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  1. 1. Building Better Financials Using Pro-Forma Financial Statements & Their Importance to Your Enterprise Drew Tulchin & Michael Whitehead-Bust Social Enterprise Alliance 5 th National Gathering March 5 th , 2004
  2. 2. Who You Are & What Brought You Here Today <ul><li>What is your primary job title? </li></ul><ul><li>What is your familiarity & comfort with financial statements? </li></ul><ul><li>What have you used for financial modeling to date? </li></ul><ul><li>When you leave this session, you hope… </li></ul>
  3. 3. Who We Are <ul><li>Drew Tulchin </li></ul><ul><li>Social Enterprise Associates: applies business tools to achieve financial & social ‘double bottom line’ results. ( ) </li></ul><ul><li>MBA </li></ul><ul><li>Winner, 2001 Global Social Venture Competition & Microenterprise Paper Finalist, “Non-profits Accessing Capital Markets” </li></ul><ul><li>I’m the one with the goat-tee </li></ul><ul><li>Michael Whitehead-Bust </li></ul><ul><li>Foxhall Consulting Services: supporting mission-driven entrepreneurs. Services: business planning, strategic planning, development ( ) </li></ul><ul><li>MBA/CFA </li></ul><ul><li>Winner, 2001 ICIC/National Business School Network. National competition for strategy consulting to inner city businesses </li></ul><ul><li>I’m the one with the goat-tee </li></ul>
  4. 4. Session Overview <ul><li>Introductions </li></ul><ul><li>Value, Importance & Theoretical Framework </li></ul><ul><li>Key Pro-Forma Components </li></ul><ul><li>Building a Pro-Forma Model </li></ul><ul><ul><li>Identifying key assumptions & drivers </li></ul></ul><ul><ul><li>Expense & revenue estimates </li></ul></ul><ul><ul><li>One year income statement by month </li></ul></ul><ul><ul><li>Breakeven calculations </li></ul></ul><ul><ul><li>Five-year income, balance & cash flow statements </li></ul></ul><ul><li>Handling Mission-Related Expenses & Overhead </li></ul>
  5. 5. Session Goals… (& Limitations) <ul><li>Goals </li></ul><ul><li>Increase comfort with financial statements </li></ul><ul><li>Impart skills / gain confidence to use pro-forma analysis as a central component of decision-making </li></ul><ul><li>Explore pro-forma basics </li></ul><ul><li>Emphasize importance of good research and realistic assumptions </li></ul><ul><li>Limitations </li></ul><ul><li>We are not accountants </li></ul><ul><li>(nor do we wish to be) </li></ul><ul><li>Financial analysis is a tool, and but one tool, for management decision-making </li></ul><ul><li>Time allotted for this session limits what we can share </li></ul><ul><li>Our sense of humor (sorry, no refunds) </li></ul>
  6. 6. The Value of Pro-Formas (Or, What’s Wrong with Just Using a Budget?) <ul><li>Management – understand the past & the present </li></ul><ul><li>Better understand cost/benefits of mission-driven components </li></ul><ul><li>Ratio analysis & benchmarking </li></ul><ul><li>Ability to perform (and interpret) sensitivity analysis </li></ul><ul><li>Strategy & Planning – prepare for the future </li></ul><ul><li>Forward thinking (Year 1 by month and Years 2-5 by year) </li></ul><ul><li>Facilitates more rational decision-making by clarifying business opportunity </li></ul><ul><li>Forced articulation of assumptions and clarification of research/data </li></ul><ul><li>$$$ – allocate resources, explain situations & raise capital </li></ul><ul><li>Balance sheet and cash flow statement can highlight risks </li></ul><ul><li>Used in evaluation to access new sources of capital (especially lenders, socially responsible investors, venture philanthropists, etc.) </li></ul>
  7. 7. Tips at the Start <ul><li>Use Appropriate Resources </li></ul><ul><li>Repeat, “I will not do my pro-formas in MSWord, Excel is my friend” </li></ul><ul><li>Invest in high-quality market research & choose meaningful benchmarks </li></ul><ul><li>Pay for a good accountant/finance person </li></ul><ul><ul><li>May not be the person currently handling your books </li></ul></ul><ul><ul><li>Better a passionate business-minded person who understands your mission, than the reverse </li></ul></ul><ul><li>An Art / Language, Not a Science </li></ul><ul><li>Finance people are still subjective </li></ul><ul><li>Make your work accessible & understandable to others </li></ul><ul><li>Be clear about assumptions; acknowledge what you don’t know </li></ul><ul><li>Prepare, But Also Be Flexible </li></ul><ul><li>Things will change (little-known Harvard Study) </li></ul><ul><li>Allow for more time, budget for higher expenses & assume less revenue </li></ul><ul><li>Get comfortable with red ink (non-profits aren’t use to losses) </li></ul>
  8. 8. Pro-Forma Process Framework 1) Where are you now? 3) What are the incremental steps to advance? 2) What is the goal? Stable, successful job training program with access to new $$$ <ul><li>Spin-off business applying job training & earns income </li></ul><ul><li>Benefit from brand recog. in community </li></ul><ul><li>Capitalize upon existing org skills in food industry </li></ul><ul><li>Get board buy-in </li></ul><ul><li>Conduct feasibility study </li></ul><ul><li>Etc. </li></ul>
  9. 9. Philosophy / Key Concepts <ul><li>Incrementation: think in units </li></ul><ul><ul><li>Children’s building blocks </li></ul></ul><ul><li>Establish a compelling story </li></ul><ul><ul><li>But, be realistic, transparent & state your logic </li></ul></ul><ul><li>Know your goals </li></ul><ul><ul><li>Separate financial from mission-driven </li></ul></ul><ul><ul><li>Understand limitations / pressures on each </li></ul></ul><ul><li>Earned income = Net Income </li></ul><ul><ul><li>Producing profits or just generating revenue? </li></ul></ul><ul><li>Build, measure, build, measure, build </li></ul><ul><ul><li>(The carpenter’s ‘measure twice, cut once’ - measure continuously, because what you are cutting keeps changing) </li></ul></ul>
  10. 10. Pro-Forma Components <ul><li>Key assumptions w/ market data </li></ul><ul><li>Income Statement: </li></ul><ul><ul><li>Yr 1 monthly, Yrs 2-5 annually </li></ul></ul><ul><li>Balance Sheet: Yrs 1-5 annually </li></ul><ul><li>Cash Flow Statement: </li></ul><ul><ul><li>Yr 1 monthly, Yrs 2-5 annually </li></ul></ul><ul><li>Breakeven Analysis </li></ul>
  11. 11. Definitions / Key Terms <ul><li>Variable/Fixed Costs </li></ul><ul><ul><li>Variable costs differ based on activity level. Typically driven by number of customers </li></ul></ul><ul><ul><li>Fixed costs remain constant, regardless of sales volume </li></ul></ul><ul><li>Contribution Margin </li></ul><ul><ul><li>Revenues – variable expenses = contribution margin </li></ul></ul><ul><li>Operating Leverage </li></ul><ul><ul><li>Ratio: fixed to variable expenses </li></ul></ul><ul><li>Assumptions / Drivers </li></ul><ul><li>Sensitivity Analysis </li></ul><ul><ul><li>Evaluation of changes in business results based on alterations to key assumptions </li></ul></ul>
  12. 12. Begin the Model w/ Assumptions <ul><li>Establish the background story </li></ul><ul><li>Select a reasonable goal </li></ul><ul><li>Gather data </li></ul><ul><li>Determine key indicators </li></ul><ul><li>Establish driving unit(s) of measurement   </li></ul>Note : the more specific you are with real information for outputs and outcomes, the easier it is to build towards them… (while being prepared they WILL change)
  13. 13. Assumptions – Expenses <ul><li>Audience Participation Activity (polite applause): </li></ul><ul><li>List major expenses </li></ul><ul><li>Classify: fixed or variable? </li></ul><ul><li>Identify unit(s) of measurement </li></ul><ul><li>Select drivers (what indicates the amounts?) </li></ul><ul><li>Consider growth rates / change over time </li></ul>
  14. 14. Assumptions – Revenues <ul><li>Follow same steps from expenses </li></ul><ul><li>List revenues, separate by product </li></ul><ul><li>Establish the base unit for ‘incrementation’ </li></ul><ul><li>Determine a defendable growth rate </li></ul><ul><li>Philanthropic sources excluded at this time to focus on project revenue, but note potential exceptions: </li></ul><ul><ul><li>if project produces incremental philanthropic stream (i.e. grants specifically tailored for the project) </li></ul></ul><ul><ul><li>if project requires grants for social benefits that are incremental, but inherent, project costs </li></ul></ul>
  15. 15. <ul><li>Determine monthly sales growth rate </li></ul><ul><li>Separate, describe behavior and timing of fixed / variable expenses </li></ul><ul><li>Include mission-related expenses, revenues, and org overheads </li></ul><ul><li>UBIT </li></ul><ul><li>Quick view of year one profitability / losses </li></ul><ul><li>Likely not the best evaluation of the opportunity </li></ul><ul><li>Insight into capital needs </li></ul><ul><li>Insight into level of risk </li></ul>Monthly Income Statement Steps Outcomes
  16. 16. <ul><li>Revisit original growth assumptions. Carry them forward, with applicable changes, for years 2-5 </li></ul><ul><li>REMEMBER: </li></ul><ul><li>Additional staffing, equipment, space, other needs </li></ul><ul><li>Overhead allocations </li></ul><ul><li>Even conservative projections are often optimistic – base assumptions on sound data </li></ul><ul><li>Rationality wanes after Year 3 (sometimes before). Don’t ‘bet the farm’ on Year 5 projections </li></ul>2-5 Year Income Statements
  17. 17. 5 Year Balance Sheets <ul><li>Articulate assumptions: </li></ul><ul><ul><li>A/P </li></ul></ul><ul><ul><li>A/R </li></ul></ul><ul><ul><li>Inventory </li></ul></ul><ul><ul><li>Capital Expenses & Depreciation </li></ul></ul><ul><ul><li>Financing / Capital Structure: Debt? PRI? Philanthropy? Parent Org investment? </li></ul></ul>Note : Ensure consistency with I/S assumptions
  18. 18. Cash Flow Statements <ul><li>Monthly (Year 1), yearly Years 2-5 </li></ul><ul><li>Note model structure </li></ul><ul><li>Work with good financial professionals </li></ul><ul><li>Be prepared for red, but have a plan (in advance) </li></ul><ul><li>Can have positive net income, but be cash flow negative </li></ul>
  19. 19. Breakeven Analysis <ul><li>The Formula: </li></ul><ul><li>Fixed Costs / (revenue per unit – </li></ul><ul><li>variable costs per unit) = BEP in units </li></ul><ul><ul><li>Is it attainable? </li></ul></ul><ul><ul><ul><li>Does market research back it up? </li></ul></ul></ul><ul><ul><ul><li>What is capacity? </li></ul></ul></ul><ul><ul><li>Account for start-up costs/overhead allocations </li></ul></ul>Advanced Note : Do you know your degree of operating leverage?
  20. 20. Handling Mission-Driven Costs <ul><li>Distinguish whenever possible </li></ul><ul><ul><li>Promotes management of “business” side and “program” side </li></ul></ul><ul><ul><li>Increases appeal to funders </li></ul></ul><ul><ul><li>Facilitates social return & SROI analysis </li></ul></ul><ul><li>Initial goal statements make it easier to attend to mission in terms of added expense - hard questions WILL come up </li></ul>
  21. 21. How to Handle Overhead Allocations? <ul><li>Handle in strategic & thoughtful manner </li></ul><ul><li>Depends on entity’s legal status </li></ul><ul><li>‘ Gray area’ treatment as fixed or variable </li></ul><ul><li>Have an easily explained story </li></ul><ul><li>Have information be transparent in assumptions </li></ul>
  22. 22. Final Thoughts <ul><li>Do your research </li></ul><ul><li>Clarify goals (& costs) of mission-related activity </li></ul><ul><li>Rigorously research & analyze </li></ul><ul><li>This is a living document </li></ul><ul><li>Listen to what it tells you, but utilize all tools / data </li></ul><ul><li>Have fun </li></ul>
  23. 23. Resources <ul><li>Robert Higgins. Analysis for Finance Management </li></ul><ul><li>Jeffry Timmons. (Note spelling). New Venture Creation: Entrepreneurship for the 21st Century </li></ul><ul><li>The Motley Fool </li></ul><ul><li>What others do you recommend? </li></ul>
  24. 24. Questions & Answers Michael Whitehead-Bust: [email_address] (coming soon) Drew Tulchin: [email_address]
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