Mastering Pro Forma Financial Statements: The Three You Need

There are several terms to relate to pro forma and the finance concepts around it. These include the following:

• Financial or Accounting Ratios: These figures are calculated from financial document figures, and they give a snapshot of a firm’s financial status and enable comparisons to other firms. Below are five frequently used financial ratios:

  • Debt-to-Equity Ratio: Total liabilities / stockholder’s equity

  • Current Ratio: Current assets / current liabilities

  • Quick Ratio: (Current assets – Inventories) / current liabilities

  • Return on Equity (ROE) Ratio: Net income / shareholder’s equity

  • Net Profit Margin: Net profit / net sales

• Pro-rata: This term describes a proportionate allocation. Used for dividend payments, insurance premiums, and interest rates, pro rata calculations determine the fractional payment from the whole. For example, in dividend payments each investor is paid according to their number of shares and based on the company’s number of shares outstanding. If the company has 400 shares outstanding at $2 per share, the maximum amount of dividends paid will be $800. The whole is $800. If one shareholder has 201 shares, their dividend will be:
  
  (the number of shares / the number of shares outstanding) * the total dividend payment
  
  In this case: (201/400) * $800 = $402

• Pro bono: This comes from the latin term “pro bono publico,” meaning to work for the public good. It is voluntary work of no cost to the recipient. It often refers to free services from a professional to clients without the financial means to pay for them.

• Quid pro quo: This term is a Latin phrase that means “something for something.” It occurs when two participants mutually agree to exchange something for something else. In business, this can take the form of goods, services, or tradable assets. These have also been called “favor for favor” arrangements, and the term can be used to describe unethical behavior such as the exchange of financial backing for political favors.

• A quid pro quo contribution: This is a charitable contribution, but with one major difference. In a regular charitable contribution, the donor does not receive anything in return for their donation. In this type of donation, the Internal Revenue Service (IRS) allows the donor to deduct the entirety of their donation that is eligible. In a quid pro quo contribution, the donor receives something for their gift from the charity. The difference between what they have donated and the value of what they receive is the deductible amount. For example, a parent donates $500 at the school charity event to help them start a garden. In return, she receives a $50 gift card to the local grocery store. This is a quid pro quo contribution of which she may only claim $450 of as contributions for the tax year.

• Budgeting: The plan created to balance expenses with revenue. The creation of this plan enables people and businesses to know whether they can afford to do the things they need to do and purchase the things they need. Following a budget ensures that people stay out of debt, can save, and pay their bills. Traditional budgets track expenses, payments to eliminate debt, and building an emergency fund as a buffer. Budgets should be compiled and reevaluated regularly.

• Interim financial statements: These cover a period of less than one-year, interim financial statements may be issued for quarterly periods or any period. They usually contain the same documents that would be found in an annual statement, such as income statements, balance sheets, and statement of cash follows, and should match by line items. Some interim financial statements may be reviewed, such as in publicly-held companies, but they are not generally audited. Differences between interim and annual financial statements are in the following:

• Disclosures: Some disclosures are not required in interim financial statements, or may be presented as summaries.

• Accrual basis: Accrued expenses may be reported within one reporting period or spread over multiple reporting periods. This variance can cause inconsistencies when interim reports are compared and should be defined for reviewers.

• Seasonality: Season trends not seen in annual statements may be revealed by interim statements. These may be helpful in seeing seasons of major profit and loss.

• Compilation: When financial statements are prepared or compiled by an outside agent, they are referred to as a compilation. The outside agent does not provide auditing or assurance services, just puts the data into financial statements. This type of service is less expensive than review or auditing services.

• Notes to the financial statements: Also called the footnotes, and sometimes in the explanatory notes, notes to the financial statements explain how a company arrives at its numbers and any possible irregularities or inconsistencies. These are the details that explain the methodology, what decisions were made, and why to clarify the reports.  

• External financial statements: When financial statements are distributed to people or organizations not involved in the company’s operations, they are considered external financial statements. They are often compared to other companies or to previously released external financial statements and follow GAAP. A complete set includes the following:

  • Income statement

  • Balance sheet

  • Statement of cash flows

  • Statement of comprehensive income

  • Statement of stockholder equity

  • Footnotes

• Common-size financial statements: Common size financial statements display all the items as percentages of the common base figure instead of as numerical figures, enabling comparisons between different companies or periods. Though most companies do not report in this way as it is not required, this type of reporting decreases bias.

• Free Cash Flow Analysis: A free cash flow (FCF) analysis calculates the amount of cash a company can put aside after it has paid its expenses at the end of an accounting period. Free cash flow shows a company’s ability to grow internally give profit back to its shareholders. The formula for assessing free cash flow is:
  
  Net cash flow – capital expenditures - dividends
  
  OR
  
  (Net income + amortization + depreciation + deferred taxes) – capital expenditures - dividends

• Variance Analysis:  A variance analysis clarifies the difference between expected and actual results. Analyzing variances can improve operational efficiency. Using budgets as estimates and actual costs, the differences (called variances) are calculated. The point of variance analysis is to determine if the project or business forecasts were accurate and to adjust based on this knowledge. For more information on cost variance and how to calculate it specifically for projects, see “Hacking the PMP: Studying Cost Variance.”