreneur.com/article/77674
8. https://www.gfoa.org/financial-forecasting-budget-preparation-process
9. https://www.techfunnel.com/fintech/7-important-factors-financial-forecasting-
business/

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