Why Bother With Pro Forma Financials?

Sherman McCorkle

How important are the financials as part of the business plan?

There is a saying among accountants that "accounting is the language of business." If that is true. then the balance sheet and the profit and loss statement portray the history of your company. But what happens when you have no history? Then you need to write the fiction that we refer to as pro forma financials.

Pro forma is Latin and literally means "as a matter of form." Venture capitalist joke that pro forma is French for "wild guess." So why would you need to create a fictional balance sheet, profit and loss statement and cash flow statement as part of your business plan? Well, there are three reasons: to prove you can, to test your assumptions, and to determine if your hard work will ever be worth it.

Proving that you can create pro forma financials is an indicator of your financial aptitude. Demonstrating that you understand how sales flow through the various financial reports and the impact that your spending decisions can have on cash flow and profitability show the reader that you have a firm grasp on the business of running a business. Investors are investing in your ability to execute a plan. Your fluency in this language of business is one of the factors that they are examining.

Second, the pro forma financials give you a framework under which you can test your assumptions. A good set of pro formas will allow you to examine different scenarios that may present themselves. Believe it or not, more sales are not always the answer to more profit. Your financials can help you predict what the optimal mix of sales and expenses can be as you grow.

In addition to allowing you to test your assumptions, your financial projections allow the investor to understand your assumptions about the business. Investors can quickly spot false assumptions and oversights when presented with pro forma financial statements. Common oversights include under or overpaying employees, forgetting about state taxes, underestimating the cost of sales and overlooking the cost of professional services, such as attorneys and accountants.

At the end of the day, however, the most important reason for creating your financials is to help you understand whether your entrepreneurial endeavor will be worth your while. When your assumptions have been properly represented and tested within the stark reports that make up pro forma financials, you can often get a more objective view of the market value of your idea. Not every idea is a good idea and not every good idea is a profitable idea.

So take the time to create the pro forma financial statements and share them with as many people as will honestly review them. The money and time you save will likely be yours.

I was recently told by a venture capitalist that my ratios were wrong. What is a ratio?

Financial ratios are comparisons between elements of the financial statements, often between the income statement and the balance sheet, which provide a way to measure your business against others. Since businesses vary widely, ratios give a basis for comparison between companies with similar characteristics.

Many industries have ratios that indicate the relative health of a business within a given market segment. These ratios vary from industry to industry but understanding them also reinforces your fluency in the language of business. Since ratios are often based on the metrics of successful companies, they can also help to identify areas that may need improvement and serve as a planning tool.

A ratio is established by dividing one number by another, such as total number of sales by the number of employees. This number, in our example Sales per Employee, can then be used for comparison to similar companies. Ratios that fall outside of an accepted norm may indicate that further investigation is needed.

Bankers, venture capitalists and other financial types often use ratios to express the health, competitiveness or liquidity of a business. As an entrepreneur talking to people in this industry, it helps to understand what ratios they deem important. Loans are often based on ratios that compare the rate at which the company generates money, such as net sales/total assets, current assets/current liabilities and cash and receivables/current liabilities.

Ratios can be a helpful tool to give a quick indication of the conformity that a business has with regard to other successful businesses, but they often don't tell the whole story. Like a bikini, they often cover more than they reveal.

For the whole story, you often need to fully examine the financial statements.

Sherman McCorkle is president of Technology Ventures Corporation.