What is Pro-Forma Ratio Analysis in Financial Accounting?

Pro-Forma Ratio Analysis

Pro-forma is a Latin word meaning ‘for the sake of form’. A Pro-forma analysis is a way to project the financials of a firm in a future period. In order to create Pro-forma analysis historical data is used as the base of accounting. Therefore, Pro-forma ratio analysis can be termed as a way of accounting that uses data from the past to forecast the results in the future.

Sometimes, Pro-forma analysis is also used to omit the irregularities of accounting. For example, instead of projecting the future position, a Pro-forma report may show the performance of the company if no irregularities were present in its operations.

Types of Pro-Forma Analysis

There are mainly four components of Pro-forma analysis which are as following −

Pro-Forma Balance Sheet

The Pro-Forma balance sheet is a future projection of a balance sheet and it includes all the details a current balance sheet may contain. For example, one can create a future balance sheet containing accounts receivable, cash flows etc. in a Pro-Forma form depending on the trends in the past. One can then plan the future and present course of action to omit the drawbacks or losses in a systematic manner.

Pro-Forma Cash Flow

A Pro-Forma cash flow statement contains the future cash inflows and outflows after reviewing the details in the past. It may show a company’s cash inflows and outflows over a chosen period of time, such as one year.

Pro-Forma Earnings

A Pro-Forma Earnings report is the opposite of a Pro-Forma total expenses projection where the change in revenue in the next year is shown. It is formed to show the projected change in revenue in the coming year by taking into consideration the past and present data related to earnings. This helps the company to imbibe the right course of action if any drop in earnings is projected.

Pro-Forma Total Expenses

In Pro-Forma Total Expenses determination, the change in total expenses in the coming year is projected.

For example, if the cost of goods sold in the current year has increased by 10 percent, then one can calculate if the company has the resources (cash inflows) to compensate for the changes.

Steps to create a Pro-Forma Statement are as follows:

The creation of a Pro-Forma statement requires only financial modeling as the accounting is already done to make the future projections.

Step 1 − Projections of the Revenue

To create a Pro-Forma statement, one should start with the projection of the future revenues that the firm can earn. This may include informed guesses or the information that is available to the accountant. Making Pro-Forma adjustments to the guesses must be done as accurately as possible to get the best results then.

Step 2 − Project the Costs and Depreciation of Current Assets

The next step is to calculate the changes in costs and depreciation of the current assets. This step also includes the changes in liabilities. It also includes changes in each and all of the expenses of the items.

Step 3 − Projecting the Cash flow

The last step in creating a Pro-Forma analysis is to project the cash flow from the operations. This is done by adjusting the potential profitability, making adjustments to the cash flow statement, and tweaking the value of the business.

After these steps are performed, the created document will show all necessary information, such as gross profit, cash inflows, net revenues, restructuring costs, changes in total liabilities, cost of goods sold, cost of sales, etc.

The Pro-Forma Analysis is often found to be accurate if the above mentioned steps are performed correctly. However, as is obvious, there will be some leeway in the projection of future circumstances, however accurate the estimation is.