Question

We need pro forma income statements because the breakeven analysis is “not enough.” But

why, exactly, would a breakeven analysis, with or without profit target, be “not enough?” What

is it that a pro forma income statement delivers or includes that a breakeven analysis doesn’t, and

when would this additional information be especially valuable?

I have to write a 300-word reflection of this prompt, could someone help explain?

Answer 1

Pro forma, a Latin term that means “for the sake of form” or “as a matter of form”, refers to a method of calculating financial results using certain projections or presumptions.

The presumptions about hypothetical conditions that occurred in the past and / or may occur in the future are used to project the most likely outcome for corporate results in reports known as pro forma financial statements. For example, a budget is a variation of a pro forma financial statement as it anticipates, based on certain assumptions, the inflow of projected revenues and the outflow of funds for a defined future period, usually a fiscal year.

Essentially, pro forma statements present expected corporate results to outsiders and are often used in investment proposals. A pro forma income statement is usually a financial statement that uses the pro forma calculation method, often designed to draw potential investors' focus to specific figures when a company issues an earnings announcement. Companies may also design pro forma statements to assess the potential earnings value of a proposed business 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 (GAAP). 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.1

In financial accounting, pro forma refers to a report of the company's earnings that excludes unusual or nonrecurring transactions. Excluded expenses could include declining investment values, restructuring costs, and adjustments made on the company’s balance sheet that fix accounting errors from prior years.

In managerial accounting, accountants design financial statements prepared in the pro forma method ahead of a planned transaction such as an acquisition, merger, change in capital structure, or new capital investment. These models forecast the expected result of the proposed transaction, with emphasis placed on estimated net revenues, cash flows, and taxes. Managers are then able to make business decisions based on the potential benefits and costs.

Pro Forma Example

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. The steps are:

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 asset accumulation assumptions. Your estimates should be conservative.
2. Estimate your total liabilities and costs. Your liabilities include loans and lines of credit. Your costs will include items such as your lease expense, utilities, employee pay, insurance, licenses, permits, materials, taxes, etc. Put in a great deal of thought into each expense and keep your estimates realistic.
3. To create the first part of your pro forma, you’ll use the revenue projections from Step 1 and the total costs found in Step 2. This portion of the pro forma statement will project your future net income (NI).
4. Estimate the cash flows. This portion of the pro forma statement will identify the net effect on cash if the proposed business change is implemented. Cash flow differs from net income because, under accrual accounting, certain revenues and expenses are recognized prior to or after cash changes hands.

A pro-forma income statement gives a better analysis compared to break-even analysis which only shows the amount of products which must be sold in order to break-even. The proforma statement gives a detailed analysis of all income and expenses which can be used to project future statements and can be used for monitoring and control.