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

Who You Are & What Brought You Here Today

    What is your primary job title?

What is your

familiarity

&

comfort

financial statements?

with What have you used for financial modeling to date?

When you leave this session, you hope… 2

Who We Are

   

Drew Tulchin

Social Enterprise Associates: applies business tools to achieve financial & social ‘double bottom line’ results. ( www.socialenterprise.net

) MBA Winner, 2001 Global Social Venture Competition & Microenterprise Paper Finalist, “Non-profits Accessing Capital Markets” I’m the one with the goat-tee    

Michael Whitehead-Bust

Foxhall Consulting Services: supporting mission-driven entrepreneurs. Services: business planning, strategic planning, development ( www.foxhallconsulting.com

) MBA/CFA Winner, 2001 ICIC/National

Business School Network.

National competition for strategy consulting to inner city businesses I’m the one with the goat-tee 3

Session Overview

     Introductions Value, Importance & Theoretical Framework Key Pro-Forma Components      Building a Pro-Forma Model Identifying key assumptions & drivers Expense & revenue estimates One year income statement by month Breakeven calculations Five-year income, balance & cash flow statements Handling Mission-Related Expenses & Overhead 4

Session Goals…

(& Limitations)     Goals Increase comfort with financial statements Impart skills / gain confidence to use pro forma analysis as a central component of decision-making Explore pro-forma basics Emphasize importance of good research and realistic assumptions    

Limitations We are not accountants (nor do we wish to be) Financial analysis is a tool, and but one tool, for management decision-making Time allotted for this session limits what we can share Our sense of humor (sorry, no refunds)

5

The Value of Pro-Formas

(Or, What’s Wrong with Just Using a Budget?)

Management – understand the past & the present

 Better understand cost/benefits of mission-driven components   Ratio analysis & benchmarking Ability to perform (and interpret) sensitivity analysis

Strategy & Planning – prepare for the future

 Forward thinking (Year 1 by month and Years 2-5 by year)   Facilitates more rational decision-making by clarifying business opportunity Forced articulation of assumptions and clarification of research/data

$$$ – allocate resources, explain situations & raise capital

 Balance sheet and cash flow statement can highlight risks  Used in evaluation to access new sources of capital (especially lenders, socially responsible investors, venture philanthropists, etc.) 6

Tips at the Start

Use Appropriate Resources

 Repeat, “I will not do my pro-formas in MSWord, Excel is my friend”   Invest in high-quality market research & choose meaningful benchmarks Pay for a good accountant/finance person   May

not

be the person currently handling your books Better a passionate business-minded person who understands your mission, than the reverse

An Art / Language, Not a Science

   Finance people are still subjective Make your work accessible & understandable to others Be clear about assumptions; acknowledge what you don’t know

Prepare, But Also Be Flexible

   Things will change (little-known Harvard Study) Allow for more time, budget for higher expenses & assume less revenue Get comfortable with red ink (non profits aren’t use to losses) 7

Pro-Forma Process Framework

1) Where are you now?

2) What is the goal?

Stable, successful job training program with access to new $$$ a.

b.

c.

3) What are the incremental steps to advance?

Spin-off business applying job training & earns income Benefit from brand recog. in community Capitalize upon existing org skills in food industry a.

b.

c.

Get board buy-in Conduct feasibility study Etc.

8

Philosophy / Key Concepts

    

Incrementation: think in units

 Children’s building blocks

Establish a compelling story

 But, be realistic, transparent & state your logic

Know your goals

  Separate financial from mission-driven Understand limitations / pressures on each

Earned income = Net Income

 Producing profits or just generating revenue?

Build, measure, build, measure, build

 (The carpenter’s ‘measure twice, cut once’ - measure continuously, because what you are cutting keeps changing) 9

Pro-Forma Components

    

Key assumptions w/ market data Income Statement:

 Yr 1 monthly, Yrs 2-5 annually

Balance Sheet:

Yrs 1-5 annually

Cash Flow Statement:

 Yr 1 monthly, Yrs 2-5 annually

Breakeven Analysis

10

Definitions / Key Terms

     Variable/Fixed Costs   Variable costs differ based on activity level. Typically driven by number of customers Fixed costs remain constant, regardless of sales volume Contribution Margin  Revenues – variable expenses = contribution margin Operating Leverage  Ratio: fixed to variable expenses Assumptions / Drivers Sensitivity Analysis  Evaluation of changes in business results based on alterations to key assumptions 11

Begin the Model w/ Assumptions

     Establish the background story Select a reasonable goal Gather data Determine key indicators Establish driving unit(s) of measurement

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)

12

Assumptions – Expenses

Audience Participation Activity (polite applause):      List major expenses Classify: fixed or variable?

Identify unit(s) of measurement Select drivers (what indicates the amounts?) Consider growth rates / change over time 13

Assumptions – Revenues

     Follow same steps from expenses List revenues, separate by product Establish the base unit for ‘incrementation’ Determine a defendable growth rate Philanthropic sources excluded at this time to focus on project revenue, but note potential exceptions:  if project produces incremental philanthropic stream (i.e. grants specifically tailored for the project)  if project requires grants for social benefits that are incremental, but inherent, project costs 14

Monthly Income Statement

   

Steps

Determine monthly sales growth rate Separate, describe behavior and timing of fixed / variable expenses Include mission-related expenses, revenues, and org overheads UBIT    

Outcomes

Quick view of year one profitability / losses Likely not the best evaluation of the opportunity Insight into capital needs Insight into level of risk 15

2-5 Year Income Statements

Revisit original growth assumptions. Carry them forward, with applicable changes, for years 2-5 REMEMBER:   Additional staffing, equipment, space, other needs Overhead allocations   Even conservative projections are often optimistic – base assumptions on sound data Rationality wanes after Year 3 (sometimes before). Don’t ‘bet the farm’ on Year 5 projections 16

5 Year Balance Sheets

 Articulate assumptions:      A/P A/R Inventory Capital Expenses & Depreciation Financing / Capital Structure: Debt? PRI? Philanthropy? Parent Org investment?

Note: Ensure consistency with I/S assumptions

17

Cash Flow Statements

     Monthly (Year 1), yearly Years 2-5 Note model structure Work with good financial professionals Be prepared for red, but have a plan (in advance) Can have positive net income, but be cash flow negative 18

Breakeven Analysis

 The Formula: Fixed Costs / (revenue per unit – variable costs per unit) = BEP in units   Is it attainable?

 Does market research back it up?  What is capacity?

Account for start-up costs/overhead allocations

Advanced Note:

Do you know your degree of operating leverage?

19

Handling Mission-Driven Costs

  Distinguish whenever possible  Promotes management of “business” side and “program” side   Increases appeal to funders Facilitates social return & SROI analysis Initial goal statements make it easier to attend to mission in terms of added expense - hard questions WILL come up 20

How to Handle Overhead Allocations?

     Handle in strategic & thoughtful manner Depends on entity’s legal status ‘Gray area’ treatment as fixed or variable Have an easily explained story Have information be transparent in assumptions 21

Final Thoughts

      Do your research Clarify goals (& costs) of mission related activity Rigorously research & analyze This is a living document Listen to what it tells you, but utilize all tools / data Have fun 22

Resources

    Robert Higgins.

Analysis for Finance Management

Jeffry Timmons. (Note spelling).

New Venture Creation: Entrepreneurship for the 21st Century

The Motley Fool What others do you recommend?

23

Questions & Answers

Michael Whitehead-Bust: [email protected]

www.foxhallconsulting.com

(coming soon) Drew Tulchin: [email protected]

www.socialenterprise.net