Startup entrepreneurs face a daunting challenge in forecasting cash flow, profitability, and return on investment. It can be so overwhelming that many just ignore the numbers and jump right into developing a product or service. Certainly, a refined product or service is a critical early step in launching the entrepreneurial venture; however, understanding the financial aspects of the business, including the inputs to the product or service development is paramount to forecasting cash flow and business profitability, is equally important.
In business, particularly in the start-up phase, “pro forma” financial statements provide a way for the entrepreneur and potential investors to see the financial forecast of a business given a set of assumptions. The pro forma financials will include a set of assumptions on which the numbers were based, a cash flow statement, an income statement, and a balance sheet statement. Together, these statements provide an approximation of business performance considering the assumptions. Most investors place little value on the numbers a start-up provides because the core assumptions may be inaccurate (Rogers, 2014). And if the assumptions are inaccurate, the financial performance will change. One of the best ways to understand how assumptions change the financial performance of a business is to build an interactive pro forma.
The interactive pro forma will allow an entrepreneur to quickly change assumptions and easily see the possible financial impact on the business as those assumptions flows through the other financial statements. Once set up, it allows an entrepreneur to play a “What-if” game with assumption inputs and watch how those changes affect the business performance. The interactive pro forma is also a great tool to use when seeking outside investment. If the assumptions are challenged by an investor, they can be modified in real-time, and those modifications flow out to the other statements. This provides an instant view of the new business financials once new assumptions are in place.
Building the Interactive Pro Forma Spreadsheet
Spreadsheet tools make building an interactive pro forma easy, although it does take some knowledge of the tools and a few hours to set up the models. Most of the time spent should be given to considering the assumptions. Assumptions are the most important part of the model and are where entrepreneurs should put the bulk of their time.
Here’s one way to build an interactive pro forma:
- In a spreadsheet program, create a new workbook with four tabs. Label each tab as follows: Assumptions, Cash Flow Statement, Income Statement, and Balance Sheet.
- On the Assumptions Tab, list all of your assumptions about the business. Depending on the business one might choose product pricing, sales figures, monthly costs of operation, depreciation, taxes, insurance, etc. Make sure everything that could affect the business costs or revenue structure is included.
- On the Cash Flow Statement tab, include the beginning cash balances, your sources of cash, and the uses of cash for each month. Use the assumptions to drive the revenue (sources) and expenses (expenses) on this tab. Note that the cash that’s left over at the end of each month becomes the Beginning cash balance for the following month. The Cash Flow Statement shows how the business will use the money it receives each month.
- The Income Statement tab pulls data from the Cash Flow Statement tab but formats it differently. The Income Statement in a pro forma shows whether the business is profitable for a period by looking at the revenue and expenses based on the original assumptions (and cash flow).
- The Balance Sheet pulls data from the Cash Flow Statement and the Income Statement to provide a look at the assets, liabilities, and equity of a company at a point in time. It helps the entrepreneur better understand what the company owes (liabilities), what it owns (assets), and the equity held by shareholders.
The above points are oversimplified. The idea is to give an overview of the process. Each entrepreneur should develop his or her own pro forma to understand the specifics of his or her business better.
Using an interactive pro forma will help an entrepreneur get a better handle on his or her business by allowing the exploration of What-If scenarios that might impact the business. It is much better to explore these scenarios in advance of the launch and develop contingency plans than it is to encounter the problems in “real-time” without possible solutions waiting.
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Reference
Rogers, S. (2014). Entrepreneurial Finance: Finance and Business Strategies for the Serious Entrepreneur (3rd ed.). New York: McGraw-Hill Education.