Entrepreneurial Finance, 4th Edition By Adelman and Marks PRENTICE HALL ©2007 by Pearson Education, Inc. Upper Saddle River, NJ Chapter 6 Forecasting and Pro Forma Financial Statements

Entrepreneurial Finance, 4th Edition By Adelman and Marks PRENTICE HALL ©2007 by Pearson Education, Inc. Upper Saddle River, NJ Forecasting  A forecast is a quantifiable estimate of future demand.  Forecasting in business is the process of estimating the future demand for our products and services.  Forecasting for the financial manager also requires estimates of future interest rates.

Entrepreneurial Finance, 4th Edition By Adelman and Marks PRENTICE HALL ©2007 by Pearson Education, Inc. Upper Saddle River, NJ Practical Sales Forecasting for Startup Businesses  Steps to take for a sales forecast: › Listing what you know: –Expertise, experience, knowledge of charges and fees. –Previous revenue and cost information based on experience. › Research similar companies via EDGAR competing company annual reports, or industry-specific publications. › List three types of expenses: –Startup –Fixed –Variable › Develop a revenue forecast

Entrepreneurial Finance, 4th Edition By Adelman and Marks PRENTICE HALL ©2007 by Pearson Education, Inc. Upper Saddle River, NJ Forecast of Revenue for a Startup - Autoshop

Entrepreneurial Finance, 4th Edition By Adelman and Marks PRENTICE HALL ©2007 by Pearson Education, Inc. Upper Saddle River, NJ Mistake in pro formas or a bad investment? Initial investment in storeTerminal Value 7-Year Unit- Level IRR avg annual interest rate "True" IRR avg annual interest rate $ 466, $ 584, %4.2%25.2%3.3% Source of first three cells: Autoshop business plan

Entrepreneurial Finance, 4th Edition By Adelman and Marks PRENTICE HALL ©2007 by Pearson Education, Inc. Upper Saddle River, NJ Pro Forma Financial Statements  A pro forma financial statement is a projected statement based on the forecast.  The three basic pro forma statements are: › Pro forma income statement › Pro forma cash budget › Pro forma balance sheet

Entrepreneurial Finance, 4th Edition By Adelman and Marks PRENTICE HALL ©2007 by Pearson Education, Inc. Upper Saddle River, NJ Pro Forma Balance Sheet Using Percentage of Sales  Percentage of sales method is based on the fact that assets and liabilities historically vary with sales. › Thus any increase in sales will cause a subsequent buildup in both assets and liabilities. › Both profit margins and dividend (owner) payout ratios determine the amount of internal financing that can be applied to support increased asset buildup. › See examples Chapter 6 Adelman & Marks and Vermont Teddy Bear Company Forecasting

Entrepreneurial Finance, 4th Edition By Adelman and Marks PRENTICE HALL ©2007 by Pearson Education, Inc. Upper Saddle River, NJ Financial Statements Income Statement Balance Sheet Statement Of Cash Flows

Entrepreneurial Finance, 4th Edition By Adelman and Marks PRENTICE HALL ©2007 by Pearson Education, Inc. Upper Saddle River, NJ Building Integrated Financial Statements BUILDING YOUR PRO FORMA FINANCIAL STATEMENTS Build-up Method Comparable Method Final Steps

Entrepreneurial Finance, 4th Edition By Adelman and Marks PRENTICE HALL ©2007 by Pearson Education, Inc. Upper Saddle River, NJ BUILD-UP METHOD Revenue Projections COGS Operating Expenses Revenue Worksheet COGS Worksheet Operating Expense Worksheet Preliminary Income Statement

Entrepreneurial Finance, 4th Edition By Adelman and Marks PRENTICE HALL ©2007 by Pearson Education, Inc. Upper Saddle River, NJ COMPARABLE METHOD Choose industry metrics Compare your projections to other companies and industry average Benchmark other companies in the industry

Entrepreneurial Finance, 4th Edition By Adelman and Marks PRENTICE HALL ©2007 by Pearson Education, Inc. Upper Saddle River, NJ BUILDING INTEGRATED FINANCIAL STATEMENTS INTEGRATED FINANCIAL STATEMENTS Income Statement Monthly forecasts for years 1 and 2 Adjust monthly forecasts according to seasonality Annual forecasts for years 3-5 Balance Sheet Consider Accounts Receivable Show outflow and depreciate PP&E Consider Accounts Payable Statement of Cash Flows

Entrepreneurial Finance, 4th Edition By Adelman and Marks PRENTICE HALL ©2007 by Pearson Education, Inc. Upper Saddle River, NJ  Focus on major infusions of cash describe the nature of your  accounts receivables and payables  Mention PP&E expenses PUTTING IT ALL TOGETHER 2-3 page explanation of your Financial Spreadsheets  Talk about revenue drivers  Talk about seasonality  Discuss the expense categories  Focus on major infusions of cash  Describe the nature of your cash flows  Accounts receivables and payables  Mention PP&E expenses  Talk about major asset categories, and any Liabilities that aren’t clear from the previous discussion Discuss the Income Statement Discuss the Cash Flow Statement Discuss the Balance Sheet

Entrepreneurial Finance, 4th Edition By Adelman and Marks PRENTICE HALL ©2007 by Pearson Education, Inc. Upper Saddle River, NJ Reduced survival chance Underestimating time to secure financing Top-down versus bottom-up forecasting Lack of comparables Underestimating time to generate revenues Underestimating costs Not understanding the revenue drivers Common mistakes entrepreneurs make