Financial forecasting for the future is not easy, and it becomes more difficult in a volatile economy. However, the basics of financial forecasting remain the same. Small-business owners must develop the talent to plan ahead. It is one of their essential talents if they want their business to succeed.
In order to do a good job of financial forecasting for the small-business firm, the owner should develop a comprehensive set of projected financial statements. These projected financial statements, called pro forma financial statements, help forecast future levels of balance sheet accounts as well as profits and anticipated borrowing. These pro forma financial statements are the small-business owner's financial plan.
Why Small Businesses Need Pro Forma Statements
Having this financial plan allows the owner to track actual events against the financial plan and make adjustments as the year passes. This is invaluable to the owner in order to keep the business out of financial trouble in a changing economic environment. If the business firm needs a bank loan or other financing, these pro forma financial statements are usually required.
Small businesses can develop their pro forma financial statements for varying time periods. The most common time periods are either six months or one year. Sets of pro forma financial statements for three or five year time periods are often developed for banks or equity investors when seeking financing. Both venture capitalists and angel investors require pro forma financial statements.
In order to prepare a comprehensive financial plan, the best method is to first prepare a pro forma financial statement. Then, you will need a cash budget and, finally, a pro forma budget sheet. Here is an overview of each of these statements.
Pro Forma Income Statement
The pro forma income statement provides a projection of how much profit the firm anticipates earning over a given time period. Generally, the small-business owner follows four steps to develop the pro forma income statement:
- Establish a sales projection
- Set up a production schedule
- Calculate your other expenses
- Determine your expected profit
After using your sales projection as a starting point, you use your production schedule to calculate the cost of goods sold if you are selling a physical product. If you are selling a service, then you need to place a value on your service and substitute that value for the cost of goods sold.
Other expenses that you subtract from sales include general and administrative expenses, taxes, dividends, and interest expenses. At this point, you arrive at your gross profit estimate, which is your goal for the pro forma income statement.
Small-business owners can't assume that just because they show an expected profit for their business that all is well. Profit is not the same as cash in the till. Cash up front is necessary to operate day to day operations. As a result, small-business owners must also develop a projected cash budget in order to assure that they will have adequate cash in the future to operate their firm.
Cash budgets are done on a monthly basis. Cash receipts or inflows, which are usually sales revenue, are based on the sales projections from the expected income statement. Cash expenditures or outflows are calculated similarly. The difference between them is the net cash flow. The business owner has to take into consideration whether or not he allows customers to pay on credit and account for that when calculating cash inflows upon receipt.
Each month, the small-business owner then calculates if there will be enough cash to meet the minimum cash balance and the firm's cash needs for the month. If not, the owner will have to borrow. If there is excess cash, the owner can repay past loans. In this way, the business owner can keep a good handle on the cash position of the firm.
Pro Forma Balance Sheet
After developing the pro forma income statement and the cash budget, the small-business owner now has all the information necessary to develop the pro forma balance sheet. The pro forma balance sheet shows the cumulative changes in the firm over time.
The owner also needs information from the prior year's balance sheet. The amount of each line item on the balance sheet can be obtained from one of these three documents. Some of the accounts on the balance, possibly long-term debt and/or common stock, will remain unchanged.
If the firm's assets increase from the previous time period, then the firm's owner has to look at the liability side of the balance sheet and find where the increase is in liabilities to support the increase in assets. That is only one possible scenario for the business owner.