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If you're looking to learn about pro forma income statements, then you've come to the right place.
We're about to cover what a pro forma income statement is and how to create one for your business.
My motivation for this post is to explain the differences between creating a pro forma for existing businesses versus new businesses. They’ll require different approaches.
We'll start by discussing what a pro forma is, which is the same for both scenarios.
A pro forma income statement is simply a future version of an income statement.
Since an income statement summarizes our financial performance over some period, a Pro Forma Income Statement represents how we want our business to perform in the future. In essence, it contains our financial goals for the company.
Your particular needs often determine the future time frame chosen for your Pro Forma. Maybe you’re getting a loan, an equity investment, or just planning for the next quarter.
Creating your pro forma is straightforward if you understand just a few concepts. We’ll first cover the process for existing businesses, so if you’re only interested in new companies, feel free to skip ahead.
The benefit of an existing business is that it already has financial data.
Calculating a pro forma requires your existing income statement, so if you don't have an income statement, you have bigger problems than creating a pro forma. It’s hard to organize your future finances if your current finances aren’t in order.
With our income statement in hand, we then have to decide at what point in the future we will establish a goal, or outcome, for our Pro Forma.
For this example, we'll just choose six months from today.
We’ll start preparing our Pro Forma by focusing first on revenue. We need to establish a benchmark, or some goal, that we'd like to achieve in revenue six months from now.
For argument’s sake, let’s say a 20% increase in revenue.
If today, our monthly revenue is $100,000, then a 20% increase equates to $120,000 six months from today.
That’s it! This approach is the generally recommended method to forecast revenue for our pro forma
The unfortunate thing about forecasting revenue in this way is that it doesn't tell us what the hell we need to do to achieve our desired 20% growth. It’s great that we have a timeline and a goal, but it kind of feels like we’re throwing darts in the dark.
To make our forecast a little more tangible, it’s often helpful to convert our forecasted revenue into some metric that tells us more about how the business operates.
For instance, if we're selling products, and each product sells for $100, then our forecasted revenue equates to the sale of 1,200 units, which is easier to digest.
When we know how many units we need to sell, we may get a clearer picture of what else we need to do. For instance, we may now better understand how many customers we need, the number of leads we need from marketing, and maybe even the marketing budget required to achieve these numbers. See what I mean? Converting our forecast gives us more actionable insight about what we need to do to realize the increase of 20%, which ultimately means we need to generate 200 more monthly customers over the next six months.
Now that we have revenue figured out, the costs will be even easier.
Most tutorials tell you to create what is known as a “common size” income statement to forecast costs. Converting our income statement into a common size format requires dividing each line item by revenue.
You may have noticed that if we’re dividing everything by revenue, revenue becomes 100% because anything divided by itself is 1, or 100%. In essence, what we’re doing is converting each line item based on its relative value compared to revenue (i.e. the “common” denominator).
Once we’ve converted all costs into a percentage of revenue, we simply multiply each one by the forecasted revenue to get our costs for the pro forma.
All that’s left is to fill in our profit margins with simple subtraction. There’s nothing else to it!
If we need to forecast our pro forma over multiple future periods, say on a month-by-month basis over the next few years, we use the exact same approach detailed above.
1. Forecast revenue for each month based on percentage growth
2. Convert current costs into percentages of revenue
3. Multiply forecasted revenue by those percentages
Another issue with the standard approach we’ve just discussed is that it treats our costs as if they grow at the same rate as sales. Forecasting costs in this manner can be quite an oversimplification.
A savvier way to handle costs is to consider the differences between fixed and variable costs.
Fixed costs tend to stay constant over longer periods. These costs can be rent, salaries, insurance, and other expenses that don’t fluctuate much with a given level of revenue. If we don’t expect to hire any new employees, it doesn’t make sense to use a percentage of revenue to forecast salary costs.
Variable costs grow (and decline) along with revenue. Each new unit of product you sell has a cost associated with it, and those costs will be higher if revenue is higher and lower if revenue is lower. Variable costs tend to be directly involved in producing and delivering whatever you’re selling to customers (but don’t need to be). The percentage-based approach may be more appropriate for variable costs.
To develop a more “realistic” forecast, we’ll want to identify which line items on our pro forma are fixed versus variable, then forecast them appropriately.
Armed with the knowledge we’ve covered so far, you can create intelligent pro forma income statements that impress any banker or investor. Congrats!
The unfortunate thing about developing a pro forma for a new business is that we don’t benefit from an existing income statement as we did in the established business example. We’ll have to do a lot more calculations based on assumptions as a result.
We won’t dive into the specifics of every calculation since we explain some of that in this post, but here’s a simple example you can download to follow along over the next few sections: Download Here
New businesses are the perfect candidate for using what is known as a bottom-up forecast (in contrast to top-down).
This method is what most investors will want to see if you plan on raising money. What we need to do is focus on the activities you're doing that drive revenue.
Revenue drivers are activities we, or the business, do that “drives” revenue (a fantastic explanation, I know). These are often activities like digital advertising, cold calling, content marketing (wink, wink), or any number of other initiatives used by companies to create new sales.
We use revenue drivers because it’s a lot easier to control the number of cold calls we make each day versus the sales we make from cold calls. When we focus on the activity, it’s also easier to understand whether we’re producing the desired result (i.e. revenue), and if not, we can try something else.
There are many different revenue drivers, but our chosen method for generating new business should be appropriate for the amount we charge customers. We don’t want to spend three months courting a new client to sell them a $20 product. Alternatively, we likely won’t sell a $100,000 service with a couple of Google ads – although it could be the first step.
To get some ideas, look at how companies with similar business models generate new business. The chosen method often determines at what price we need to sell our product to make a profit.
When we have some idea of how we’re going to drive sales, we can look at how the transaction between the business and the customer occurs, which is a critical part of our revenue model.
The simplest example is a customer giving the business money in return for some product or service. In more complex scenarios, payment may occur over multiple installments after negations, contracts, and delivery timelines. The characteristics both situations have in common is that there is an exchange of value (money) at some point in time (transaction cadence) in return for receiving something of value (goods, services, or both).
Once we have some reasonable assumptions regarding how many customers we’ll acquire, how much money they’ll pay, and when they’ll pay, we should have enough information to calculate revenue.
If we want to extend this forecast further into the future, we simply focus on increasing our revenue-driving activities (as long as they’re working).
Remember that our chosen methods for generating new business will need to change as the business grows. We may bring in $15K per month, making 300 cold calls a day, but we won’t be able to make $150K per month making 3,000 cold calls each day because it probably isn’t possible. At some point, we need to hire someone or find a more scalable method.
If you read the first section describing how to forecast revenue for existing businesses, you might have noticed that this is precisely the opposite approach. Instead of focusing first on revenue (top-down) and then backing into how many customers we need, we’re focusing on getting new customers and then arriving at some amount of revenue (bottoms up).
Now that we’ve forecasted revenue, we can stick it on the top line in our income statement and turn our attention toward costs.
It’s hard to provide a general rule to forecast costs for new businesses because the costs required to run a food truck are much different from those needed to run a software business.
Our work history also plays a factor in what we should do. If we’ve worked in the industry we’re entering, we may have a good idea of the typical costs, but we may have no idea if we’re new to an industry. The second scenario is where we’ll need to consult our trusted advisor: Google.
A good place to start is searching for terms like “startup costs for [insert business],” or “typical [insert business] costs.”
Here’s a basic list of common small business startup costs that turned up with a quick search.
The key idea is that we’re looking for businesses in a similar industry or with a similar business model. If we can find examples at a smaller scale, when things are less complicated, that’s probably best. Otherwise, we may need to look at larger, public companies and drastically simplify their costs to arrive at some starting point.
Compile a list of all the costs you’ll need (or think you’ll need) to run the business. Once we have our list, the next important step is categorizing each item into one of two buckets: fixed costs or variable costs.
As we covered in the existing business section, variable costs increase (or decrease) as sales grow (or contract). These costs become more important as you scale the business because they depend on revenue, which means you can’t grow revenue without growing these costs.
Fixed costs stay relatively constant – at least for a while – and are more important in the beginning because they’ll make up a higher percentage of overall costs.
Some examples of variable costs include sales commissions or materials (if you sell products), and fixed costs might be rent or salaries.
To illustrate why this distinction matters, let’s imagine you and I start a business, and in the beginning, we expect sales to be relatively low; say one hundred units.
In the image above, we can see that variable costs are a relatively small percentage of total costs because we’re not selling much. On the other hand, our fixed costs stay the same no matter how much we’re selling.
After all, we still need to pay salaries, rent, utilities, and any other required costs.
As we grow sales for this business, it means we’ll also have more variable costs, and they will grow as a percentage of total costs. Once we’re selling 1,000 units, the business may look very different from a cost perspective.
Hopefully, our fictitious business helps illustrate the role variable costs play in growth. Even though they may seem small initially, they will significantly impact the business’s profitability later on. Small mistakes made early can compound over time.
At this point, we should feel relatively comfortable categorizing each cost as either fixed or variable.
Lastly, we should note some expectations regarding how to estimate each cost. Fixed costs are simple because they don’t change, but variable costs aren’t as straightforward. Use your best judgment to determine some way to estimate each variable cost. When in doubt, rely on the common size percentages we discussed in the existing business section.
Now we’re done with the hard part, and all we have left is to add each cost to our pro forma income statement.
There are two primary cost categories on the income statement: cost of goods sold and operating expenses.
The first section, Costs of goods sold, includes the direct costs of producing revenue. Without the expenses in this category, we simply couldn’t offer goods or services to customers.
The second section, Operating expenses, includes the costs of running the business. Hopefully, these costs are necessary, but they aren’t directly involved in producing or delivering goods or services to customers.
Sometimes we encounter costs that we can classify under both categories. For instance, consider a building where 75% of the space is used for manufacturing, and 25% is for office space. We may want to apply the manufacturing space to costs of goods sold and office space to operating expenses.
Now categorize each cost from our list into the appropriate section of the pro forma income statement.
All that’s left is to add up our costs of goods sold and operating expenses to calculate our profit margins!
As you can tell, this process is heavily research-focused, but since we don’t have any historical data, relying on what we can find about similar existing businesses is the next best thing.
If you’re ready to try this process independently, you’ll generally need to use spreadsheet software like Microsoft Excel to put the pro forma together. If you’re not familiar with spreadsheets, then it will be another learning curve to overcome.
Luckily, if you are creating a pro forma for a new business, you can try our software, Poindexter, for free! We’ve made it easy to create pro forma financials in a fraction of the time, and it won’t require any special knowledge. Who needs the added stress after all? If you’re ready to get started, you can sign up for free here.
Do you still have questions? Drop me a comment below, and I’ll be happy to respond. Thank you for stopping by!
