I'm a Karl Ulrich, I'm a professor at the Wharton School. This session is on pro forma financial statements. The word pro forma is just Latin for as a matter of form. And what it means is, it's a forecast of future financial statements for your business prepared in a fairly standard way, a way that people expect to see financials for new ventures. The important point to note here is that this is not an accounting of your actual financial performance. It's a projection of what you believe will happen in the future. And they're called pro forma financial statements. The analysis is generally done monthly. So, you analyse at the level of months, and you do it, typically, for 36 months. In some businesses, it might go out for five years or 60 months, but most of the business, most of the statements that I see done these days, are done for three years or for 36 months. There are three standard forms in a set of pro forma financial statements and they are the income statement, the cash flow statement and the balance sheet. Now, let me just point out right now that as an entrepreneur, you need to learn some accounting and you're not going to learn it here. You need to take a course in accounting if you haven't already done that. There's some very good courses available for free online, including a great one offered by my colleagues at the Wharton School. This is not a substitute for an accounting course, but I want to talk about accounting in the context of the pro forma financial statement. The other thing that usually goes with a set of pro forma financial statements is a detailed budget for what you actually plan to spend for the next 12 months. Investors usually want to see what exactly are you planning to spend money on for the next 12 months, because they're providing that capital they want to know how you're going to spend it. So your pro forma financial statements are usually accompanied by a 12 month budget. Now, the three statements, the income statement, the cashflow statement, and the balance sheet are interrelated. And so, for instance, the income statement is not the same as the cashflow statement. And the reason for that is that under accounting conventions, income is not the same as cash. So for instance, if you have spent cash on inventory that shows up on the cash flow statement but doesn't show up anywhere on the income statement because an inventory transaction isn't related to income. So cash flow statement and income statement are not the same because accounting the way we do accounting in business, cash is not the same as income. Similarly, on the balance sheet, the balance sheet shows assets and liabilities, not just cash. So it'll also show some things like debt inventory, receivables, shareholder's equity, retained earnings, a few other assets categories and liability categories that are not shown elsewhere. So, we really need these three distinct statements, the income statement, cash flow statement and the balance sheets. These are also, as you probably know, exactly the same statements that are used in reporting financial performance of companies and in particular for public companies. Now the questions that are answered by performance financial statements are these. What do I believe this business could look like financially in the future? And the reason that's important is you want to be able to show to yourself and to investors what the future prospects for this business are. And so the pro forma financial analysis says, hey, in year three, this business could have this revenue and operate with this level of profit. And that informs the question of might this be a good investment, might this company actually be quite valuable someday? The second question the statement's answer is what's the relationship between my key performance indicators? That is the things that I as a manager control, and the financial performance of the organization. So for instance it might show what's relationship between the number of retailers that I've set up to sell my product, and the financial performance of the company. The third question that is answered by the pro forma financial statements is how much cash do I need before I reach breakeven? So effectively, how much cash is required to support the negative cash flow associated with the early months or years of starting up this business? And then the last question that's answered by these statements is, is my operating plan, that is what I say I'm going to go do over the next months and years, is that consistent with my financial plan, and is it financially feasible? I want to give you, use and example to illustrated the performer financial statements. I'm a founder and investor in a company called Belle-V Kitchen that sells kitchen products. This is an example of a bottle opener that we sell. And just for the sake of an example, I'm going to imagine a company that's called Carl's Openers, and we make two products. We make a bottle opener and we also make a wine opener. So Carl's Openers has two products, a bottle opener and a wine opener. And I want to show you what the pro forma financial statements might look like for that business and use it to underscore a few key points. First thing I want to say is that, you the entrepreneur in preparing these financial statements, start with the income statement. That's the place to start. So let's focus first on the income statement. Now this is an example of a monthly analysis for the first year of the business. And so you see, it's just got 12 columns for the 12 months and then the last column is the annual total, which just sums up across the rows, across the 12 months. This is usually where you start. And as you build the spreadsheet, you will typically build, you will use 36 columns, which will be the 12 months for each of the next 3 years. And then you'll provide an annual summary for each of those three years. Let's just look at what's in the income statement. The top portion of the income statement shows revenues and revenues are usually shown by product line or by service line. So in this example of Carl's openers I show we have two products, a bottle opener and a wine opener. And so it shows the revenues for each of those two product lines separately. And then just sums them up as our total revenues. The next category of items shown on the income statement are the cost of goods, sometimes known as cost of sales. And sometimes referred to by the acronym COGS which just refers to cost of goods sold or COGS. COGS are the costs that you incur in direct proportion to the number of units you sell. And usually the COGS are what you pay your supplier to provide you with the product that is what is your cost of that product. Or what does it cost you to manufacture or deliver the service that you're providing? Your actual costs associated with delivering a unit of product or service. Those are your COGS or Cost of Goods Sold. And of course the difference between the revenues and the cost of goods sold is called your gross margin. That's the difference between what you bring in, and the actual cost of providing that product, that's the gross margin. The next category of items shown on the income statement is referred to as SGNA, or sales general and administrative costs. And those are the things that are required to operate your business that don't vary directly with sales. So typical examples there would be administrative payroll, or rent, or insurance. Those are all things, utilities, that don't vary directly with the quantity of product you sell. And they're called SGNA or Sales General and Administrative Costs. If you take the revenues minus Cost of Goods, that gives you gross margin, gross profit. If you subtract from that your SGNA, you're left with what's called your EBITDA, which is earnings before interest, taxes, depreciation, and amortization. You could think of this as your operating income before you pay the costs of financing the business, is basically the way to think about it. And for many businesses, EBITDA is your actual earnings. For businesses that have a lot of equipment or have debt, it isn't exactly the same as your net income. Usually in your pro forma financial statements, you will also show some ratios as a percentage. For instance, it's usually, most people want to see what is my gross profit percentage or my gross margin percentage. And that's simply the ratio of my gross profit to my revenues. And similarly, the other ratios are calculated as shown here. The first point I want to make is to think about how to build this model. And as I said at the beginning, I'm not going to teach you enough about accounting that if you know nothing about accounting you can build these financial statements. But after you've learned some accounting, I want to make this important point, which is as you build the income statement, you shouldn't just type in to the income statement a number for revenues. Rather, you should build a spreadsheet model that calculates that revenue, based on some operating parameters of the business. Let me give you a concrete example. Shown here in this spreadsheet, I show revenue of $5,500 for bottle openers for the month of January. I shouldn't just type in 5,500, because where does that number come from exactly? Instead what I should do is put in some rows in that spreadsheet for, how many retailers do I expect to have in January? How many openers do I expect to sell per store in January? What's the average sales of my product to that retailer? And then, I'll also have some rows for how many units do I expect to sell directly to consumers, say on my website. What's my average direct selling price? And I can use those five parameters to then calculate how, what my total revenues are for bottle openers. So the difference here is that if I model my spreadsheet using some parameters that I can better understand, like how many retailers do I have? How many units do I expect to sell per retailer, and what do I expect the average selling price to that retailer to be? I have a more principle reason for coming up with that number, 5,500. It's also much easier for me to modify this model. It's also much clearer what my assumptions are and it links financial performance to the things that I as an entrepreneur can directly control, like how many retailers do I have. You do a similar thing with the costs, what's my factory price per unit. What's the freight per unit? What duties do I pay per unit? Enter those into your model to drive your cost of goods rather than just putting a number there that maybe you calculated on a scrap of paper. Now of course, every business is different and every business will have a different model that drives it's revenues. But you should think about for your business, what is the fundamental logic for where my revenues come from? And create a spreadsheet model that uses those parameters as your input. Not just a number that you calculate on the back of an envelope and stick in the spreadsheet. One of the challenges in preparing pro forma financial statements, is deciding which scenario you show. You of course know that your future is uncertain. It's very difficult to predict what your actual revenues or costs are going to be out in year three. And so you have the choice, when you're preparing these models of showing a conservative scenario, or showing a very aggressive scenario. Or maybe showing your expected case scenario. And I'm just going to give you my sense of current practice in entrepreneurship. I've been involved in 28 ventures. I've seen exactly three that have exceeded their plans significantly. As a general rule in current practice, entrepreneurs are optimistic. And they're optimistic in those scenarios. The net effect of that is investors have come to expect that your financial statements are a little bit aggressive. They are a little bit optimistic. And so, as a matter of practice, I believe that most entrepreneurs show the 80th to 90th percentile outcome. That is that the scenario that is only 20% likely to play out in the future. That tends to be what's shown in the proforma financial statements. Now that's not ideal, I would much prefer that entrepreneurs and investors come to expect maybe several scenarios that are articulated in the pro forma financial statements, but it is the state of correct practice. Particularly, prior to the launch of the product. Now of course as the business operates for some time, the numbers have to get more and more realistic because investors start to look for, is the management team hitting their plan? So once the business actually starts to operate and generate some revenues, typically the pro forma financial statements start to come much closer to what management truly believes is the likely outcome for the next few periods. Let me also make an observation, just a little hint. Which is I think it's bad form, it's just bad practice as an entrepreneur, to make this statement, well these are conservative assumptions. People seem to do it all the time they say well we've modeled conservatively that we'll have two hundred retailers in January. The reason I say that is that they're never conservative. In most cases, they're optimistic. And so you're sort of revealing you don't know what you're doing if you call them conservative scenarios. I find investors don't like to hear that. They want to see your scenario. Don't characterize it as conservative. It's probably optimistic. And investors expect it to be a little optimistic. Let me just go through Some Best Practices, again build your model using key revenue and cost drivers so your assumptions are clear and so your logic is clear to where your revenue and cost numbers come from. Start with the Income sheet. All right the income statement and then use that to drive the cash slow statement and the balance sheet. Use detailed worksheets at a monthly level to drive the summary sheets. Model your financials monthly typically for 36 months and then provide an annual summary so we can see the annual data. And then lastly although you probably want to provide some summary financials in your business plan, or your pitch deck that is shared with investors, you probably benefit from just providing the perform of financials as a separate document. It's usually a PDF file generated from a spreadsheet. Just provide that as a separate document, that's often the way investors expect to see it. Lastly let me give you some practical advice, you do need to know some accounting. And at a minimum you can take an online course. As I said Wharton offers a great one online. Just take the accounting course, because you need to understand the language of business if you're going to be an entrepreneur, and this isn't enough accounting to really understand the language of business. You start by building the income statement, and I would recommend that you, the CEO, you the entrepreneur, build your own financial model, particularly the income statement. I think it's important for you to understand it. And understand it at quite detail level. So you should build it yourself. Having said that, getting the balance sheet and the cashflow statement to work properly, to link those three documents is a little tricky. If you aren't good at it, if you haven't done it before, then I would engage a partner or consultant to help you build out the full financials. There are some very good templates available online. One of the template in fact the one I used for that example comes from the non profit called score and you can go to the score.org website to download those spreadsheets. There are some paid services that will automatically generate financials from a set of assumptions One of them that entrepreneurs I know have used is called Live Plan. This isn't an endorsement of Live Plan, I'm just pointing out it's one of the examples of those companies. Those can generate financials automatically from some very user friends assumptions. In my experience, investors expect to see a true spreadsheet model. And so I think you might use live plan to help generate those spreadsheets but probably do need an actual Excel document. Or spreadsheet document that contains your financials. And you might need to get some help to do that. But I do think you the entrepreneur, you the CEO, do need to create your own income statement as a way to get started. Pro-forma financial statements, they're sort of a necessary evil in entrepreneurship, but I do think they're very important to help you really think through the feasibility of your financial plan. And it's consistency with the operating plan that you anticipate over the next months and years.
