In the last few posts, I have discussed how to project startup revenues and costs for your venture. With these foundational financial model inputs, you can now go to Step 3 and build your pro forma financial statements. There are three primary financial statements for business: Income Statement, Cash Flow, and Balance Sheet. Let’s start by looking at each role in documenting and communicating a startup’s projected financial performance.
Important: I suggest that founders generate statements covering three years, month by month. However, I think it is best to begin by building out a detailed financial model for the first 12 months. A detailed model includes the documentation of all basic assumptions and the associated estimations. Then, once you have a working model that can readily adapt to different scenarios, you can expand it to the entire 36-month period.
Income Statement
Entrepreneurs need to be able to plan operations and evaluate decisions using financial accounting information. Budgets, cash flow forecasts, and breakeven analyses are not only essential management tools, but they are also usually required information for potential investors or lenders.
Once you have completed a thorough bottom-up analysis of projected revenues and costs, you can integrate these estimations into a proforma profit and loss statement. The proforma income statement summarizes anticipated sales revenues and expenses for a specified period.
Preparing an Income Statement Forecast
Reasons to Prepare an Income Statement Forecast. There are two main objectives in generating a proforma income statement.
The first reason is to project and capture performance in terms of sales, such as the percentage of increased sales or new business. Most enterprises measure success in terms of increased customer acquisition rates and resulting sales volume. However, if the expectation is that additional sales mean higher profits, which may not always be the case, certainly increasing sales is part of the financial plan. But there is much more to it than sales performance.
The second reason for the income statement focuses on measuring profits, that is, the difference between revenues and expenses. Sales must be profitable for the venture to succeed. A firm can determine the profitability of either products or customers. But, in the end, the enterprise must be profitable for long-term viability.
Here are the significant elements of an income statement.
Revenues. Sales revenue is the total amount of proceeds or gross income from sales to customers. Remember, you should break down the various revenue streams from individual products and service offerings in detailed statements.
An integral part of estimating revenue generated from each product offering is linking your sales numbers to your promotional channel strategies and calendars. It is essential to show why you believe these sales will occur during a particular month. This linkage is particularly crucial before having any sales history. Once you have a record of actual sales, you can begin to build estimates based on a combination of strategy and history.
Costs of Goods Sold. The following income statement line to project is called the cost of goods sold, sometimes referred to as direct costs. This cost area can be challenging for new venture founders to estimate. While not every product or service has a cost of goods sold component, many do. The cost of goods includes the materials and labor associated with sales from the same period. The cost of goods sold represents the resources that go into producing the products ultimately recognized as sales. These costs typically include materials, labor, and manufacturing expenses.
Costs of goods sold are a variable expense, meaning that the cost of the product is not accounted for until the sale transaction occurs. [Note: this is just for accounting purposes. In reality, you most likely have already paid for the labor and materials before the sale, so it still impacts your cash.] The details should include labor and associated raw materials required to produce the product. In addition, you must add shipping costs if not paid by the customer. If your business has multiple product lines, the cost of goods sold for each product line should be calculated to determine gross profit by product line. This last point is essential. I see many statements with multiple revenue-generating products recorded as one line to account for the associated costs of goods. Unless the cost of goods comprises the same components and cost amounts, this is the wrong way to present the information.
In many cases, the costs will vary based on the sales of the specific product associated with said costs. It is a best practice to monitor each product and its costs separately so you can make adjustments as historical performance data emerges. You can end up with a skewed view of your product costs and profit contributions made by each product.
Gross Profit. The next entry in the income statement is gross profit. This statement line should include, where possible, the gross profit by whatever categories the sales are classified (e.g., product line, geographical region). One calculates gross profit as sales less those costs of goods directly incurred to achieve the sales.
It is worth stopping for a moment to consider the importance of the gross profit line. Your gross profit numbers indicate the degree to which your products contribute to the venture’s overall profitability. The gross profit percentage is something that you carefully monitor once you start generating sales. An important metric is also the gross profit percentage of an individual sale unit. Understanding how much a unique product contributes to profit is vital to calculating when your business will hit the all-important breakeven point. Monitoring gross profit and associated gross margin (gross profit as a revenue percentage) allow you to determine profit trends and long-term viability. As part of this analysis, you should monitor and compare margins to industry benchmarks and similar enterprises. These comparisons enable you to validate that your pricing and cost of goods sold are trending in the right direction based on your business model and overall industry performance.
Operating Expenses. This section of your income statement classifies expenses associated with your venture’s operation. The costs recorded in this section are labeled indirect expenses. This statement section covers several expense categories such as salaries, benefits, marketing, research and development, and computer and office supplies.
There are some standard methods to categorize and list expenses. I suggest that you work your way down from top costs down. For most startups, the leading expenses will be in three categories, salaries, product development, and marketing. The remaining categories may cover general expenses such as supporting technologies and software, professional fees, insurance, co-working space costs, etc.
Like the direct expenses and resulting gross margins, you want to monitor each indirect expenditure as a percentage of total revenues. You should research industry and competitor cost percentages for pre-launch estimates for each category. For example, what is a typical percentage of salaries to revenues within your industry? These comparisons help founders evaluate if the anticipated costs align with what is going on in the marketplace. You can use this information to support your estimates and drive talent acquisition strategy and competitive salary rates. Once you start generating actual data, you can measure how your business model is working and make changes as needed.
One last area you include in the operating expense section is non-cash expenses, sometimes called intangible costs. Typically, you keep expenses like depreciation and amortization separate from tangible expenses because they do not impact your operating cash amounts. The cash outlay for these expenses happens in an earlier period than the one you are accounting for in the current income statement. Founders are allowed to write off depreciation expenses incurred on purchasing tangible assets that the venture will use for a specific period. For example, if a founder purchases professional video production equipment for business use, a certain percentage of the cameras, screens, and lighting can be deducted as an expense for a specified period. The amount of depreciation depends on how long the equipment will last based on use and aging. One calculates the depreciation amount by dividing the asset’s cost by the estimated number of years in its life minus any salvage value. Again, you want to work with your professional accountant to determine the depreciation method, time, and dollar amount. There are several depreciation methods, each having a different impact on the reporting of operating income.
You can also expense intangible assets such as specific intellectual properties such as patents, trademarks, and trade secrets. Startups can deduct the cost of these assets as expenses over several years using a process called amortization.
Operating Profit/Loss. Operating income is determined by subtracting costs from sales and does not include taxes or interest charges. Operating income is the amount the business earns after expenses but before taxes and other income, such as interest. You can refer to this as earnings before interest and taxes (EBIT). EBIT is the earnings (net income) before interest expense, interest income, and income taxes. It measures the profitability of the company’s current operations as if it had no debt or investments.
EBITA. This label includes earnings before interest expense, income, income taxes, depreciation, and amortization. It measures the profitability of a company’s operations without impacting its debt, investments, and long‐term assets. This line item allows the founder and investors to see how much cash is generated via operations, but for non-operational and non-cash income and expenses.
Other Income and Expenses. This category includes interest expenses by each type of debt (e.g., leases for computers, lines of business credit, and bank loans) and other income and expenses not related to the normal operations of the business.
Pretax Income. Income before taxes is calculated by taking operating profit and factoring in other income and expenses. It denotes the income that will be subject to corporate income tax.
Income Taxes. This line item is the management’s estimate of how much tax will be on its earnings. Detail should reflect amounts owed for federal and state taxes.
Net Income. This final income amount shows what earnings remain after all income and expenses and are available for dividends or reinvestment in the company.
Founders and investors can use the income statement to evaluate the business’ financial condition. The income statement shows how the business makes a profit by displaying how much it generates in sales and how much it costs to run the business. I like to think about the income statement as a way to document the financial impact of:
- The Product (Revenues-Costs of Goods Sold = Gross Profit)
- Operations (Gross Profit – Operating Expenses = EBIT)
- Debt Financing (Operating Income-Interest Income & Expenses = Pretax Income), and
- Taxes (Earnings before Taxes – Income Taxes = Net Income)
Cash Flow
An income statement may show that the company is profitable over a given period but does not give any information about the cash position. A seemingly profitable venture can go bankrupt if its short‐term cash position is insufficient to meet its short‐term liabilities such as salaries, interest payments, and other receivables. This situation is particularly true with early‐stage companies, which, more often than not, are cash strapped. Therefore, this statement and its use to predict cash availability to pay bills are the most important for the entrepreneur to understand and use. It is advisable to have a month‐by‐month cash flow forecast for the company’s first two to three years as cash reserves will fluctuate wildly.
Preparing a Cash Flow Forecast
Reasons to Prepare a Cash Flow Forecast. Keeping close tabs on required and available cash is the most crucial estimate an early-stage enterprise can monitor. While correct revenue recognition is essential for a compliant profit and loss statement, cash flow is much more critical to operations. For early estimates, month-by-month budgeting is the best approach. Costs almost always are incurred, while revenues are less reliable. Knowing your cash position helps determine the amount, timing, and disbursement schedule of financing you will need to continue operations before becoming self-sustaining.
A cash flow forecast shows the amount of cash coming in (receivables) and cash going out (payables) during a particular month. The forecast also indicates to a bank loan officer (or the entrepreneur) what additional working capital the business may need if any. In addition, it provides evidence that there will be sufficient COH to make the interest payments on a revolving line of credit or to cover the shortfalls when payables exceed receivables.
Cash flow statements use information from both the income statement and balance sheet (see below). Your account explains changes in cash flows resulting from business operations and financing activities. The reconciliation section of the cash flow worksheet begins by showing the balance carried over from the previous month’s operations. Next, one adds the net inflows/outflows or current month’s receipts and disbursements. This adjusted balance will be carried forward to the first line of the reconciliation portion of the following month’s entry to become the base to which the next month’s cash flow activity will be added or subtracted.
Modifications to sash flow statements occur as new things are learned about the business and paying vendors. You should compare the cash flow forecast to each month’s projected figures with each month’s actual performance figures. It will be helpful to have a second column for the actual performance figures alongside each of the “planned” columns in the cash flow worksheet. Look for significant discrepancies between the planned and actual figures.
Founders and investors pay close attention to cash flow management and performance. One of the critical metrics that startups should monitor closely is what is commonly called the burn rate. The burn rate is when a new venture uses up its cash to finance overhead before generating positive cash flow from operations. In other words, it’s a measure of negative cash flow. Burn rate is cash spent per month. The burn rate is determined by looking at the cash flow statement. The cash flow statement reports the change in the firm’s cash position from one period to the next by accounting for the cash flows from operations, investment, and financing activities. Compared to the amount of cash a company has on hand, the burn rate gives investors a sense of how much time is left before the company runs out of money— sometimes called your runway.
As part of a founder’s financial discipline, you should monitor your venture’s cash position daily. I would make this information, along with metrics such as burn rate, runway, and breakeven, a significant part of a performance dashboard.
Balance Sheet
The balance sheet provides a picture of the business’s financial position at a particular point in time—generally at the end of a financial period (e.g., month, quarter, or year). It encompasses everything the company owns (assets) or owes (liabilities), as well as the investments into the company by its owners and the accumulated earnings or losses of the company (equity). The balance sheet equation is assets=liabilities+shareholder equity. Investors and banks commonly analyze various assets and liabilities ratios on the balance sheet to determine a venture’s viability.
Preparing a Balance Sheet Forecast
On the balance sheet, one divides assets into short and long-term categories. Current assets are converted into cash within one year. These assets include current cash balance (from cash flow), payments due from customer sales (accounts receivable, and inventory. You will consider inventory as a current asset if sold within one year from receipt; however, specific business inventories can be further segregated into work‐in‐process (WIP), raw materials, or finished goods inventories.
Tangible and intangible long-term assets include items such as buildings, vehicles, and computer equipment, along with forms of intellectual property. Record these assets at their original cost minus any accumulated depreciation, treated as expenses in the current income statement.
On the other side of the balance sheet equation, you have the liabilities and shareholders’ (stockholders’) equity sections. Liabilities consist of any amounts the company owes creditors. Similarly, liabilities are current if you pay them within one year; otherwise, they are considered long‐term. Short-term liabilities include any interest payments on loans recorded in the income statement and any payments you owe suppliers (accounts payable). Longer-term liabilities are typically balances on loans linked to long-term assets such as mortgages on a building or lease payments for a company vehicle.
The difference between the total assets and total liabilities is called stockholders equity. Much like an individual, the number is considered the net worth of the venture. This number comprises any stock issued by the company and accumulated earnings retained throughout the years, as shown in profits from the income statement.
When analyzing a company’s balance sheet, managers and investors view it in terms of its type of business. For example, fixed assets account for a more significant percentage of total assets in a manufacturing operation than a distributor or professional services company. Therefore, analyze the balance sheet with the volume of the company’s business in mind. For instance, one compares receivables to sales to determine how quickly the company collects its cash or current liabilities compared to expenses to see if it is paying its short‐term obligations in a timely fashion.
Bringing It All Together
While each of these statements is a separate document, several linkages exist. For example, select information from cash flow analysis links to the balance sheet, such as net increase or decrease in cash as demonstrated in the case analysis, will be reflected in the cash asset column in the balance sheet. Any cash outlay for an asset will be in both statements. Net income from the profit and loss statement will impact the balance sheet’s cash flow and retained earnings. As founders and investors analyze a venture’s performance, it is essential to review these statements together, not in isolation.
A Note on Financial Templates
In general, I am not a fan of pre-determined financial templates. While they can be helpful as a starting point, no one template ever covers the assumptions and estimates particular to your business model. If you use a template with pre-existing formulas, ensure you can readily adjust any parts of the statements, labeling line items, and assumptions. However, I think it is worth your time to start with a blank slate, using one of the standard computer spreadsheet programs such as Microsoft Excel or any full‐faceted business software to generate your financial statements. If you plan to start with an existing template, you should look for templates that best fit your business model and your overall financial planning approach. For example, not all templates provide 36-month-by-month entry capability. Many template designs annualized performance over a 3-5 year period. Does the template include the three statements with proper integration embedded in the model? Some templates provide several analysis tools and metrics based on the inputs into the statements. Such analytics as breakeven, customer acquisition costs, and monthly recurring revenue are vital data points for startups. For customer acquisition and revenue modeling, does the template provide the capability for multi-tier pricing, retention, and churn rates? Finally, how does it support assumption documentation, different currencies, performance graphics, and data uploads or downloads? Sometimes you can find templates designed for a specific industry (Hospitality) or product category (SAAS).
Template pricing models include free downloads, trial periods, one-time fees, and recurring costs for online systems. The good news is that there are plenty of options. All that said, you may want to check out some of the samples from my startup resource database.
Next Series Post
The startup finance series continues with a focus on key performance indices (KPIs) or post-launch startup metrics. The following post will build on the earlier post on pre-launch metrics.
For more on this subject and other entrepreneurship topics, get a copy of Patterns of Entrepreneurship Management, 6th Edition.
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