Your pro forma income statement (also called profit and loss statement, or P&L statement) is the tool used by businesspeople and investors to determine if a company is profitable (or not) over a period of time.
It shows what the revenues, cost of goods sold, expenses, and profits of a company would be, based on a set of given assumptions.
The income statement answers seven questions for you and your potential investors:
- Are revenues growing fast enough to make it an attractive investment?
- Are revenues growing so fast that your credibility will be questioned?
- Is your gross profit margin (i.e., gross profit divided by revenues) within acceptable limits for the industry? If higher than the rest of your industry, have you explained what specific strategies you will be implementing to make that happen? It won’t happen by accident!
- Are expenses within acceptable limits for your industry? Or are you predicting significant revenue growth without the corresponding expenditures incurred by others in your industry?
- Are EBITDA/Revenues and Net income/Revenues within acceptable limits for your industry? If higher than the rest of your industry, have you explained what specific strategies you will be implementing to make that happen? One does not achieve such higher performance levels by just being “good.”
- Is the first year profitable? For most start-ups, EBITDA for the first year will be negative . . . and that’s okay!
- Is the company predicted to “dig itself out of the hole.” Although the first year will almost always exhibit negative profit (aka a loss), cum net tells you how long it will take for the cumulative profits to compensate for the early losses.
Let’s take a look at an income statement to understand how these seven questions get answered.
The figure below shows an income statement for the first five years of a company.
All income statements are organized into 4 horizontal sections:
The first section shows all primary revenue sources.
Cost of goods sold (aka COGS)
The second section shows costs associated with actually creating products that were responsible for revenues. This includes the cost of raw materials, shipping products to customers, and labor associated with manufacturing and maintaining inventory.
Just below this section, COGS are subtracted from revenues to calculate gross profit. It is used to determine how efficiently your company produces its products. It is most meaningful when compared to other companies in your industry.
The third section lists all expenses incurred by the company categorized by corporate division: General and Administration, Manufacturing and Production, Marketing and Sales, and Research and Development.
Summary lines on income statement
The fourth section is a series of totals and summaries that help you understand the company. They include:
- EBITDA. Literally, earnings before interest, (income) tax, depreciation, and amortization. This is calculated by subtracting expenses from gross profit.
– This is the value that most investors look at when they are trying to determine how well the company is predicted to do. Also, for most industries, it will be one of the primary determinants for valuing the company in the case of an acquisition.
- Depreciation. This is calculated from the depreciation schedules and useful lives of major purchases (i.e., fixed assets) you have made. Specifically, it is the sum of all depreciations for major purchases made prior to or during this period.
- EBIT. Earnings before interest and (income) tax. Calculated by subtracting depreciation from EBITDA.
- Interest. Any interest earned by the company from its assets, or any interest paid by the company.
- Provision for income taxes. This is calculated by multiplying your income tax rate by EBIT.
– However, if you had previous years of accumulated losses, they will be subtracted from the current year’s EBIT first. Notice, for example, in the company shown in the figure, no income tax is shown for fiscal year 3, even though it was profitable; losses from its earlier years were subtracted from its profits of year 3.
- Net income (loss) after tax. Calculated by subtracting interest and income tax from EBIT.
- Cum net. Cumulative net earnings. The sum of all net incomes for all periods up to and including the current period.
Except in very unusual circumstances, revenue is terrific, but revenue without gross profit is not sufficient. Similarly, gross profit is terrific, but gross profit without positive EBITDA is not sufficient.
Read Four Things a Cash Flow Statement Tells You to learn more about the pro forma cash flow statement. At that point, we’ll also see that positive EBITDA is great, but positive EBITDA without positive cash flow is also not sufficient.
Using your income statement is the best way to find out exactly how much revenue and profit (or loss) your company is generating; and how efficient it is in generating that profit from the sales. These are imperatives for launching and running a viable business.
Other articles you may find helpful in the series:
- Why Does My Startup Need Pro Forma Financial Statements?
- Four Things a Cash Flow Statement Tells You
- Four Things a Balance Sheet Tells You
Al Davis is a Serial Entrepreneur, Angel Investor and Author of six books. He is CEO of Offtoa, Inc., his fifth startup.
Photo courtesy of Jessica Wilson (Creative Commons).