If you want to start a small business but don’t know where to begin, a pro forma is the perfect starting point. To begin, a pro forma is a projected or estimated financial statement that presents a reasonable idea of what a firm’s financial situation would be given present trends and future assumptions. Pro forma statements generally use ‘what if’ scenarios to formulate business plans, estimate cash flows and project future financial position. When applying for a commercial loan you are often required to provide financial projections; in fact, the Small Business Administration (SBA) requires a 1 year pro forma income statement and narrative explaining how you will reach your projections. Formulating a business projection can be a daunting task but the following step by step guide will give you enough insight to create a bulletproof pro forma.
Chose a Business
The most obvious step in creating a business projection is choosing a business or industry. Once you have your business in mind do as much research into that business as possible. Some common searches would be industry trends, customer demographics, profit margins, capital investment needs, cash flows, revenue sources, most common expenses and other relevant topics. The research you do will form the building blocks of your assumptions which will create a more realistic pro forma. For example, if you are trying to start up a pizza shop you will do research into the average cost to startup a pizza shop, the cost of the ingredients, the cost of an oven, the average revenue and expenses, the profit margin for the average pizza pie and the best pizza recipe you can find on Google. Once you do your research you can move on to the next step.
Location, Location, Location
One of the most important variables in any business startup is the location. The location will drive many of the assumptions in your projection including labor cost, average rent, customer purchasing power, foot traffic and many others. Even if your business is primarily online, location makes a huge difference when you are trying to reach new customers. Once you chose your ideal location you want to do as much research as possible into that specific location as it relates to your chosen industry. Specific metrics you want to look for are population size, disposable income, competition and average cost to do business (rents, taxes, licenses).
Pin Down Your Market
After you chose your business and your location you want to really pin down a target market. Your target market will be a specific group you plan to sell to and it can be as broad or as narrow as you want, but it must be realistic; saying you want to target the entire market doesn’t count. For example, lets say you want to start a tattoo shop. You want to target people between the age of 18-30 who have disposable income and who listen to rock music (sorry if I offend anyone). You want to do research on how many people match this target market in your desired location and pin down an estimate on how many you can reach.
The Most Important Number In Your Pro Forma
If you are catching on to the common theme of this blog post by now you will realize that research is more important than the numbers. Anyone can put together a pro forma that projects million dollar profits every year for the next five years, but if you don’t have concrete research to backup your assumptions then your small business loan application will be rejected every time. Every number you put on your pro forma will be scrutinized and any number that is not in sync with industry averages will cause the bankers to sing bye bye bye. The most important number to start with for any pro forma, in my opinion, is the total number of customer transactions in a given year. If you did enough research on your industry and the location you’re providing your goods or services you can come up with a solid estimation on the number of customer transactions in a given year. For example, if you live in Seattle and want to sell umbrellas you can approximate how many times a year it rains, how many people buy umbrellas when it rains and how many of those people you are able to reach. Once you pin down the number of transactions you think you can reach then you can build the remainder of your pro forma.
Once you have a realistic estimate for the number of customer transactions in a given year you can more clearly project your total gross and net revenue. Depending on the nature of services you are providing or the goods you will be selling you can approximate the timing and frequency of your revenue streams. For example, if you are selling clothing online you will expect the majority of your revenue to come in the form of high volume cash sales. However, if you are in the professional service industry then your revenue cycle might consist of sales on account on a cyclical basis. You also should factor in any returns or discounts in your calculation as well as an allowance for bad debt if you are dealing with a high volume of sales on account.
Variable costs are those costs that vary in direct proportion with a company’s production volume; they rise as production increases and fall as production decreases. If you are able to estimate the per unit cost of your product and the total number of units sold then you will be able to approximate your total variable cost. As a guide, sales price per unit less variable price per unit will net you your gross margin. The gross margin per unit should reflect that of the industry, so track this metric closely to ensure an accurate snapshot of your variable cost.
Variable costs differ from fixed costs such as rent, advertising, insurance and office supplies, which tend to remain the same regardless of production output. The ability, or inability, to cover fixed cost is usually what makes or breaks a business. Assuming your product is priced higher than its cost of production, a business should never lose money. However, we know this is not true because a business needs to produce and sell enough product in order to cover its fixed cost. For example, a pizzeria in NYC must make and sell an astronomical amount of pizza in order to pay the high rent each month. If you are able to estimate the total fixed cost then you will be able to determine how many units you need to sell to turn a profit.
Break Even Analysis
The break even formula is an aspiring business owner’s best friend and, used with the right assumptions, can predict if a business will make or lose money. The formula for break even is computed as follows (Total Fixed Cost/[Price Per Unit – Variable Cost Per Unit]). As an example:
Mike wants to sell pizza (can you tell I really like pizza?) and estimates he can sell a pizza pie for $10 (I know nothing about the economics of pizza, this is simply an example and does not reflect the true price and cost of pizza, also we will assume Mike makes great pizza). It cost $5 in ingredients, labor and other variable cost to make each pie. Additionally, fixed cost per month is $2,000 which includes rent, office supplies, uniforms and other fixed cost. Using the break even formula, Mike needs to sell 400 pizza pies per month just to cover his fixed cost ($2,000/[$10-$5]=400 delicious pies). At this point Mike knows exactly how many pies he needs to sell, how many employees he needs to hire to produce this amount of pies, and how many hours his store needs to be open to reach this number.
Are We There Yet?
Almost…. If you are comfortable with your assumptions and your break even analysis yields realistic expectations for your business then you are ready to generate a pro forma financial statement. Use all the information you gathered above and generate an Income Statement, Balance Sheet and Statement of Cash Flows showcasing all your business assumptions. Your income statement should consist of your revenue less your total variable cost less all your fixed cost. The balance sheet should have any liabilities you will incur, any assets you will have to purchase, any equity you put in the business and any cash you will have at the end of the year. Lastly, your statement of cash flow will show all the inflows and outflows from operations (revenue inflows and cost outflows), from financing (proceeds from loans and principal payment of debt) and from investing activities (purchase or sale of capital assets).
Remember, the easy part is putting the numbers in the appropriate format. A quick google search of a pro forma financial statement will yield thousands of examples and templates you can copy from. However, remember to backup every number on the pro forma with well documented research.