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SESSION 13

Financial (2)
Pro forma statements

Session Outline

Objective

The culmination of the business plan is the creation of the statements. All the previous research on revenue projections, costs (direct and indirect), purchases (assets), and start-up financing (debt/equity) will be used to build the required pro forma statements.

This session will help you to assemble your pro forma statements and understand the importance of each in managing your business start-up and monitoring the success. The pro forma statements include the following:

Cash flow (The most important document)

Income statement (Profitability)

Balance sheet (What you own, what you owe)

Break-even (How long you will “burn cash”)

Learning Points

Learning to build the financial statements

Understanding the value of each statement

Understanding how to analyze the statements

Learning how to make decisions based on the statements

Review of the course

Introduction

Entrepreneurs are not expected to be accountants. In fact, the best use of an entrepreneur’s time should not be to focus on bookkeeping. Entrepreneurs who are not comfortable with financial data should not be expected to learn to do books – it will be very inefficient and frustrating. The net result will be an entrepreneur who does not love what he/she does and a set of books that took too long to develop (and may be inaccurate).

The best use of an entrepreneur’s time is to be involved with his/her market (customers, employees, suppliers, alliances, etc.). A part time accountant can develop the books more efficiently, and accurately than the entrepreneur. With this in mind, the purpose of this session is not to make you an accountant or a bookkeeper – the intent is to provide you with the knowledge to understand financial statements so that you can monitor/measure your business success and intervene, when and where necessary, to prevent business failure. An inability to take appropriate action can lead to business failure and the financial statements are the indicators of where problems are arising.

Financial statements are measurements of performance. In the case of pro forma statements you are projecting how well your business will succeed. Once the first year is over, the actual statements will determine how well you did in comparison to your projections. Consider golfing, bowling or another sport. If you play the sport and don’t keep score you would never know how well you were doing and would probably not improve. Keeping score is useful to measure performance to determine where you need to intervene to make improvements. A golfer, for example, keeps statistics on score, number of putts, fairways hit, greens hit in regulation and sand saves. The reason is in order to find which area of his/her game needs improvement. Then they can seek the appropriate strategy to improve that part of their game. In business the same concepts apply. The “score” is recorded in the financial statements and the entrepreneur has to understand the statements (not necessarily create them). In understanding how to read financials, the entrepreneur is like the golfer who can understand and act on the information to improve.

THE STATEMENTS

Cash Flow

The reason the cash flow is the most important document for an entrepreneur is because a start-up does not have many (if any) cash reserves. Furthermore, after the start-up financing the entrepreneur will unlikely get any rescue financing.

Cash flow tracks the cash on hand in the business, monthly. Many times you will find that sales are excellent but there is no cash on hand. Whenever a sale is made, you will have costs (getting the product/service to the client) before you have the receipt from the sale. So, frequently you will be “cash poor” but sales rich. Your income statement will indicate that you are having a profitable year but at a specific point in time, during that year, you will experience a “cash crunch” which needs to be managed.

The pro forma cash flow statement shows the cash surplus, or shortfall, that will occur in each month. Based on seasonality of sales and the lead time for inventory, you will have a cash balance (or deficit) at the end of each month to deal with. You need to show the business plan reader that you understand when you will predict to have these “cash crunches” and how you will cover the months with a cash shortfall. The cash flow statement does that.

Essentially, the cash flow is like a bank account. It records the cash put into the business each month (not sales) and the cash taken out of the business each month (not expenses). Each month has an ending cash balance or deficit. For example, if you see that the month of May will leave you with a $500 cash shortfall you can perhaps get the landlord to wait a month for the rent, get an advance on sales or even sell a business asset (results in inflow of cash).

Income Statement

The income statement measures the profitability of your business. It records the sales that were made and deducts the direct costs of making those sales to get a gross profit. Then the indirect (overhead) costs are deducted to get the net profit.

There are industry standards for Gross Profit Margin. Dun and Bradstreet, Standard and Poor’s and Statistics Canada have averages for each industry for Gross and Net profit margin. For example, the cost of goods sold in the bakery industry is 60% - this means that 60% of all sales are direct expenses which means that 40% of all sales are Gross Profits (so 40% is the gross profit margin). In the travel industry, 85% of sales are cost of goods sold, which means that the industry has 15% gross profit margins.

The importance of this is that the business plan reader has access to industry standards for gross profit and net profit margins. If your financial pro formas show a significant variance from industry norms you will be questioned as to why you will be able to exceed industry standards ( especially as a start-up ).

Gross profits – overheads (indirect costs) = Net profits. Net profit margin is the % of sales that becomes your net profit. To work with the previous example:

Sales $30
- Cost of goods sold $20
=
Gross profit $10 (34% Gross profit margin)
- Overheads $
=
Net Profit $

This is an income statement based on one unit of sale (one grass cutting). What we have done here is to allocate overheads and we find that we end up with $5 in net profit for each lawn done (16% net profit margin).

Some typical problems with the income statement include:

Inadequate total sales to cover the overheads
Cost of goods sold are too high (poor purchasing/negotiations with suppliers)
Gross profit margins are good but overheads are too high resulting in poor net profit margins.

Balance Sheet

The balance sheet determines:

What you have (assets), what you owe (liabilities), and what you own (equity). The balance sheet is very important to measure the amount of the business that is leveraged, the efficiency of the assets of the business and the breakdown of the business ownership.

Assets (what you have)

Typical assets on a balance sheet are cash, accounts receivable, inventory, equipment, office furnishings, auto, computer, and office equipment.

Critical questions that arise from an examination of the assets on a balance sheet:

Are the accounts receivable too high? Is there a danger that the accounts receivable will become bad debts. This is a particular issue in a small community where friends and family expect you to extend them credit (accounts receivable for you) and then they don’t pay.

Is the inventory current? In a lot of businesses the inventory may be evaluated at book value (the initial cost of acquiring the inventory) when, in fact, the market value (what it could be sold for now) is a lot less. The fashion industry, in particular, is susceptible to this fluctuation as the inventory becomes obsolete each season.

Are inventory levels too high? Too low? It is inefficient to carry too much in inventory but you also want to avoid stock-outs (when you have customers but can’t service them because you’re out of inventory). Ideally you have just-in-time inventory where you get it as needed for each day but this depends on your supplier and their ability to get you daily inventory.

Is the equipment efficient? Managerial decisions need to be made based on the efficiency of the equipment. Comparing the ratio of productivity to equipment will help you decide if it is time to invest in new machinery that will require an investment but be much more productive (analyze return on investment and payback period).

Liabilities (what you owe)

Typical liabilities on a balance sheet are accounts payable, short term loans and long term loans.

Critical questions that arise from liabilities:

Are the accounts payable too high? In some ways it is good to have accounts payable because it frees up cash for other uses, but at the same time it can get out of control. It is very similar to using a credit card – it is useful to manage cash flow when your cash is low but you need to pay it back in times when you have cash surpluses. At the start-up phase your accounts payable will be low to zero because you’ll be too risky to lend money to. Many entrepreneurs finance their business by running their own personal credit cards to the maximum but this is a personal liability as the money you get from the credit goes into the business as your equity and an asset (cash).

Is there too much debt in the business when compared to the amount of equity (ownership). Investors watch this ratio carefully – every lending institution will want to see some equity (owner’s risk) before they will consider granting a loan. If not managed well, the owner can easily owe more than he/she owns.

Does the type of debt match its use? Long term debt (lower interest rates) should be used to finance capital expenditures (equipment, building e.g.). Short term debt (higher interest rates) should be used to finance smaller, short term expenses like inventory and salaries. This is similar to home management – you wouldn’t take out a mortgage to buy groceries and you shouldn’t use a credit card (interest rat of 18%) to buy a car.

Owner equity (what you own)

This section of the balance sheet shows what the business owns (assets – liabilities or “what you have” – “what you owe”. It also shows who owns what part of the business. In a sole proprietorship the entrepreneur owns all the equity. In a partnership the ownership can be equal among partners or vary.

Critical questions on equity:

How much of the business is owned (equity) vs. owed (liabilities)?

Who controls the business (owns the majority of the equity)?

Is there sufficient equity for a second round financing

Example

Let’s consider a start-up where you have $3,000 of your own money to put in the business, Tewatohni’saktha gives you a grant of $2,000 and a matching loan of $2,000. You purchase $5,000 of inventory from a supplier and pay for it with $ 2,000 in cash and an agreement to pay the remaining $3,000 in 60 days.

Your balance sheet will now look like this (N.B. A balance sheet shows the position of a business at a specific point in time while the cash flow and income statement track the performance over a period of time):

Assets

$ 5,000 (your $3,000 + $2,000 grant + $2,000 loan - $2,000 cash for inventory)

Inventory

$5,000

TOTAL ASSETS $ 10,000

Liabilities

Accounts payable $3,000 (The portion of the inventory to pay)

Loans $2,000

TOTAL LIAB. $5,000

Your ownership $5,000 (Your $3,000 + grant from Tewatohni’saktha )

Notice, in our example on balance sheet, that the numbers must “balance”. “Everything you have” must balance with “Everything you own + Everything you owe). Or, to put it another way:

(Assets)-(Liabilities)

What you have – what you owe = what you own

Break-even analysis

Initially the business is being supported by start-up financing. It is very important for the business to quickly reach a point where the revenues will be able to pay all business expenses. Until that time, the business is dependent on external money to keep it afloat. This is the “burning cash” phase where the business burns (consumes) more cash than it is generating in revenue. The break-even point is where the revenues of the business cover exactly the expenses. After break-even, the business starts to “throw cash” (generate more revenue than it consumes, also known as profits).

So, a business plan reader is very interested in when the business is projected to reach that important break-even point. The break-even point can be determined in terms of # of units sold and also the dollar volume of revenue. The time that this break-even point occurs is vital to know.

Break-even is a function of the:

Fixed expenses (overheads like rent, loan repayment, utilities)

Variable expenses (cost of goods sold, direct labor and materials)

Revenues (Gross sales)

The way it works is that each sale has a selling price and a cost of goods sold. So, for example, you purchase a notebook for $1.00 and sell it for $2.00. Your revenue (per notebook) is $2.00 and your cost of goods sold (per notebook) is $1.00.

The important question is: How many notebooks need to be sold (at $2.00) in order to break-even? How long will this take?

Now we know we are making $1.00 in gross profit for each notebook sold ($2.00 selling price - $1.00 cost of goods sold). This gross profit is also known as “contribution margin” because it contributes to paying the fixed costs. We need to know what the fixed costs are of this business so we can determine how many units need to be sold.

Let’s assume the fixed costs of the business (manager salary, rent, loan repayment, utilities) is $2,000 per month. We now know that we need to get $2,000 each month to pay for our fixed costs. We know that we make $1.00 (gross profit) for every notebook we sell. So, we would need to sell 2,000 notebooks each month (2,000 notebooks x $1.00 = $2,000 to cover fixed costs).

This breakeven point changes if we have to alter our price. Suppose the competition reduces their price for notebooks to $1.50. Now we will have to sell at $1.50 also. Our gross profit is now $ .50 instead of $1.00 ($1.50 selling price - $ 1.00 cost of goods sold). To cover our fixed monthly costs of $2,000 we now need to sell 4,000 notebooks (4,000 notebooks x $ .50 = $2,000 to cover fixed costs).

Let’s stay with the first scenario. 2,000 notebooks needed to be sold, monthly, to cover fixed costs of $2,000 a month. We may predict to sell 2,000 notebooks for each of the first few months. In that case we are “burning cash” until we reach that point where we are selling 2,000 books per month (break-even point).

There is a formula for the break-even point that can be used to simplify the calculation:

Break-even (in units) = Fixed costs/contribution margin (selling price – cost of goods sold) = Units needed to break even

In our previous example we could plug in the following numbers:

Break-even = $2,000 (fixed costs)/$1.00 contribution margin ($2.00 selling price - $1.00 cost of goods) = 2,000 units

The financial section of the business plan summarizes all the research you have done to accumulate the estimates necessary to paint a financial picture of your business start-up. The financial statements will also become your ongoing score sheet to assess how well your business is doing and so that you may intervene, when the financials indicate a problem, to prevent the business from failing.

EXERCISE # 1

You are selling a hand car washing service. You will get, on average, $15.00 per vehicle washed, including add-on sales (air fresheners, waxing, etc). You are paying workers $5.00 for each car washed. You calculate that it costs another $3.00 per car for materials (soap, clothes, etc).

You calculate that there will be 150 days in the year when you can wash cars (weather data from previous years) and you expect, realistically, 20 cars on each of those days.

You need $1,000 a month for yourself, the rent is $200 per month (Shell station parking area + $50 for electric access and use of telephone). You will borrow $2,400 from Tewatohni’saktha for start-up costs to be paid back in one year, interest free. (start-up costs include equipment $1,000, washing supplies $500, promotional material $1,000 and discounts/coupons $500) You will put $2,000 of your own money into the business. You will also put your car (worth $1,000) into the business and it will cost you about $50 a month for gas and maintenance on the vehicle which will be used for advertising and getting supplies. You have also decided to use Tewatohni’saktha’s promotional fund to get $1,500 a year to be used for advertising, signs and business cards (a grant to entrepreneurs annually).

Using the above information, and the templates below,develop the income statement for this business, the balance sheet, and calculate the break-even point.

Income Statement

Year one

Gross Revenue (1)

Cost of goods sold (2)

Gross Profit (contribution margin)(1 – 2)

Rent

Salary (paid per time period not commission)

Utilities

Loan repayment

Auto expense

Other

Total Overheads (4)