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We're about to walk through a simple step-by-step process for creating a Pro Forma Balance Sheet. We put this guide together because there doesn't seem to be any great resources for beginners, so if you're unsure where to start, you're in the right place.
By the end of this article, you will know how to create projections for each standard balance sheet section. The example we'll complete is a pro forma balance sheet for a fictitious restaurant. If you'd like to follow along, feel free to download the template:
The only prerequisite before continuing is that you have a basic understanding of the balance sheet. If you're new to the topic, then our previous blog post explaining how to read a balance sheet should be more than enough background. We also have a video for the more visually inclined.
A pro forma balance sheet is a balance with forecasted future values. As we know, balance sheets contain a running balance of all existing assets, liabilities, and equity for a business. Pro Forma’s contain running balances for the assets, liabilities, and equity we wish to have in the future. These balance sheets are excellent tools for planning serious changes to the business, whether you're thinking about taking on a new loan, purchasing a large piece of equipment, or even buying another company.
You can download the template we’ll use to create our pro forma step-by-step here: Download Template.
We'll start at the top of the balance sheet with Current Assets and work our way down section-by-section, ending with Shareholder's Equity.
Within each section, we have to treat each line item as a unique forecast, making the balance sheet more tedious than the other pro forma financial statements.
How we forecast each item will be different depending on the section. We want to keep this tutorial simple, so we'll use the pro forma income statement to help forecast much of the balance sheet. This approach means we need to create the income statement first.
Here's our tutorial on the pro forma income statement as a reference.
You may have noticed that our example template includes completed pro forma financial statements. We're providing them to limit our conversation to the balance sheet as much as possible, but we ultimately need the income and cash flow statements to complete our balance sheet. We'll see how that's the case by taking a look at our first section.
Current assets represent resources that a business expects to use some time over the next 12 months. These assets are also the business’s most liquid, meaning they're relatively easy to turn into cash.
There are several ways we could go about forecasting each asset. A safe fallback option, if you're in doubt, is to use a percentage of revenues. The idea is that revenue represents the size of company operations. Current assets are heavily used in operations, so it's fair to assume that these assets will also grow as revenues grow. The primary exception to this rule is cash.
Even though cash is typically the first line item on the balance sheet, we don't handle it first. The reason is that its value comes from the cash flow statement.
We're not going to cover exactly how to calculate cash because that's what the cash flow statement is for, and we're focusing on the pro forma balance sheet.
All we need to know right now is that the value of cash on the balance sheet is equal to the cash we have at the end of the period, as reported by the cash flow statement.
Cash may seem underwhelming as our first example, but this is one of the conventions that make the balance sheet more difficult. We won't even know if everything balances until the cash flow statement is complete.
Luckily, cash has already been handled in our example template, so we’ll move on to the next item.
Receivables describe the current cash balance customers owe the company.
Generally, receivables indicate that we’ve sold something to customers for which they haven't yet paid. As you might have guessed, the close relationship between sales and receivables makes revenues a great option to use as the basis for our projections.
To create a forecast for receivables, all we need to do is multiply revenue by some percentage. This percentage represents the size of accounts receivable relative to revenues at a given point in time.
If we have previous financial statements, we can get this percentage by dividing receivables and revenue from the same period.
When the percentage is consistent across multiple periods, there is likely some correlation between sales and receivables.
New businesses will need to take a different approach. An excellent place to start is by Googling typical percentages for your industry. Then, once you start generating sales, you'll be able to replace it with something more accurate.
The last step we take is multiplying the percentage and forecasted sales to determine the projections for receivables.
We can then take that forecast and stick it right on the balance sheet.
When it comes to inventory, we could once again use the percentage of sales method, but we're going to do something slightly different. We know Inventory gets used to produce the goods or services we're selling, which means it's a cost, and we can probably get a better forecast by using some percentage of costs instead.
The costs for inventory are often found in the Cost of Goods Sold (COGS) section of the income statement, which we'll use for our forecast.
First, we'll divide inventory by COGS to get the percentage (or Googling if we have no data).
If we get a consistent percentage across multiple periods, we can assume a correlation between costs and inventory.
We can then multiply our percentage by future COGS to get the forecast for our balance sheet.
This step wraps up the explanation of our first section, and the only thing left is to add it all together for our total current assets.
Fixed Assets represent the first of our longer-term investment decisions. Your level of inventory, for instance, is largely based on customer demand; however, a new equipment purchase is more likely to be a decision you make for the company.
How we forecast fixed assets depends on the situation we're facing. The most straightforward scenario is when we don't expect any additional asset purchases.
If we don't need to purchase any assets, then we can forecast the same asset values into the future. It’s similar to saying we expect no change in these assets. In the case of our restaurant, we’ll assume the current level of kitchen equipment is sufficient for now.
The potentially tricky thing, in this case, is if we need to deal with existing depreciation. The easiest way to handle depreciation is to look at the income statement for prior periods, which is where depreciation lives.
When we find the most recent value for depreciation, we can assume it best represents the most current depreciation rate and use it for our forecast.
We then need to add the expense to accumulated depreciation every period, and that’s it!
We'll need to take a few additional steps if we plan to purchase some new assets.
Forecasting new asset purchases requires the use of two numbers: a Price and Useful Life. Our restaurant appears to be running short on dishes and silverware, and they’ve set a budget of $25,000 for the new investment. Adding our transaction to the balance sheet requires we first add $25,000 to the existing asset balance.
Now we’re left with Useful Life, which is what helps us calculate depreciation. A quick Google search for “typical useful life” values should turn up some helpful resources. Here’s one such example. It turns out the new dishes we just bought have a useful life of five years, so we’ll divide the purchase value by five.
We then add the new depreciation to any existing depreciation, and we’re done with fixed assets.
The last thing we need to do is add up our current and fixed assets to get total assets, which is the line we need to match with total liabilities and equity.
We won’t spend too much time discussing current liabilities because we’ll handle them similarly to current assets. Both “current” sections are highly related to business operations, which is what the income statement is all about.
The laziest thing we could do is use a percentage of sales, just as we did before.
However, we're starting to get pretty good at this. I bet we can do better. If we want to be even more "scientific," we would find something else from the income statement that is a closer reflection of the current liability in question.
In the case of our restaurant example, Accounts Payable may primarily consist of invoices we owe to the vendor from whom we buy our supplies. We might then reason that the "Supplies" expense would be more of a driving factor for this payable.
We can always check by dividing the liability and the item in question to see whether the resulting fraction looks consistent enough to indicate correlation.
Once we've found the right match, we can forecast accounts payable by multiplying our fraction and future supplies expenses.
Now we rinse and repeat, and all that's left is adding everything up to get our total current liabilities.
Long-term Liabilities are the second section representing longer-term decisions, and much like fixed assets, it’s harder to make blanket statements like we made for the "current" sections.
There are a few more moving parts with liabilities. Unlike fixed assets, where we had asset value and useful life, we have more to consider with liabilities. Take the case of a simple loan. We need to be concerned with at least three numbers: the balance, the interest per payment, and the principal per payment.
The good news is that we don’t need to worry about this section if we don’t have any debt and don’t expect any new debt.
Otherwise, how we proceed depends on whether we're dealing with an existing debt or new debt.
As we just discussed, we'll need to know three numbers before adding new debt to our balance sheet.
There are more accurate ways to forecast the debt balance, but they'll require fancier equations, which just distracts from the core concepts we're learning. All we need right now is an approximation, not tiger-woods-like precision, so we'll use the simple interest method.
The first thing we'll do is divide the total loan amount by the length of the repayment period, which gives us the principal we need to pay each year. In the case of the restaurant, we’ll pay back a $75k loan over five years.
Now let’s take the amount of new debt and multiply it by the annual interest rate to get our approximate interest payment for the year. Our restaurant has an 8% annual rate.
Next, we need the ending balance each year. We can get the ending balance by subtracting the principal payments from the beginning balance.
Then we carry the ending balance over to the next year and repeat the calculation.
Ultimately, our forecast should look something like this:
The ending balance is what we’ll track on our pro forma balance sheet, so we’re now done with existing debt!
You may be wondering why we calculated the interest, as we didn’t use it, and that’s very astute of you to notice. We calculated interest because although we don’t explicitly need it now, we do need principal and interest separated to complete the other pro forma financial statements (which we won't cover right now).
Existing debt can be a bit trickier. If we don’t have all of the relevant information, we may have to get creative to estimate it.
Just like our new debt scenario, we’ll need three numbers: the existing balance, interest per payment, and principal per payment.
Luckily, we already have the existing debt balance, as it’s the most recent value reported by the balance sheet.
The other two values may not be as apparent without the information readily available, so we may have to fill in some gaps.
Although we need both the interest and principal for complete pro forma financial statements, for now, we're going to focus on the balance sheet and ignore interest payments. Our chosen focus means we're only concerned with the principal. Assuming nothing much changed, we can grab last year's principal amount from the cash flow statement (because that's where we find it).
We can then assume the same rate of contribution each year until the debt is paid off.
Now we can calculate the ending debt balance we’ll need for our pro forma balance sheet.
Once we've completed this process for each of our long-term liabilities, we just need to add them up for a total. We can then take our total and add it to current liabilities for our total liabilities.
We've reached the final section of our pro forma balance sheet, and it's the easiest of all, so congrats on getting past the hard part!
Shareholder’s Equity contains two primary elements: capital contributed by investors or founders and retained earnings.
If we don’t plan on issuing new stock -- by raising equity capital -- then we just forecast the same value into the future.
On the other hand, if we're raising $25K from investors, we add the new funds to the previous stock balance for total stock value.
Retained earnings represent the lifetime earnings (i.e., profit) of the business. To forecast these earnings, we take the most recent value for retained earnings and add the net profit for the current month.
This way, retained earnings will continue to grow (or decline) based on future net profit.
We can now add everything up to get total equity, which leaves us with one final task. The moment of truth. Adding equity and liabilities together and seeing whether it matches our total assets.
If it matches, then we're all done, and you've conquered the balance sheet!
If you'd like to create a pro forma balance sheet without equations or spreadsheets, check out Poindexter. It's free to sign up, so there's nothing to lose!
