Using Income Statements, Balance Sheets, Cash Flows, and Pro Formas to Drive Profitability

Using Income Statements, Balance Sheets, Cash Flows, and Pro Formas to Drive Profitability

If you’re serious about profits, you need to run your business by the numbers. Since the quality of your product and/or service should be a given, you next need to focus on the numbers to drive your business ahead.

Let’s examine the financial statements and projections as well as the specific numbers that you will want to zero in on to achieve your profit-oriented goals.

Set an Ambitious Profit Goal

To start, I like to set a big, fat, juicy profit goal for the year – a significant step above the past years, but still a number that could be achievable.

Next, will turn the profit goal into a budget. I might start by projecting an aggressive but possible sales target. Then, I might project total expense targets for each major business category. I would look at the sales in more detail, such as by category, by projected volume, by pricing, and/or by customer to see if I can realistically build to my sales goal. Then, I would take a look at my expenses in detail within each category to see if I think these are in line with my sales goal.

At this point, I might decide that my initial big, fat profit goal was too aggressive, and I would instead dial it back to an amount that is more realistic.

After potentially adjusting my profit goal, I would create profit and loss pro formas, which are essentially projected income statements, for each month of the year. I would also create a balance sheet goal for the end of the year – if the business is particularly complex, or if you have a bank that insists on them, I would create balance sheet pro formas for each month of the year.

For businesses where cash flow is tight, I would create cash flow projections, both annually and monthly. I would create an annual cash flow pro forma, as well as monthly cash flow pro formas.

Pro Forma Income Statement

At the end of every month, compare your pro forma income statement to your actual income statement and deeply examine the numbers. The tendency that many small businesses have is to delay this task or even put it off to the point where it becomes of little meaning. For example, if you don’t get around to examining your January actual income statement until the third week in February, it will be too late for your observations to lead to impactful changes for February.

If you’re assembling the income statement yourself, you and I know that you have a million things to do, and hence a million reasons to not to get around to evaluating your monthly income statements. This is a BIG mistake. Similarly, if you have someone on your staff who is assigned to assemble the monthly income statement, chances are they have a number of other tasks to complete and will give you a lot of reasons why it will take them one, two, or even three weeks to get around to this.

Once you have the actual income statement for the month in front of you, load it onto a spreadsheet so that you can compare it to your pro forma income statement. Next, you create a variance analysis, which basically is just the numerical difference between the actual and pro forma amount for every item.

Example:

Sales for January:
Actual $3,450
Pro-Forma $3,500
Variance -$50.

The first thing I look at with the variance analysis is if the sales are off and why this is the case. Then I start thinking about what changes I can make in order to boost sales for the following months. Is a particular customer buying less than last year? Is there a product line that is underperforming?

Next, I would look at the overall expense categories. For example, if I am spending 50 percent more than I budgeted on Facebook ads, but my total marketing cost is still within budget and I am reaching my sales goals, then I won’t be too concerned. On the other hand, if marketing costs are running 20 percent over budget, and I suspect this trend may continue next month, then I would consider making fast changes.

Pro Forma Balance Sheet

Traditional business practice would suggest you create an actual balance sheet at the end of every month. However, creating an actual (or pro forma) balance sheet takes a lot of time, especially if you have inventory or receivables. I would consider taking a shortcut and not creating a monthly balance sheet unless your business situation truly warrants this approach (if you’re borrowing money from your bank, they may require a monthly balance sheet).

In any event, you need to create an annual balance sheet. It will be required by tax authorities if you have any business other than a sole proprietorship. Even if you have a sole proprietorship, you should create a balance sheet, although technically the business doesn’t have a balance sheet distinct from your personal balance sheet.

The balance sheet will give you a snapshot picture of the financial health of your business. For example, a balance sheet will allow you to quickly compare the total debt versus the net worth for the business.

Cash Flow Pro Forma

With a cash flow pro forma, you project ahead your uses and sources of cash to help determine if you’re headed for a cash flow crisis. Why is this so important? Many small businesses realize they are headed for a cash flow crisis only very late in the game. As a result, they must make draconian expense cuts to try to survive.

On the other hand, a business that creates and uses cash flow pro formas can be proactive and take earlier and less drastic action to avoid a crisis.

Operating by the Numbers

Pro forma income statements, balance sheets, and cash flows are of course just projections – in the real world, the results will always be somewhat different.

However, the questions to ask yourself are: Do I really understand the difference (the variance) between my pro forma income statements and my actual income statements? Is the difference really significant and should I consider making changes or is it just “noise”?

For example, if my sales are coming at 20 percent less than my pro forma projections, and I can’t figure out any way to boost them, then I would totally slash my expenses for the rest of the year and completely redo my pro forma income statements.

On the other hand, if my expenses or sales are running a little higher or lower, then I might just make a mental note to myself and tell my team of the modest changes that I would like to make, but not spend the time and effort to redo the pro forma income statements.

Finally, at the end of the year, even if you haven’t hit your exact big profit goal but you’re somewhere in the vicinity, you should pat yourself on the back, compliment your team, and celebrate! All three of which are things I tend to forget to do myself.


About Bob Adams

Bob Adams is a Harvard MBA serial entrepreneur. He has started over a dozen businesses including one that he launched with $1500 and sold for $40 million. He has written 17 books and created 52 online courses for entrepreneurs. Bob also founded BusinessTown, the go-to learning platform for starting and running a business.

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