Learn how to create a pro forma income statement to help to grow your business

Your startup won’t end up well-capitalized, with strong balance sheets, healthy cash flows, and long runways by random chance. To achieve this, you need to forecast your revenue, anticipate your expenses to predict how quickly your business will grow. 

A pro forma income statement allows you to explore different situations and their potential impact on your business so you can make more strategic business decisions. 

Want to know more about how a pro forma financial statement can help strengthen financial planning? Let’s begin with a definition.

What is a pro forma income statement?

The Latin term “pro forma” means "as a matter of form" or "for the sake of form.” A pro forma financial statement tests assumptions to project financial performance over a period that is yet to occur. 

Pro forma statements use “what-if scenarios” and hypothetical data to create forecasts. However, the foundation of these statements is historical performance.

There are three types of pro forma financial statements:

• Pro forma income statement: This financial statement projects future revenues and expenses for your business, highlighting forecasted fixed or variable operating expenses. Starting with historical earnings, it assesses the future financial impact of certain decisions or assumptions. 
• Pro forma balance sheet: This financial statement helps in assessing a company's future assets, liabilities, and equity. While it includes all the components of a typical balance sheet, the information in the pro forma balance sheet was forecasted based on expected events that may or may not occur. 
• Pro forma cash flow statement: This financial statement forecasts your business's future cash inflows and outflows. It presents cash inflows and outflows in three categories: operating, investing, and financing. To create a pro forma cash flow statement, finance teams can use either the direct or indirect method of cash flow reporting.

While pro forma financial statements and projections are often synonymous, they are not the same. Pro forma is based on current financial statements (i.e., “real data”), and financial projections can be based purely on assumptions. For instance, early-stage startups with little data to draw upon can create projections based on industry-specific assumptions and have no real data.

Understanding the pro forma income statement

An income statement is a report that indicates the profitability of your business during a specific period. Similarly, a pro forma sheet reflects your potential profitability based on hypothetical scenarios. 

These scenarios can include but are not limited to new acquisitions, losing an account, an asset purchase, or undertaking a loan. They help business leaders determine the cause-and-effect relationship between their actions and the associated impacts on the business income. 

Also referred to as pro forma profit and loss statements (pro forma P&Ls), pro forma income statements are used in different ways by stakeholders both internally and externally. 

• For startup founders: Pro forma P&L statements help to guide major financial decisions, such as debt refinancing, large purchases, mergers or acquisitions, and leases.
• For FP&A teams: They help develop various sales and budget projections, compare balance sheets, make cash flow projections, calculate financial ratios, and create financial models. 
• For investors: Pro forma income statements are very useful for investors as they help them evaluate the growth potential of a business.  
• For creditors: Pro forma statements can be used to evaluate a company’s loan application. 

While pro forma income statements look a lot like regular income statements, they are quite different in terms of how they are created. Unlike the typical income statement, which is created based entirely on actual performance data, pro forma statements are based on the company’s current performance data and various assumptions about the future.

Pro forma income statements vs. GAAP income statements 

In the US, public companies are required by the Securities and Exchange Commission (SEC) to follow the rules and uniform reporting standards which are found in the generally accepted accounting principles (GAAP) developed and maintained by the Financial Accounting Standards Board (FASB). Private companies commonly follow the same standards. 

GAAP requires that financial reports must be based on historical information and actual transactions. But, pro forma income statements are not GAAP-compliant as they use hypothetical figures and assumptions to project future performance or show the impact of potential transactions. 

While pro forma statements do not have to follow the strict accounting standards required for GAAP compliance, it is important to clearly mark them as “pro forma” to avoid any misrepresentation to investors. Failure to do so can result in significant reputational damage, and for public companies, penalties imposed by the SEC.

Pro forma modeling is great for budgeting and strategic planning. Yet, unlike GAAP income statements, they cannot be used for external reporting, such as filings with the SEC, audits, or tax purposes. 

How to create a pro forma income statement

Since pro forma income statements and a regular income statement are quite similar, the general process of creating one is the same. The only difference is in the data you input. A regular income statement uses historical performance data, while a pro forma uses assumptions and variations of the different inputs. 

1. Create a baseline income statement

Creating a baseline income statement will help you understand your current and previous fiscal years. It gives you a deeper understanding of your growth trajectory, baseline revenue,  and cost growth rates. 

2. Define the time period 

A typical income statement only covers the previous year. However, it's common practice in SaaS to create a three-year pro forma income statement. Depending on your requirements, you can include assumptions for a single financial year or extend them for a period of 3-5 years. Shorter time frames can be useful for evaluating ongoing business operations, while a longer period helps in assessing major investments.

3. Determine the assumptions you will use in your projections

Next, consider all the changes coming next year to determine the assumptions you will use in your projections. These changes can include both internal and external factors. 

Changes could also include external factors such as a tightening economy or new competitors entering the market. The more detailed (and conclusive) your assumptions are, the more precise your financial projections will be.

• Internal factors are activities within your organization, including sales, marketing, operations, and recruitment. You can identify internal factors by looking at your baseline income statement. Then ask yourself, how do the current factors impact your future revenue?
  
  For example, let’s say you’re considering how fast you might need to grow your current sales team to achieve your revenue goals over the next three years. Answering that question will require sales capacity planning. You’ll also want to factor in the ramp-up time for new sales reps you might hire as that can directly impact how fast you can generate that revenue. 

• External factors include factors beyond your control, such as competition, market demand, changes in government regulations, and more. For example, increases in inflation may require a review of your pricing strategy to ensure your company is able to maintain its current gross margin.   

Financial forecasting software can help you stay updated and identify growth trends while determining the assumptions you will use in your models.

4. Forecast your revenue and expenses

Once you’ve determined what your assumptions will be, you can use them to forecast your revenue projections. 

Using a revenue planning software makes this task easy. You just need to plug in the numbers based on your assumptions to see if they make sense. Adding a revenue forecasting tool to your toolbox can also save a lot of time as they allow you to quickly test a wide range of variables to forecast your revenue under different circumstances. 

Next, estimate costs that can impact your profitability. These include the cost of goods sold (COGS) and your operating expenses (OpEx). COGS includes the direct costs of delivering your software service, such as hosting fees, and software licensing. Your OpEx includes sales and marketing, research and development, and general and administrative costs. Be as comprehensive as possible in estimating these expenses to ensure a more realistic financial forecast. 

Pro Tip: Keeping your bookkeeping up to date will help ensure the numbers you’re using to project your COGS and OpEx for your pro forma income statement are  reliable.  

5. Add assumptions and projected values in the income statement

You’ll only know your projected profits when you plug in all your forecasted revenue and expenses into the proper lines on your pro forma statement. 

Note that you can use any template that includes an income statement to easily create your pro forma income statement as both types of statements are typically formatted the same way. The main differences are that the pro forma statement will include actuals for the current year with future years projected as opposed to only actuals data from the current and past years. 

5. Perform a scenario analysis to test your assumptions 

Perform what-if analysis by adjusting assumptions to see how changes affect your projections. This way, you can prepare for various outcomes and plan for a sustainable and sensible future growth. 

It is always advisable to leverage a cutting-edge scenario planning tool for this activity, as it can help you create more accurate and dynamic pro forma models. Thus, you get better insights into potential risks and opportunities. 

Adjustments to pro forma income statements

Pro forma projections require several adjustments to reflect the impact of your assumptions. These modifications are necessary to understand your projected future performance better.

The objective l of pro forma income statement adjustments is to:

• Remove non-recurring, irregular, or extraordinary items: By excluding these items, such as one-time gains or losses, restructuring costs, and non-operational expenses, FP&A teams can better see how the business is really performing. For example, if your company had high restructuring costs this year, adjusting the financial statements to exclude these costs helps stakeholders understand the true profitability.

• Allow for normalization: The adjustments also enable teams to compare company financial changes over time. For instance, consider a period with a large one-time government grant. By adjusting the financial statements to exclude this grant, you can focus solely on the company's operating performance for that period. 

Example pro forma income statement for a SaaS company

This pro forma example projects revenue, costs, and expenses based on anticipated growth and market trends for the next three fiscal years. 

Adjustments to pro forma income statements

Pro forma projections require several adjustments to reflect the impact of your assumptions. These modifications are necessary to understand your projected future performance better.

The objective l of pro forma income statement adjustments is to:

• Remove non-recurring, irregular, or extraordinary items: By excluding these items, such as one-time gains or losses, restructuring costs, and non-operational expenses, FP&A teams can better see how the business is really performing. For example, if your company had high restructuring costs this year, adjusting the financial statements to exclude these costs helps stakeholders understand the true profitability.

• Allow for normalization: The adjustments also enable teams to compare company financial changes over time. For instance, consider a period with a large one-time government grant. By adjusting the financial statements to exclude this grant, you can focus solely on the company's operating performance for that period. 

Benefits and limitations with pro forma statements

Pro forma income statements are helpful for financial planning. However, they also have some limitations and should be used cautiously. 

Benefits

• You can create and compare different pro forma income statements based on different assumptions to help you decide between various strategies. 
• Pro forma analysis is also great for investment forecasting. They help you evaluate the financial impact of major capital investments and restructuring projects. 
• Pro forma income statements can help you raise funds as investors are keen to see how you plan to scale your business. 
• Pro forma statements also help you see when you need to make changes in your operations to prevent a drop in your profitability or boost revenue. 

Limitations

• Pro forma projections are based on educated “assumptions.” They can vary based on several factors and might not always provide an accurate forecast. 
• You cannot use pro forma reporting for comparing different companies because they each might be using different methods for forecasting and making assumptions. 
• If your pro forma statement includes assumptions and hypothetical scenarios that are not based on objective information, you risk misleading your stakeholders about your company’s true financial outlook. This can cause significant damage to your reputation in the business community, your customers, and your investors. For a public company regulated by the SEC, it is a crime punishable by law. 

Using technology to create reliable and well-informed pro forma statements

Although pro forma financial statements have some limitations, they are important for budgeting and forecasting. By creating different scenarios and looking into the future, you can anticipate problems and spot opportunities for business growth. 

A purpose-built, comprehensive financial planning software for SaaS and B2B businesses, Drivetrain provides the full range of FP&A features required by finance teams to create reliable, accurate pro forma statements. The intuitive UI enables finance and non-finance teams alike to quickly create multi-dimensional models. Using the platform’s other cutting-edge features, including scenario planning, what-if analysis, sales capacity planning, and advanced reporting, you can now create realistic pro forma financial statements. 

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