Summary:
Pro Forma Financial Models are used for projecting and analyzing financial and investment performance to assist with decision making
Pro Forma Models has developed a standardized modeling methodology based on institutional-level investment processes
Pro Forma Financial Modeling has best practices to assist with formatting, structuring, accuracy, and interpretation
Pro Forma Financial Models are generally a net positive to businesses and investors but also carry their own set of pitfalls
It is important to clearly label Pro Forma Financial Model output as “Pro Forma” to ensure consumers of the output are not being misled
What is Pro Forma Financial Modeling?
Pro Forma Financial Modeling is the process of creating a forward-looking projection of a company’s financial statements or an investment’s performance to calculate and observe the impact of future events and/or decisions. Pro Forma Models are typically created in Microsoft Excel due to the program’s robust capabilities, ease of use, and long-standing industry adoption.
What is Pro Forma Financial Modeling Used For?
Pro Forma Financial Models are used for projecting and analyzing financial and investment performance to assist with decision making. Pro Forma Models are used by people at various levels within companies, from Interns to CEOs, and outside of companies, such as Equity Research Analysts and Lenders.
Pro Forma Models are typically created to:
Value a business or investment
Raise equity and debt capital
Merge with another company
Acquire a company
Invest capital internally to grow the business
Allocate available capital
Budget to set operating targets
Analyze risks and develop risk management strategies
Perform stress testing, sensitivity, and scenario analysis
What Data is Included in a Pro Forma Financial Model?
Pro Forma Financial Models need to be prepared in a manner that handle necessary complexities required for the analysis, but are also easy to understand. A typical model will at a minimum include the following:
Assumptions and inputs
Income statement
Balance sheet
Cash flow statement
Executive summary output report
Pro Forma Models utilizes a standardized financial modeling methodology refined by the team’s long-standing tenure as institutional investors and financial modeling professionals. More details on the Pro Forma Models financial modeling methodology are available in the, “Understanding Pro Forma Models,” blog post.
All Pro Forma Financial Models are not created equal. Models created with a defined methodology, such as the Pro Forma Models methodology, will stand out in comparison to unstructured financial models. To learn more about financial modeling best practices to help you with your next Pro Forma Financial Model development, refer to the, “Financial Modeling Best Practices,” blog post.
Why Make a Pro Forma Financial Model?
By this point, it is apparent that Pro Forma Financial Models are useful tools for forecasting, decision making, and solving problems. Following best practices and a structured methodology helps make Pro Forma Financial Models more impactful and easier to understand. Utilizing a spreadsheet tool, most commonly Microsoft Excel, to develop Pro Forma Financial Models allows for visualizations, such as graphs and charts, to be developed, which helps make the Pro Forma Financial Model output more impactful. Pro Forma Financial Models help predict financial outcomes, analyze potential scenarios, draw comparisons, and make more informed decisions.
Who Uses Pro Forma Financial Models?
Pro Forma Financial Models are used by a variety of professionals and are applicable to any business looking to conduct forecasting and analysis.
A few common examples of Pro Forma Models users include:
Equity Research Analysts use Pro Forma Financial Models to analyze a company’s financial results, develop forward looking opinions, and release research reports as well as valuation estimates.
Investment Bankers use Pro Forma Financial Models to an opportunity to take a growing private company public through an initial public offering (IPO).
Lenders use Pro Forma Financial Models to underwrite a real estate investment’s performance to determine an appropriate debt-level to provide to a borrower while ensuring required covenants, such as debt service coverage ratio (DSCR) or debt yield, are met.
CEOs utilize Pro Forma Financial Models to forecast business performance, make investment decisions, and raise capital.
Start Up Founders utilize Pro Forma Financial Models to forecast business growth, value their business, and determine the amount of equity to give up as they raise capital to support growth.
Sales Teams utilize Pro Forma Financial Models to forecast next year’s sales as well as their profit and loss (P&L) statement to establish quotas and milestones, as well as expense budgets.
Common Types of Pro Forma Financial Models:
Pro Forma Models apply to a variety of financial statement, with the most common being the 3-statement model, which consists of modeling an:
Income statement
Balance sheet
Statement of cash flows
Examples of common Pro Forma Models are provided below:
Start Up Pro Forma Financial Projection: Utilize assumptions to develop a 3-statement model for expected future financial results of a start up business. This type of Pro Forma Model is more challenging and subjective to develop as there are no historic financial results to serve as a base. Pro forma statements generated from this type of model will typically undergo more scrutiny from investors and lenders as the projections are fully based on projections. This type of Pro Forma Model is a necessity for any start up business and will form a key piece of the business plan.
Annual Pro Forma Financial Projection: Utilize existing annual historic financial results to develop forward looking pro forma financial statements on an annual basis. This type of pro forma is useful for communicating expected operating results to management and investors.
Monthly Pro Forma Financial Projection: Utilize existing monthly historical financial results to develop forward looking pro forma financial statements on a monthly basis. This type of pro forma is useful for communicating expected operating results to management/investors and is a useful tool for business operators as it is more granular and sets expectations on a monthly basis.
Investment Pro Forma: This type of Pro Forma Model is used to analyze an investment, which could range from a real estate investment, stock investment, capital equipment investment, or a request for funding from an investor/lender. The goal of this Pro Forma Model is to project investment performance with hopes of showing a return that will satisfy investor metrics.
Scenario Analysis: This method of pro forma financial modeling involves analyzing possible scenarios that could occur in the future and predicting the potential outcomes and impact on the business. The pro forma modeling process will show the change in value of a business or cash flow after various scenarios occur.
Benefits of Pro Forma Financial Models:
Utilizing Pro Forma Models in your business and investment process bring a variety of benefits, including:
Valuation: Public companies are generally easier to value at a high-level as they are freely traded and can be roughly valued based on market capitalization. Private companies are more challenging to value as they are not freely traded and lack liquidity. Pro Forma Financial Models can be developed to project future free cash flows and apply multiples to determine a fair value for the business. This is useful when it comes to calculating net worth, determining funding capacity, recapitalizing an existing investment, or restructuring a company.
Improved Decision Making: Pro Forma Financial Models build forecasts based on potential real-life situations allowing decision makers to have more information about future outcomes and risks.
Deeper Understanding: Building Pro Forma Financial Models involves diving deep into the details of a business or investment, which will provide a better view of the opportunity. The deeper understanding also applies to the industry the business or investment is involved in, allowing for a better understanding of the sector and any structural risks and opportunities.
Capital Allocation: Pro Forma Financial Models help business owners and investors allocate capital more efficiently by being able to analyze probabilities of success and areas of future growth. Pro Forma Financial Models also allow investors and business owners to compare opportunities, including the ability to make different business or investment opportunities apples-to-apples comparable by using investment metrics like internal rate of return (IRR) or net present value (NPV).
Performance Review: Pro Forma Financial Models create forecasts and benchmarks that can be tracked against with actual results through the use of variance analysis. Tracking actual performance against Pro Forma Financial Model expectations helps to identify operating opportunities as well as better refine the Pro Forma Financial Modeling process to develop more accurate projections in the future.
Risk Management: Pro Forma Financial Models help to carry our due diligence research and forecast potential future outcomes of a decision. A common example of risk management is considering to raise the debt-level of a business and analyzing the impact on cash flows to ensure lender covenants can be met.
Downfalls of Pro Forma Financial Models:
Overall, Pro Forma Financial Models are widely considered to be a net positive for businesses and investors, but they are not without their limitations and downfalls. Limitations and downfalls of Pro Forma Financial Models include:
Terminal Value Reliance: Valuation Pro Forma Financial Models typically have heavy reliance on the terminal value, which is the main contributor to returns (IRR, NPV, etc.). If assumptions are too aggressive leading up to the terminal cash flows, the cash flows will be too high and the resulting terminal value will be inaccurate. In addition, the terminal value typically requires an assumption for an exit capitalization rate or multiple, which presents opportunity for manipulation.
Time Requirements: Preparing a Pro Forma Financial Model is a time-consuming process to ensure all calculations are correct and that all required data is appropriately input into the Pro Forma Model. Many investors and business owners will mention, “Analysis Paralysis,” which is an inability to make a decision driven by over-thinking and over-analyzing a problem or opportunity.
Inaccuracy: Pro Forma Financial Models are developed with a wide variety of assumptions about future investment and/or business performance. The assumptions about the future could be deemed completely inaccurate due to changes in the industry, business, or investment.
Manipulation: Small assumption adjustments within the model can result in drastically different results, which makes Pro Forma Financial Models prone to data manipulation which could provide inaccurate output results.
Errors: Although Microsoft Excel provides a robust spreadsheet tool, it can be prone to errors especially if multiple people are utilizing the Pro Forma Financial Model and accidentally overwrite formulas or misinterpret inputs.
Pro Forma Financial Modeling Best Practices:
Pro Forma Financial Modeling has best practices to help drive financial and investment decision making. Examples of best practices, which are fully described in the “Financial Modeling Best Practices,” blog post, include:
Identify the Pro Forma Model purpose
Clarifying the desired outcomes of the Pro Forma Model
Understanding the end use of the Pro Forma Model
Developing a structure for the Pro Forma Model including standardized formatting
Preserving integrity of the Pro Forma Model by integrating checks and balances
Testing, reiterating, and updating the Pro Forma Model as needed to ensure it is accurate and current
Pro Forma Financial Modeling Disclaimer:
Pro Forma Models and their associated pro forma financial statements present like regular financial statements, but are not GAAP (Generally Accepted Accounting Principles) compliant. To be GAAP compliant, financial statements must be based on actual historic financial results. Due to this, it is important to clearly identify Pro Forma Financial Models and their associated financial statement output as "Pro Forma" to ensure a business is not being misrepresented to investors, financial institutions, and regulatory bodies.
Pro Forma Models:
Pro Forma Models has a variety of institutional-quality pre-built financial models and is available for custom pro forma financial modeling engagements. Examples of some top selling models include: