There are two reasons why you are on this page right now. First, you are just starting with your business, and you want to learn about pro forma. Second, you are not sure if you are making your business proforma income statement correctly.
Before we discuss the process of creating a proforma income statement for your business, let’s start with the definition of proforma.
Pro forma: What is it and why I need one
Pro forma is the process of calculating financial results with the use of presumptions or projections. It is a Latin term that means “for the sake of the form” or “as a matter of form.” Businesses used this to describe a document needed to conform to a specific doctrine or norm.
A pro forma income statement is a component of the financial projections of any business. It should be included in the financials of a business plan. This income statement is just like a historical income statement. The only difference is that it projects the future instead of the past. It will help you make some operational changes right away if the projections predict a decrease in profitability.
Now that you know what a proforma is, the next part is about creating a proforma income statement for your startup business.
Uses of Proforma Income Statement
Pro forma income statement has several uses. Some of which are as follows:
Planning and Control
The income statement is used in estimating in-coming budgets and sales. It serves as a planning tool to set standards for future operations and business activities. The financial information is used to control and monitor the performance based on the set standards. It is achieved through the use of various tools like variance analysis and ratio analysis.
Reporting
Some businesses are required by the legislation to prepare a pro forma financial statement as part of their financial report.
Financial Modeling
It is also used in creating a summary of the expenses and incomes of your business. The financial models can help you in deciding, and it is based on the presumptions done by the company.
Steps on How to Create a Proforma Income Statement
Below are the steps in preparing the proforma income statement:
Step #1 Calculate Business Revenue Projections
When creating a proforma income statement, you should use realistic market assumptions. You can do some research or talk to the experts to determine the expected yearly revenue, asset accumulation, and cash flow.
Here are steps on how you calculate revenue projections of your business:
a. Estimate How Much to Sell
Determine how much of your product you are going to sell within a specific period. Also, you should have a better understanding of the market.
b. Calculate the Projected Income
To calculate your projected income, multiply your total estimated sales by the amount you charge for every item you sell. After estimating how much you will sell, determine the cost of each product.
c. Calculate the Projected Expenses
Next, calculate the projected expenses of the company. It is a must to figure out how much the company is spending in producing your products or services.
d. Subtract projected expenses from projected income
The final step in calculating business revenue projections is subtracting projected income from your projected income.
Step #2 Estimate Liabilities and Costs
Liabilities are the lines of credit and loans of the company. On the other hand, the costs are your lease, insurance, materials, licenses, employee pay, permits, etc. In creating the first part of your company pro forma, you will use the business revenue projections calculated from step one and the estimated costs and liabilities.
This step is your chance to evaluate if all your expenses are necessary and what you can do to reduce them.
Step #3 Estimate Cash Flows
Cash flow is calculated by making some adjustments to your net income by subtracting or adding differences in expenses, credit transactions, and revenue, leading from transactions that happened from one period to the next.
These adjustments are carried out due to non-cash items calculated in the income statement and total assets and liabilities. Since some transactions do not involve cash items, some are re-evaluated when computing the cash flow from operations.
Cash flow is calculated using these two methods:
Direct Cash Flow Method
The direct method adds the receipts and the different cash payments, including cash paid to suppliers, cash paid as salary, and cash receipts from customers. These numbers are computed using the starting and ending balances of the different business accounts and assessing the net increase or decrease in your account.
Indirect Cash Flow Method
With the indirect cash flow method, the operating activities are computed by getting the net income off the company’s income statement. Because it is set on an accrual basis, revenue is recognized if earned and not received.
This part of the proforma statement will project the company’s future net income, dividends, sale of assets, issuance of stocks, etc. The estimation of cash flow is considered as the second part of your pro forma financial statement.
Step #4 Creation of Chart of Accounts
The chart of accounts will complete your proforma income statement and includes data collected for a three to five-year period. The first year is detailed and broken into every month increments. The following years will be split into by quarter, and the fourth and fifth years are then broken into yearly.
Final Thoughts
Some business owners are surprised at how good a pro forma income statement is to their startup operations. But, if done correctly, you can consider it a strategic planning tool to direct your company in the right direction.
Follow the steps in this guide to make sure you get the correct estimations and numbers in completing a proforma income statement. Others think that the income statement will not benefit new businesses. But for others, it is a good start in foreseeing the future of the company. If you want to share your thoughts about the topic, or have questions, feel free to comment below.
