After a meeting of small business owners last night, it occurred to me that the use of term ‘pro forma’ is uncomfortable for many. I wanted to make a moment to help readers understand pro formas and their value.
Financial folks use the term pro forma frequently as though everyone else knows exactly what is meant. As small business owners, perhaps you feel you should know what ‘pro forma’ means, but don’t want to ask. Perhaps as a P&L (profit and loss…a business unit) manager you feel the same way conversing with the CFO (chief financial officer). You might also encounter Pro Formas as an investor.
Do not feel bad. The topic is illusive enough there are innumerable articles just defining it.
What Is a Pro Forma?
In a financial context, a pro forma is simply a set of financial statements used for forecasting purposes. For instance, you business may be considering an acquisition, major capital (cash) expenditure, or material (having meaningful impact) investment. Acting as if the event has already occurred, a pro forma is used to evaluate the impact, to decide if the proposal should be undertaken.
I liked this excerpt from Wikipedia best, “…pro forma statements summarize the projected future status of a company, based on the current financial statements.”
Some Examples Uses
Your company is considering acquiring another company. To do so a large loan may be needed. Can your organization make the loan payments that will be required? Not just next month, but for however long is required?
New Product Development
Developing a new product can place major demands on a company. Not only cash expenditures, but resources like development staff. You need to know if you have enough cash available—or access to cash—to finish the job. And, if you are pulling team members from other projects, what happens if the other products (and the cash they would generate) are delayed?
Major New Customer Project
We all love it when a customer comes to us with a ‘big new project.’ Similar to new product development (NPD), you need to understand whether the project is too big for you to handle, or not. Do you have the financial resources required enabling you to build or lease a new facility, outfit it with new equipment, and hire and train new staff, in order to even begin the work the customer has hired you for?
Major Internal Expenditure
You need to reengineer a major component in your division. To get executive approval—especially from the CFO—you may be asked not just how much it will cost overall, but when you need the cash (e.g. how much, when), as well as when you can start generating new cash to start paying the company back.
These are common examples of situations, and the questions they raise, that pro formas are used to answer.
Why Do You Need It?
For instance, imagine yours is a seasonal business selling barbeques. In September, you’re flush with case and decide to acquire a very profitable side-business. Only, in January, you realize your cash reserves are too low to buy inventory for spring sales.
The process of creating a pro forma, a what-if assessment, has a good chance of saving you business-terminal embarrassment—just when you thought things were going well!
CASH – You may have noticed I used the word frequently. That is because CASH is the most important thing for a small business, most businesses for that matter, to manage. When discussing Cash, we are talking about Cash On Hand (what’s in the bank), Access to cash (can you get a loan if you need it); and where it may be needed.
The process of generating a pro forma also helps provide a structure that captures frequently forgotten items. Rick Goldstein, CEO of GPX Software, points out, the most frequently overlooked items are Staff wages, HR and benefits costs, and, Number 1—by far—is Taxes.
In short, creating a pro forma drives you through the process of playing, “What If…”. Think of it as doing paper trading of stocks for a while, before actually putting any money in the game.
An Unexpected Bonus
In today’s economy, availability of credit remains very tight. In part, this is due to banks’ risk aversion as well as new reporting regulations. To consider a new business loan your bank will almost certainly require a 3-year pro forma. They will ask you to forecast where your business is going. They will analyze your forecast, evaluate your assumptions, and decide whether they agree…and in turn consider the loan.
Even if you do not need a loan currently there is value in creating multi-year pro forma now. If you create, and regularly update, your pro forma (your forecast of what you think is going to happen), you have can evaluate your own performance.
Updated at least annually, preferably quarterly, comparing your pro forma against actual performance gives you a tool for studying and improving your performance. Doing so also lets you review the assumptions you use to build your pro formas in the first place.
Here’s the kicker:
Over time, the bank can compare your pro formas, your forecasts, against actual performance. Over a period of 3-5 years, you will then have a track record of performance that helps them determine how big a risk you may be. A documented history of performance can go a long way toward overcoming ‘risk aversion’ and demonstrating credit worthiness.
Discussing pro formas is a large topic. If you were not previously comfortable with the topic, hopefully this article helps. If you have any contributions, real-world examples, feel free to share.