Definition
Pro-forma earnings are reported earnings results of a company that exclude non-recurring items, such as restructuring costs, changes in accounting rules, or certain large one-time expenses. They give a picture of a company’s profits under what it views as normal operating conditions. The purpose of pro-forma earnings is to provide investors a clearer view of company’s ongoing operational performance.
Key Takeaways
- Pro-Forma Earnings are a type of financial measurement that disregards certain costs, such as non-recurring expenses, that a company doesn’t consider part of its regular operational activities. They provide an alternate view of a company’s profit potential.
- This type of financial reporting can give investors a better understanding of a company’s long-term earning potential, however, they might also mask significant information. Therefore, they should not be used in isolation to judge a company’s financial performance.
- Pro-Forma Earnings aren’t regulated in the same way as Generally Accepted Accounting Principles (GAAP) earnings. Because of this, it’s up to each company to decide what is and isn’t included in pro-forma calculations. This can lead to manipulation or inflation of pro-forma earnings.
Importance
Pro-forma earnings are significant in finance as they provide investors and financial analysts a clearer picture of a company’s financial health.
They are adjusted earnings figures that exclude exceptional or one-time costs and are not defined by Generally Accepted Accounting Principles (GAAP). This practice allows companies to present a perspective of their earnings that they believe more accurately reflects ongoing business performance and provides a better basis for forecasting future performance.
While pro-forma earnings have their critics and can be misleading if used manipulatively, they also have their utility in financial analysis as they bridge the gap between the actual financial position and a potential financial position by eliminating non-recurring activities.
It gives users the ability to compare companies on an ‘apples to apples’ basis.
Explanation
The fundamental purpose of pro-forma earnings is to provide investors and analysts a clearer view of a company’s profitability. This financial measure is often utilized by organizations to present a more accurate picture of their financial performance, excluding one-time charges or gains, extraordinary items, or effects of an accounting change.
Pro-forma earnings offer a more normalized earnings metric by eliminating non-recurring items that might distort the understanding of a company’s ongoing earnings capacity. They are used to better depict a company’s operational performance, which in turn assists the stakeholders in making informed decisions.
Pro-forma earnings are especially useful when there are significant fluctuations in net income due to special circumstances not related to normal operations, like a natural disaster, legal judgement or restructuring cost. For instance, if a company sold a division of its business, the revenue generated would distort the total income for that fiscal year.
Therefore, excluding such vast one-time revenues would facilitate more accurate year-over-year comparisons. However, it’s crucial to note that while pro-forma earnings can help show a business’s possible future profitability, they’re based on estimates and assumptions, and adjustments should be thoroughly reviewed because they can sometimes be used to manipulate earnings presentations.
Examples of Pro-Forma Earnings
Microsoft Corporation: In the tech industry, new product development and upgrades are an inherent part of operations. It’s not uncommon for firms like Microsoft to show pro-forma earnings where non-recurring costs such as costs for product development or software upgrades are not included. The company may report pro-forma earnings to highlight the underlying business performance.
Amazon Inc.: Amazon often showed pro-forma earnings during its early years of business. The company was not profitable for many years and consistently reported losses. However, they used pro-forma earnings to highlight their operational performance excluding non-recurring costs such as expansion costs and the costs of entering new markets.
Merck & Co. Inc.: Pharmaceutical companies often report pro-forma earnings by excluding the costs of research and development which are very high and not usually recurring. For example, Merck & Co. Inc. might report pro-forma earnings where the expense of developing a particular new drug is not included. This helps to provide a clearer picture of the firm’s earnings from its ongoing operations.
Pro-Forma Earnings FAQ
What are Pro-Forma Earnings?
Pro-Forma Earnings are a set of financial results that a company presents excluding unusual or nonrecurring transactions. They are often used to present a clearer picture of the company’s underlying operational performance.
Why are Pro-Forma Earnings used?
Pro-Forma Earnings are used to provide investors and other stakeholders with a more accurate measure of a company’s ongoing business performance. They exclude items that are not considered part of normal business operations, like restructuring costs or gains from sale of a division. This makes it easier to compare performance from one period to another.
Are Pro-Forma Earnings misleading?
While Pro-Forma Earnings can provide a clearer view of operational performance, they also have potential to be misleading. This is because companies may exclude expenses that, while not part of ‘normal’ operations, still affect the company’s profitability. Therefore, it’s important for investors to understand what is and isn’t included in these figures.
What’s the difference between Pro-Forma Earnings and GAAP earnings?
Pro-Forma Earnings differ from GAAP (Generally Accepted Accounting Principles) earnings in that they exclude certain financial transactions that are included in GAAP earnings. These transactions may include restructuring costs, costs related to mergers and acquisitions, and any other nonrecurring items.
Can Pro-Forma Earnings be trusted?
While Pro-Forma Earnings can provide useful insight into a company’s operations, they should not be used in isolation. Investors should also assess a company’s GAAP earnings and understand the differences between the two. It’s also crucial to read the notes accompanying financial statements, as these provide detail on what has been excluded from the Pro-Forma earnings.
Related Entrepreneurship Terms
- Non-GAAP Earnings: This is an alternative earnings measure used by companies along with GAAP (Generally Accepted Accounting Principles) earnings. Pro-forma earnings fall under this umbrella as they exclude certain costs or revenues.
- Extraordinary Items: These are non-recurring gains or losses from events or transactions that are not considered part of normal business operations. Extraordinary items are often excluded when calculating pro-forma earnings.
- Earnings Before Interest and Taxes (EBIT): This is a measure of a firm’s profit that includes all incomes and expenses except interest expenses and income tax expenses. Pro-forma earnings often consider EBIT.
- Financial Reporting: It’s the process of producing statements that disclose an organization’s financial status to management, investors, and the government. Pro-forma earnings can appear in financial reports to provide a different perspective on company performance.
- Income Statement: It’s a financial statement that measures a company’s financial performance over a specific accounting period. Pro-forma earnings provide a version of the income statement which excludes certain items to present a different picture of a company’s profitability.
Sources for More Information
- Investopedia: It is a comprehensive source of financial knowledge. They provide definitions of financial terms, articles, tutorials, and more on a wide range of financial topics.
- Corporate Finance Institute: This site offers a wealth of finance and accounting knowledge, including definitions, methods, guides, and certifications.
- Accounting Tools: This website provides a large number of resources related to accounting and finance, including terms definitions, articles, and courses.
- Finance Strategists: It offers guides, tips, and resources on a broad range of finance features, including pro forma earnings.
