What is a pro forma cash flow statement?

A pro forma cash flow statement projects cash inflows and outflows. Cash flows are categorized as operating, financing, or investing activities. Owners may use Excel or another software product to create pro forma statements.

Business owners create the statement to forecast cash balances in future periods. If the forecast predicts a negative cash balance, management must consider borrowing funds or an equity capital investment.                                                                  

What does "pro forma" mean?

Pro forma is a Latin word meaning “as a matter of form” and refers to a set form or procedure performed in a particular manner. In business, pro forma financial statements are produced based on assumptions.

What is a cash flow statement?

The statement of cash flows details the inflows and outflows of cash and cash equivalents for a specific period. Cash equivalents are securities that earn interest and are easily converted into cash, such as money market securities. 

Each cash transaction is related to an operating, investing, or financing activity. The beginning cash balance plus the net change in cash is the ending cash balance.

The accounting standards used to create the statement of cash flows do not use the assumptions applied to a pro forma cash flow statement. The Securities and Exchange Commission has strict guidelines regarding pro forma financial information. 

Pro forma statement vs. budget statement

A pro forma financial statement is a projection created using assumptions. A budget is part of an overall business plan. 

The budgeted cash flow statement uses actual data to determine cash inflows and outflows. Payments for budgeted lease expenses are based on a lease agreement, and IT consulting costs are determined by a contract with an IT vendor. 

Budgets may also include assumptions from the pro forma financial statements. 

What's the purpose of a pro forma cash flow statement?

The pro forma cash flow statement is created to perform several types of analysis. The statements are used for risk analysis, business valuations, and to make informed decisions.

Projecting cash flow

When a business considers launching a new product, management will assess the impact on cash flow. Each new product requires cash outflows to manufacture a product or to purchase inventory. Cash inflows depend on the product’s price, and how quickly customers pay.

New products may be bundled and sold with related products. A grocery store, for example, will bundle hot dogs, buns, and picnic supplies and market the bundle during the summer months. The store owner can analyze cash flows for a group of products.

Scenario analysis for future planning

Pro forma statements reveal the financial impact of different scenarios. For example, a company produces two sets of pro forma statements. One scenario assumes that a company purchases a competitor, and the other does not.

The buyer takes on more debt to finance the company purchase, changing the firm’s capital structure. A business plan that adds more debt may reduce the company’s financial health, and potential investors may question management’s financial decisions.

Management must determine if the additional cash outflows to finance debt are offset by cash inflows from the acquired business.

Asset and liability management

Every business operates with limited resources and successful companies perform analysis to determine the best use of assets.

A manufacturer can make a component part, or outsource the process to a third party. When the product is outsourced, the manufacturer must pay cash to the vendor. If the vendor can produce the part at a lower total cost, the manufacturer spends less cash on production.

Helps with decision-making and strategic financial planning

Pro forma financial statements are also used to assess worst-case financial decisions. 

If a company division loses money, pro forma financial reports can estimate the cost of restructuring and closing the division. Management may decide to operate at a loss until long-term liabilities, such as lease agreements, are paid in full. 

Cash inflows may not cover cash outflows, but continuing operations may be more attractive than closing the division, losing all cash inflows from sales, and paying cash on a long-term lease.

Essential for financial modeling, like creating a pro forma 3-statement model

The 3-statement financial model integrates three financial statements: the income statement, the balance sheet, and the statement of cash flows. The statements are used to forecast business performance using various assumptions.

Managers create pro forma statements for all three financial statements to see the full picture of a particular decision. 

A business can change variables in the financial statements and assess the impact. What if the 10% increase in sales is a 5% decline? If customers pay at a slower rate than forecasted, what is the impact on cash flow?

What does a pro forma cash flow statement include?

The pro forma cash flow statement includes three categories:

• Cash flow from operating activities: Inflows and outflows from day-to-day operations, including customer payments, purchasing inventory, and processing payroll.

• Cash flow from investing activities: When the business buys or sells an asset, the cash inflow or outflow is posted as an investing activity.

• Cash flow from financing activities: This section includes cash inflows from raising capital by issuing equity or debt and cash outflows when investors are repaid.

The cash inflows and outflows are added to compute the net change in cash. The formula for the statement of cash flows is:

• The beginning cash balance plus or minus the net change in cash equals the ending cash balance.

Depreciation and amortization are non-cash transactions that do not impact cash flow. If planning includes a large capital expenditure (CapEx) budget and more spending on property, plant, and equipment (PP&E), the higher depreciation expense does not impact cash.

Pro forma cash flow statement example

The pro forma cash flow statement is generated using pro forma data and assumptions from the income statement and balance sheet.

How three financial statements are connected

The income statement and balance sheet formulas reveal how the three financial statements are connected.

Income statement formula

The income statement is generated using this formula:

• Revenue - expenses = net income (loss) 

The income statement is produced for a specific period (month, quarter, etc.), and the matching accounting principle matches revenue earned with expenses incurred to grow revenue. 

A multi-step income statement includes additional line items for operating expenses and cost of goods sold (COGS).

Balance sheet formula

Businesses produce the balance sheet (or statement of financial position) using this formula:

• Total assets - total liabilities = equity

The balance sheet is created on a specific date, not for a particular period. Here are the components of the balance sheet:

• Assets are resources used to generate income and sales. 
• Liabilities are amounts owed to third parties (vendors, creditors). 
• Equity is the true value of the business. If the owner sells all assets for cash and uses the cash proceeds to pay off all liabilities, any cash remaining is equity.

Note that the equity section of the balance sheet includes shareholder’s equity and retained earnings.

Here are two important connections between the financial statements:

• Cash balance: The ending cash balance in the statement of cash flows is equal to the cash balance in the balance sheet. 
• Net income: Net income in the income statement is posted as an increase to equity in the balance sheet. At the end of each month, all revenue and expense accounts in the income statement are adjusted to zero. The net balance after all accounts are closed is net income.

Select ratios and statistics that you frequently use to monitor business performance. The steps below explain how the analysis moves from the income statement to the balance sheet and the statement of cash flows.

Projecting the income statement

Start the process by evaluating historical financial results, and using the data from pro forma financial statements. For example, a SaaS business dependent on subscription revenue will make assumptions about churn rate and customer retention.

Assume that an owner computes the average income statement account balances for the past three years and then calculates each account balance as a percentage of total sales. For example, the cost of goods sold (cost of sales) is 30% of sales. 

The owner projects $1,400,000 in annual sales, a 5% increase over the three-year average. $1,400,000 in sales is multiplied by each account’s percentage of total sales. The pro forma cost of goods sold is $1,400,000 X 30%, or $420,000.

Note that the income tax account is projected based on an expected tax rate, not as a percentage of sales. 

Forecasting the balance sheet

The business owner reviews the year-end balance sheet for the last three years, and considers other factors that impact the balance sheet:

• Higher cash balance: Due to higher projected sales, accounts receivable increase. Cash inflows will increase as customer payments are processed. 

• Accounts receivable turnover: This ratio measures how quickly a small business collects cash from credit sales. The accounts receivable turnover ratio is (net credit sales) / (average accounts receivable), and is often used in pro forma analysis. This article explains why the ratio is important.

• Accounts payable turnover ratio: The AP turnover ratio measures how quickly a business pays its total supplier purchases, and is also used to forecast the balance sheet. The accounts payable turnover ratio is (net credit purchases) / (average accounts payable).

• Less short-term debt: With higher cash inflows, decision-makers can avoid borrowing from a line of credit (LOC). Loan payments due within a year are current liabilities, and higher cash collections can reduce short-term borrowing costs.

• Capital expenditures (CapX): If the business is expanding or needs to replace IT equipment and other fixed assets, the company makes assumptions about financing purchases. Fixed asset balances will increase in the balance sheet.

• Long-term debt: The firm may use a combination of available cash and debt financing for CapX. Businesses that need to conserve cash may finance all CapX purchases, increasing long-term debt.

Generate the cash flow statement using the rules of money

A pro forma balance sheet presents the balance sheet based on historical data next to the projected balance sheet. The cash flow statement is created using the four rules of money and the differences in balance sheet accounts (historical balance sheet vs. pro forma balance sheet): 

An increase in assets generates a cash outflow

A company eventually pays cash for an asset. The business may pay for the asset in cash at the sale or repay a loan using cash over time. If the inventory balance increased by $40,000 from the prior year, the asset account increase is recorded as a cash outflow in the statement of cash flows.

A decrease in assets generates a cash inflow.

When an asset is sold, cash is received immediately after the sale is closed. If the seller allows the buyer to finance the purchase, loan payments increase the seller’s cash balance. 

An increase in liabilities and equity generates a cash inflow

A new loan or issuing common stock to shareholders both produce cash inflows. When a company receives $100,000 from issuing new shares of common stock, the increase in equity is posted as a cash inflow in the statement of cash flows.

A decrease in liabilities and equity generates a cash outflow

Repaying a loan or retiring common stock shares both create a cash outflow.

Each cash flow is posted as an operating, financing, or investing activity. Most cash flow statements use the indirect method to determine cash flow for operating activities.

Using the indirect method for operating activities

The indirect method starts with net income and ends with cash flow from operating activities. Here’s an example:

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Depreciation expense is a non-cash item, and the balance is added back to the cash flow analysis. Accounts receivable, inventory, and accounts payable are all day-to-day operating activities. The rules of money determine the dollar amounts in the cash flow statement.

Financing and investing activities use the direct method to post cash inflows and outflows. Here is a completed cash flow statement: 

The change in cash is the sum of the three cash flow activities ($12,000). The $42,000 ending cash balance is posted on the balance sheet.

Short-term vs. medium-term vs. long-term pro forma cash flow statements

Owners create business plans using different time horizons. Accountants generally define “current” as one year or less and long-term is any time period beyond one year. Financial statements record assets and liabilities as either current or long-term.

Pro forma cash flow statements are created for different purposes, depending on the period.

Short-term

Cash flow statements help businesses evaluate liquidity, or the ability to generate sufficient current assets to pay all current liabilities.

Current assets include cash and other assets that convert into cash within a year. Accounts receivable balances are collected and inventory is expected to be sold within a year (in most cases). Current liabilities, such as accounts payable, must be paid within a year.

A monthly cash flow statement for the next 12 months is a useful report for liquidity. If a particular month ends with a negative cash balance, the firm must plan for a loan or some other source of capital.

Medium-term

Management defines medium-term and long-term financial periods. 

Assume that a commercial builder is bidding on a three-year project to construct an office building. The business produces a pro forma cash flow statement based on project costs and progress payments made by the customer. 

For example, assume that the customer pays 20% of the total cost when the building’s foundation is completed and inspected. The builder’s cash outflows for labor and materials are compared to the cash inflow from the payment. 

Does the business have to use excess cash to finance a cash flow deficit between payments?

Long-term

Lease agreements and loans may have terms of ten years or longer. Businesses can generate a pro forma cash flow statement on a retail location to compare lease payments and other costs with cash inflows from sales.

Other types of pro forma cash flow statements

Here are some uses of pro forma cash flow statements.

Full-year pro forma projection

Managers often consider how company finances will look at the end of the fiscal year. This projection takes the year-to-date cash flow results and adds a cash flow forecast for the remainder of the year.

This projection is particularly useful for seasonal businesses. Assume that an e-commerce company generates 50% of sales in the last two months of the calendar year. The business must spend large amounts of cash in September and October for inventory purchases.

The projection starts with year-to-date cash flows from January 1st to August 31st (the current date). Managers then project cash activity for the last four months of the year to assess cash needs.

Financing or investment pro forma projection

Startups often have to raise additional capital to fund business expansion, and investors need financial statements to evaluate the company. These financial projections include cash inflows from additional capital, and cash outflows for interest payments (if funds are raised using debt).

The projections show the financial impact of raising capital.

Historical with acquisition pro forma projection

Business owners assess a potential business purchase by reviewing the combined financial statements of both businesses. The combined cash flow statements will reveal if the acquired business increases net cash flows, or is a drain on cash balances.

Limitations of pro forma cash flow statements

Pro forma income statements have limitations, and business owners need other financial reports to make fully informed business decisions.

Cannot account for external conditions

Pro forma cash flow statements may not be created using historical financial data. Financial information posted in the cash flow statement may be excluded in a pro forma statement. For example, a cash flow projection may reduce cash outflows for a loan, assuming that the loan can be refinanced at a lower interest rate.

Not GAAP compliant

Pro forma income statements do not comply with Generally Accepted Accounting Principles (GAAP). Investors, lenders, and other stakeholders rely on GAAP-based financial statements.

GAAP requires businesses to conform to the matching principle and record revenue when earned and expenses when incurred to produce income. The cash basis is a financial accounting method that posts revenue when cash is received and expenses when cash is paid. 

A pro forma statement generated using cash basis accounting does not conform with GAAP.

Excludes critical information

Pro forma cash flow statements may exclude important transactions that impact company profitability. To illustrate, assume a business is closing a division and expects to pay $1 million in severance to former employees.

The pro forma cash flow statement excludes the $1 million cash outflow, assuming that the workers can be transferred to other positions in the company. If that assumption isn’t realistic, the cash flow statement is misleading.

Are based on assumptions and therefore include a degree of inaccuracy by design

Pro forma statements are based on assumptions, and incorrect assumptions generate misleading financial statements. The company’s 35% gross margin assumption may be too optimistic, or the tax rate assumed in the analysis is much lower than the actual tax rate.

Factors affecting the accuracy of pro forma cash flow statements

Two factors may have a large impact on pro forma cash flow statements:

External and market forces

Conditions can change and make pro forma statements less useful. A weaker-than-expected economy may make a 12% sales increase unrealistic. When customer preferences change, a new product line may no longer be attractive. Higher interest rates increase borrowing costs.

Time from the initial forecast

As time goes on, the initial cash flow forecast may no longer be useful, due to internal and external factors. Managers can quickly update business plans using software to keep the analysis current.

How to use a pro forma cash flow statement in financial analysis

Here are two additional analysis methods that may use a pro forma cash flow statement:

Scenario analysis

Managers often plan using best-case scenarios, worst-case scenarios, and other assumptions. For example, the best-case sales forecast is a 12% increase over the next year, and the worst-case is a 5% decline. 

These scenarios can be run through the model to assess the impact on cash flows.

Sensitivity analysis

Sensitivity analysis determines how a change in one variable impacts other variables. 

For example, net present value (NPV) compares the present value of cash inflows and cash outflows for a particular project or investment. If the NPV (the sum of all cash amounts) is a cash inflow, the business may decide to implement the project.

One scenario discounts cash flows at 5%, and the second scenario uses 8% for discounted cash flows. The NPV may be a net cash inflow at 5% and a net cash outflow at 8%. 

Wrap-Up: All about the pro forma cash flow statement

The pro forma cash flow statement helps you make informed forecasting, cash management, and financing decisions. Successfully generating these models necessitates clean data; however, obtaining this level of data can require numerous hours. Leverage technology to save time.

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