Let’s start off this vital part of any capital formation strategy and talk about the building block of your company, its telltale value and how well the company is doing…by its financials.

Entrepreneurs seeking funding and preparing business plans frequently ask me to explain the concept of pro forma financial statements. It’s a very important concept and is a critical part of any business plan.

Pro-forma financial statements put your vision for your company into language private investors to understand: dollars and cents. Pro-forma, in this context, is another word for forward looking. Therefore, pro-forma financials state the financial results that your business plan is expected to generate. This includes a complete set of financial statements which are a balance sheet, income statement and statement of cash flow, and looks out three to five years.

Generally speaking, the first year, when assumptions are more clearly defined, financials are expressed on a monthly basis and the remaining years on a quarterly basis.

Making assumptions about your business and market place is perhaps the most important part of assembling pro-forma financials. Investors generally give more credibility to “bottoms up” assumptions as opposed to “tops down”. An example of a “tops down” assumption is estimating a market size at say $200 million and assuming that your company will get 5% market share for annual sales of $10 million. A more credible “bottoms up” approach would be to assume that you will initially hire five sales people who will each realistically call on two clients per day, close 30% and make annual sales, on average, of $2 million for a total of $10 million in annual revenue.

Macroeconomic assumptions are also a very important element in assembling pro forma financial statements. When seeking funding the entrepreneur must demonstrate a firm grasp of how the larger economic environment will impact their business. For instance, is your business sensitive to changes in energy prices? If so, then what are your assumptions about the coming months and years? Will your business be impacted by changes in the housing market? If so, then what do you think about the near to intermediate term housing market?

When analyzing your business plan investors will realize that your pro-forma financial statements are based on assumptions and will discount accordingly. However, it is important to show potential investors that you have given careful consideration to the real forces that drive your business. The confidence you inspire will go a long way in establishing credibility.

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