Income statement

Your projected income statement: a map to profitability

This is the bedrock of your pro-formas.  To begin, you will estimate your revenue (also called sales).  This is simply the amount of cash you are bringing into the company in exchange for the goods and services the company provides.  Do you sell t-shirts for $10 each?  Then the revenue or sales for each is $10.   You will estimate this for the first year you are in business, but then you must estimate out for the next 5 years.  What kind of growth do you expect?  This should be reflected in the ensuing years.  Note that it is important to be realistic here.  Do not overstate to look good and do not understate to be modest, you’re going for as much accuracy as you can muster.  Once you’ve gone through this, you should have something that looks like this:

Of course, I have put in phony numbers here.  You need to make sure that the numbers you enter make sense.  A good quick check on that is to calculate the growth rate: (Year B - Year A)/Year A.  So for us to calculate our first year growth rate, we would get (1500-1000)/1000 = 0.5 or in other words, a 50% first year growth rate.  Now, let’s look long term: (2250-1000)/1000.  This gives us a long term, 5 year growth rate of 125%.  Is that outrageous?  Not at all… as a matter of fact, many startups grow that fast in their first year… it’s important for you to determine if that is going to be the case for your company by looking at comparable companies in your industry.

• Note: entrepreneurs often wonder if they should be showing sales figures based on their current state, or based on when/if they get funded.  The answer is both.  You need, for your own management and budgeting, a version that reflects your unfunded state.  However, you need to be able to show an investor what his/her money would enable your company to do long term, so you have to create a funded version as well.

Now that you’ve figured out your sales numbers, you need to work on the other side of the equation, expenses.  To do this, you need to list all your likely costs associated with running your business.  Often, you’ll see these costs grouped into various headings like Cost Of Goods Sold (”COGS”) and Sales, General, and Administrative (”SG&A”).  You don’t have to group them, but it sometimes makes it easier for readability.

There are some things to keep in mind here.  First, you need to make sure you understand what an expense is.  For our purposes, we’ll define an expense as anything that you purchase and use in the business to provide the goods and services which has a useful life of less than one year.  Why less than one year?  Because items that have a longer lifespan become capital assets and are treated differently from an accounting perspective.  To get a true understanding of this, please speak with your accountant.  For the purposes of this article, we will assume that all your cash outflows are expenses and that you are not investing in long-term capital goods.

Now you should have estimated out your first year expenses, detailing all the money you think you’ll have to spend in order to run the business.  Yes, your SALARY is included, but not other means of pulling money out of the business - again, see your accountant for this more advanced topic.  Now that you’ve got Year 1 down, you need to go through the exercise of projecting again.  Things to keep in mind here are inflation, pay raises, and increases in supplier costs.  A good trick is to use a percentage of sales as your basis, so as sales grow, so do your expenses.  For example, Sam’s t-shirt business may find that ink costs 10% of revenue.  So, as Sam projects out the revenue for years 2 through 5, the ink costs simply remain 10% of those years’ revenue projections.  Thus, we’d now have something like this:

And putting it all together, we get:

Note the “Net Income” line at the bottom.  This is the difference between your revenue and your expenses and is often refered to as “earnings” or “profit”.

• Note: This example is HIGHLY simplified.  Your business may have many expenses that are not reflected here that would further complicate the calculation of Net Income such as depreciation, amortization, and interest payments.  Speak with your accountant for details.

This is the basics of how to produce a pro-forma income statement.  Please feel free to post questions below.