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The Before and After of Pro-Formas

“What’s a pro-forma?” Asked a participant at a recent financial intelligence session.

Pro-forma refers to an adjusted, non-GAAP financial statement. Because the world of accounting loves to deploy terms in multiple ways, pro-forma ends up being used in two situations.

1) Non-GAAP results shared with investors
2) Internally to estimate the results of a decision (like an acquisition)

Given many firms report both GAAP (generally accepted accounting principles) numbers (as required by US law) and their own non-GAAP (or pro-forma, not required by law) results, it’s important to recognize the differences between the two and to ask why both are being shown. Remember, the firm defines the pro-forma results (that is, what the numbers include and don’t include).

What story do the pro-forma results show investors that the GAAP results don’t? If the firm is making a one-time adjustment for restructuring costs, for example, is that really a one-time thing or a one-time thing that happens a lot? If the company recently started showing pro-forma results, what’s the reason for it? Keep in mind, that pro-forma numbers, like operating earnings, at one company will not be the same as those from another business.

It’s important not to jump to negative conclusions about sharing Non-GAAP results with investors. The key is asking questions about them and understanding why they’re being used.

Pro-Forma results are also used when finance makes a projection about the benefits/costs of a business decision. This could be an investment (like a major capital purchase or acquisition), divesting a division or forming a joint venture. In this case, the pro-formas are a guide or an estimate; they are an ROI (return on investment) analysis. In other words, the pro-formas are a projection to assist with decision making.

A firm holding a Financial Intelligence session had recently announced a major acquisition, questions related to the second type (investment) pro-forma came up. After we discussed how pro-formas are an estimate, the participant asked a follow up question.

“Ok,” he said, “so does anyone refer back to the pro-forma financials once the acquisition is completed? Do they, for instance, do a one-year review?”

Rather than answer, I asked the forty other participants what they thought. People learn through discussions; it’s important to keep them involved and active during a training session.

“Here’s what happens,” commented another person. “If the acquisition outperforms the estimates, you’ll see comparisons of it versus the pro-formas. If, however, the acquisition fails to meet the pro-forma results, the pro-formas disappear, never to be found again.”

Everyone chuckled, illustrating the “real-world” of both corporate culture and financial analysis. In an ideal situation, pro-formas would be used as guides to help a company make better decisions. All too often, though, they end up being a scorecard. If I “won”, I’m happy to show the pro-formas; if I “lost” I’d prefer to avoid discussing the estimates.

The value of a post-investment review of pro-forma financials (whether the actual results end up positive or negative) isn’t rewarding or punishing people who championed the investment. It’s learning where the estimates were off and discussing the reasons why. That process builds Financial Intelligence, enabling everyone to make better decisions in the future.

 

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