Building Better Financials

1
Building Better Financials

• Using Pro-Forma Financial Statements
• Their Importance to Your Enterprise
• Drew Tulchin Michael Whitehead-Bust
• Social Enterprise Alliance 5th National Gathering
• March 5th, 2004

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Who You Are What Brought You Here Today

• What is your primary job title?
• What is your familiarity comfort with financial
  statements?
• What have you used for financial modeling to
  date?
• When you leave this session, you hope

3
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
• Im 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
• Im the one with the goat-tee

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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

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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)

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The Value of Pro-Formas (Or, Whats 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.)

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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
  dont 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 arent
  use to losses)

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Pro-Forma Process Framework
1) Where are you now?
2) What is the goal?

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

Stable, successful job training program with
access to new
3) What are the incremental steps to advance?

1. Get board buy-in
2. Conduct feasibility study
3. Etc.

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Philosophy / Key Concepts

• Incrementation think in units
• Childrens 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 carpenters measure twice, cut once -
  measure continuously, because what you are
  cutting keeps changing)

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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

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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

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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)
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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

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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

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Monthly Income Statement
Steps
Outcomes

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

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

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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). Dont bet the farm on Year 5
  projections

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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
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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

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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?
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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

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How to Handle Overhead Allocations?

• Handle in strategic thoughtful manner
• Depends on entitys legal status
• Gray area treatment as fixed or variable
• Have an easily explained story
• Have information be transparent in assumptions

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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

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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?

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Questions Answers

• Michael Whitehead-Bust
• mbust_at_comcast.net
• www.foxhallconsulting.com (coming soon)
• Drew Tulchin
• drew_at_socialenterprise.net
• www.socialenterprise.net