Pro Forma Basics

Photo by NeONBRAND on Unsplash

If you’re interested in starting a business or have a business and aren’t certain if you’re looking at your statements accurately, this early stage guide can help. In this blog post, Justin Bailey, our head of Fin Ops at 1804, will take your through the initial process and frameworks for starting a financial statement pro forma and touch on the importance of KPIs and tracking them.

Note: This is VERY introductory. If you have more advance questions, shoot an email to Justin@1804ec.com.

Let’s Get Started

This piece isn’t meant to recall images of an accountant with a green visor and glasses or your parents pleading for you to pay attention because it’s good for you. But this discussion is so vitally important you can’t run a profitable (read: pay yourself!!) business without. So, let’s push through those inevitable thoughts and get on with the material.

Being versant in this material could mean the difference in paying an out of house team thousands of dollars per month – Ugh, that’s not why you started a business – telling you what your numbers are and being so in touch with your endeavor that you know which levers to pull when you want certain outcomes without taking too much time or money from the business itself.

Ready?

Instinctively, we know what makes a business profitable – more revenue than expenses. We also know we need cash at the end of the month to pay those expenses, our employees, and ourselves. Those two key pieces are the fundamental frameworks of the standard financial statement: the Income Statement and the Balance Sheet.

First, let’s take a high level look at the Income Statement.

Income Statement

As mentioned earlier, the Income Statement broadly shows us Revenues and Expenses.

  • Revenues can be anything from bow ties to button clicks on a website.
  • Revenues should also include the discounts given over a given period and any credit card or other transaction fees included in the generation of revenue.

Expenses, however, can come in many forms.

  • They can broadly be in one of two categories – Costs of Goods Sold (COGS) and Administrative and General Expenses. Expenses such as inventory purchases or website uptime costs should factor in as COGS.
  • For a company that makes a product, inventory purchases and works to produce that product are COGS.
  • For a software company, COGS include server space and onboarding costs.

So now we have Revenue – COGS = Gross Profit. Many times the term Gross Margin is used, but that metric is Gross Profit/Revenue and is represented as a %.

All of the other expenses required for operations then come after Gross Profit. They’re labeled as Operating Expenses, and Selling and Administrative Expenses, or another similar name. These expenses include advertising and marketing costs, payroll and benefits costs, and rent, among others.

The crucial formula then is Gross Profit – Operating Expenses to give us Net Profit. 

Balance Sheet

The famous mantra for startups still reigns supreme, “Cash is King.” And we find and track that cash first on the Balance Sheet. Unlike the Income Statement, the Balance Sheet is a snapshot of where the company currently is, as opposed to the occurrences over a set period for the Income Statement. We’ll move on to tracking cash over time later, but now it’s important to know more about the Balance Sheet.

First and foremost, the Balance Sheet is governed by the equation Assets = Liabilities + Equity.

Assets fall into three main categories:

  • Current Assets
  • Long term Assets
  • Other Assets

For most companies just starting out the bulk of their assets will be in Current Assets, including:

  • Cash
  • Accounts receivable
  • Inventory
  • Some equipment
  • Pre-paid expenses
  • And others…

Long-term Assets are mainly pieces of equipment that have a life longer than a year.

Liabilities certainly include credit cards and other owed expenses, such as, accounts payable, in the current-term, and long-term are loans or other payables with a time to maturity of more than 12 months.

After Liabilities, we’ll certainly have some remaining amount that causes the Assets and Liabilities to not equal each other. If everything else has been included in either the Assets or Liabilities, this remainder is most likely the Equity. This can also be seen in the equation Assets – Liabilities = Net Worth.

For many companies early on, the net worth will be negative, so don’t get too bent out of shape if you see this. You’ll just have to work to make sure the net worth figure becomes positive over time.

What are the key levers to influence net worth becoming positive, or in a different phrase, what are the Key Performance Indicators (KPIs) to pay attention to?

Depending on your business you’ll have different revenue and income statement based KPIs. For software companies, they’ll be anything from website visits to engagement stats on social media. For hardware companies the Income Statement KPIs could include aspects of inventory levels and inventory throughput, while also being mindful of COGS and profit margins.

Balance sheet metrics are listed nicely here, here, and this quora search for financial ratios.

Cash Flow

Cash is KING!!! That’s the mantra we hear, and it really is true for startups. If we aren’t managing cash, then we aren’t doing our best by our investors (even if that just means ourselves and maybe some friends and family).

So what does the Cash Flow statement really tell us? To begin, the Cash Flow Statement is comprised of three main categories, cash from:

  • Operating Activities
  • Financing Activities
  • Investing Activities

Let’s Take These One by One

Cash from Operating Activities comprises all the flows of cash from normal, day-to-day business activities. We start with the Net Income from the Income Statement, then we have to add back in a few non-cash activities (such as Depreciation) then take into account each of the other key operating activities. Here we use the decrease in accounts receivable (decrease means we’re getting more of our money that’s owed to us), increase in accounts payable (increase means we’re getting better terms, re: longer time-based payback, of payables), decrease in inventory (decrease means less money tied up in inventory), and increases in other activities.

Cash from Financing Activities are made up by long term asset purchases (normally referred to as Capital Expenditures) and short term investments typically unrelated to the core operations of the business.

Cash from Investing Activities include dividends paid, money from investors in the form of stock purchased, any change in long-term debt levels, and, if applicable, effects of exchange rate changes.

Because we’re combining and analyzing the Balance Sheet and Income Statements together with the Cash Flow Statement, we can see interesting trends over time. We’ll normally see exactly where, how, and to what extent we’re spending or saving money over a given period. Paying attention to Cash Flow from Operations is likely the foremost goal of any startup. This metric is a type of “canary in the coal mine” for many investors.