Continuing with my series here on standard business plan financials, all taken from my Lean Business Planning site, the Profit and Loss, also called Income Statement, is probably the most standard of all financial statements. And the projected profit and loss, or projected income (or pro-forma profit and loss or pro-forma income) is also the most standard of the financial projections in a business plan.
Either way, the format is standard, as shown here on the right.
It starts with Sales, which is why business people who like buzzwords will sometimes refer to sales as “the top line.”
It then shows Direct Costs (or COGS, or Unit Costs).
Then Gross Margin, Sales less Direct Costs.
Then operating expenses.
Gross margin less operating expenses is gross profit, also called EBITDA for “earnings before interest, taxes, depreciation and amortization.” I use EBITDA instead of the more traditional EBIT (earnings before interest and taxes). I explained that choice and depreciation and amortization as well in Financial Projection Tips and Traps, in the previous section.
Then it shows depreciation, interest expenses, and then taxes…
Then, at the very bottom, Net Profit; this is why so many people refer to net profit as “the bottom line,” which has also come to mean the conclusion, or main point, in a discussion.
The following illustration shows a simple Projected Profit and Loss for the bicycle store I’ve been using as an example. This example doesn’t divide operating expenses into categories. The format and math start with sales at the top. You’ll find that same basic layout in everything from small business accounting statements to the financial disclosures of large enterprises whose stock is traded on public markets. Companies vary widely on how much detail they include. And projections are always different from statements, because of Planning not accounting. But still this is standard.
A lean business plan will normally include sales, costs of sales, and expenses. To take it from there to a more formal projected Profit and Loss is a matter of collecting forecasts from the lean plan. The sales and costs of sales go at the top, then operating expenses. Calculating net profit is simple math.
Keep your assumptions simple. Remember our principle about planning and accounting. Don’t try to calculate interest based on a complex series of debt instruments; just average your interest over the projected debt. Don’t try to do graduated tax rates; use an average tax percentage for a profitable company.
Notice that the Profit and Loss involves only four of the Six Key Financial Terms. While a Profit and Loss Statement or Projected Profit and Loss affects the Balance Sheet because earnings are part of capital, it includes only sales, costs, expenses, and profit.
Yesterday I posted here the six key financial terms every business owner or startup leader needs to know. That’s reposted from my site on Lean Business Planning. These six terms work into three essential statements (for past results) or projections (in business plans or anything referring to the future) for standard business plan financials. A pro-forma statement, by the way, is another way to say projection. TheProfit and Loss (also called Income) includes Sales, Costs and Expenses. The Balance includes Assets, Liabilities, and Capital.
And these three are conceptually linked and interconnected. The following illustration shows how they relate to each other:
The standards of accounting, like double-entry bookkeeping, make a delightfully automatic error check with the three statements. They link up conceptually so that if the balance doesn’t balance, it’s wrong. If assets are not the sum of capital plus liabilities, it’s wrong. If retained earnings don’t add up to profits less distributions to owners (as in dividends, or owners’ draw), it’s wrong. If your spreadsheet, or your software, doesn’t reflect every change in the profits to the cash and balance, and every change in balance to cash, then it’s wrong.
I’ve heard an intelligent successful lawyer claim that double-entry bookkeeping was the most important invention of the western world. I’m not going to go there in this book. I’m not doing debits and credits. But knowing how these statements link up is important. Having standard business plan financials matters if you have a business plan event and have to show your business plan to bankers or investors.
Another problem that comes up a lot as I read on with my business plan marathon: too many business plans are taking too much time and effort telling supposed investors what their supposed return on investment will be. This is usually a waste of time, energy, and space. It’s certainly a mismatch between what the entrepreneurs are thinking and what the investors are thinking.
I was surprised a couple days ago, talking to entrepreneurs, at how much emphasis they put on wanting to know what return on investment was satisfactory to investors. It was as if they thought what the plan says the company will be worth five years from now makes a difference. And it doesn’t. The illustration here is a piece of fool’s gold, iron pyrite.
It felt like these entrepreneurs are thinking: investors want to see X in returns so I have to show that in my plan. I pop up the sales forecast, pop up the profitability, and that generates a great projected valuation. So I show that I can deliver a great return.
Investors, meanwhile, are actually thinking: I want to look at the product-market fit, scalability, management team, and factors like that to determine whether the company is going to make it. If they have all that right, then they have a shot; and if not, they don’t. Projected investor returns depend on a future valuation, which depends on the sales forecast or income forecast or both. Most investors look hard at the sales and profitability projections, because they want to see credibility; I use them to get a feel for how well the entrepreneurs know the business. There’s so much cascading uncertainty on future valuation that I don’t put much stock in it.
There’s a Catch-22 about sales and profitability forecasts: credibility of the numbers means more than the numbers themselves. A plan that has both big numbers and credibility is rare.