If you want to raise money from investors you’ll have to create a business plan with pro forma financial statements projecting your company’s financial performance over the next few years. But creating pro forma financials is tough for new entrepreneurs for two reasons:
Most people aren’t used to sitting around projecting revenue and EBITDA (earnings before interest, taxes, depreciation, and amortization) 5 years into the future and try to use a generic template.
If you’re creating projections for your own budding business, you probably lack objectivity.
Given both of these hurdles, it’s no wonder that newbie entrepreneurs repeatedly make some costly mistakes on their pro formas, but you don’t have to. Here are some of the top bloopers I see again and again so that you can avoid them as you build your own financial projections:
Everything you put in your financial statements is based on a number of assumptions that you’ve made about a thousand different things in the market, your marketing, your production, your operations, etc. You need to list those assumptions so that everyone’s on the same page about where your numbers are coming from and how changes in the environment might affect your numbers. Things like how prices will increase over time or how many new customers you can get month over month are assumptions. If you think office overhead will increase at 6% per year I need to know that and know why (i.e. because overhead has increased at that rate for the last 10 years or because it was increasing at a lower rate but you expect the price of heating oil to jump up). If you think your online marketing efforts will give you an X% revenue increase each month because they’ll drive you 100 new customers each month, I need to know why – what avenues are you using and what are the associated conversion rates and costs? And, of course, remember that those costs must also show up in the pro formas themselves.
Unless you collect 100% payment upfront – and wait for it to clear – before providing any goods or services, for every client, every time; you’re eventually going to run into some who won’t pay. You need to account for this in your projections and include a certain percentage on receivables for bad debts that you’ll never be paid on.
Here’s a quick list of a few other items that don’t really need explanation but often inexplicably get left out of financial projections: taxes (both FICA, etc. and income), depreciation, amortization, employee benefits, insurance… The list goes on, so just remember to be careful to include anything and everything that represents money in or money out as you create your pro formas or you’ll have a distorted view of your potential finances.
I recommend that you include a break-even analysis in your pro formas. Since it’s not one of the three official financial statements – the income statement, statement of cash flows, and balance sheet – many entrepreneurs don’t do it. But knowing how much you need to sell just to get to zero is vital information as you plan.
All of your pro formas should be built in such a way that the spreadsheets are dynamic. By this I mean that if I change one number or one assumption in the spreadsheet, any other numbers that would be affected should automatically change as well. Building your statements this way will save you from a horrible headache and embarrassment if someone asks you to adjust your assumed revenue growth rate from 15% down to 11%. You don’t want to have to redo anything except going to the little box for growth rate and changing the one number – then everything else should automatically adjust itself.
This list certainly doesn’t cover all of the mistakes that entrepreneurs make in their pro formas but it does cover the most common bloopers and, hopefully, gives you a better idea of how to create solid pro formas.