Q: How often should I create pro formas?
A: If your business is growing, you should start from scratch once each year. Additionally, the cash flow pro forma should generally be updated on a monthly basis. The cash flow is the most critical pro forma statement. If you run out of cash, you effectively are out of business!
If major changes become likely during the year, you may want to update your profit and loss pro formas at that time. Balance sheets really only need to be updated yearly. But if you are concerned about violating any bank loan covenants regarding your balance sheet items, then you should update them more often.
In the case that you are operating a very simple business with no inventory, and you are not extending credit to your customers (such as a personalized service business where all of your customers pay by cash or credit card), and your business is operating close to the goals and projections you set at the beginning of the year, then you may want to skip updating your pro formas each month. That being said, most businesses should do a monthly update.
Q: Is it really worth the time to create pro formas?
A: Yes! To do it right will take a lot of time, but it is certainly time well spent. Pro forma profit and loss statements will allow you to see whether all of your hard work will lead to profits. Pro forma balance sheets tell you what your financial strength should like look at future points in time. Pro forma cash flows provide an early warning for cash flow problems and help you pinpoint the source of potential issues.
Q: Which pro forma is the most important?
A: Cash flow! It’s nice to project a profit—and knowing you have a solid balance sheet can make you feel good—but if you run out of cash, your business will be dead in the water!
Almost all small businesses will feel a cash crunch sooner or later, and for many businesses, it will happen fairly regularly. But if you keep your cash flow projection up-to-date, you can take steps to avoid cash shortages before the problem becomes acute. Otherwise, you will go merrily along your way, until one day you may find that you have no money in the bank, your bank credit is exhausted, your payroll is due, your key vendors are howling for payment, the IRS is calling, and customers are still paying their bills slowly. Remember, cash crunches happen all the time in successful, profitable, growing businesses, too!
Q: Any tricks for quickly updating a cash flow pro forma?
A: Since any pro forma takes quite a while to carefully update, there may be times when you need a shortcut to get a ballpark estimate. First, I would revise sales estimates and changes in the collection cycle (the amount of time it takes to get paid from customers who buy on credit). Then I would review any costs that directly change with sales, such as costs of goods sold in a product business or the costs of labor and major supplies in a service business. I would be less likely to update as frequently items that don’t directly change with levels of sales.