Entrepreneurs are often asked to create a set of pro forma financial statements for their business during the process of securing capital through a loan or investor, or when they are about to experience a big change like a merger or acquisition, or a large new customer. Future financial projections can be tricky all the way around, but the balance sheet is particularly difficult for non-accountants. Before we get into 3 common mistakes that small business owners make when developing a pro forma financial statement, you must first understand the difference between simple financial projections, and a pro forma financial statement. Here are 3 of the most common and damaging mistakes that you can make when working on your balance sheet forecast:
1. Incorrect Accounting for a Loan – There are a few ways to really screw up your balance sheet if you don’t understand how a loan impacts the balance sheet. So let’s say you are applying for a loan, and you are creating a pro forma assuming you got a $100,000 loan. After you get the loan, obviously cash should increase by $100k, you should have a loan account on the liabilities side of the balance sheet for $100k, but what happens in the subsequent months? Let’s say you have a $1,000 monthly loan payment, so cash will decrease by $1,000, but your loan balance will not decrease by $1,000. A portion of the loan payment will go toward interest expense which will not decrease the loan balance, instead it would decrease net income which ultimately decreases your retained earnings line on the balance sheet.
2. Failing to Account for Depreciation – Let’s assume that you use the $100,000 loan to purchase a building. So again your liabilities will increase by $100,000, but your assets will also increase by $100k initially. Then you need to determine how long the building will last. Typically you can assume 30 years for a new building, and then calculate depreciation for each month of the 30 years. This means that each month the value of the building will decrease due to depreciation. In our example we can assume the building will be worthless after 30 years, so we will depreciate the building to 0 over 30 years. So to calculate monthly depreciation you will just take $100,000 divided by 30 years divided by 12 months which equals $277 per month. Each month the value of your building asset should go down by $277 and your retained earnings should also decrease by $277 per month.
3. Assets Do Not Equal Liabilities + Owner’s Equity – The worst mistake that you can make when creating your balance sheet pro forma is when your balnce sheet does not BALANCE! In order to keep your balance sheet balanced, you must utilize the equation Assets = Liabilities + Owner’s Equity. This equation must always work, it must always balance. If you change the value of an asset, you must change the value of either a liability or owner’s equity account. You really need to understand accounting to make sure you are getting this right, otherwise you are going to end up with an unbalanced balance sheet which could be pretty embarrassing when you bring your financials to a potential lender or investor.
Next time you are creating a pro forma financial statement make sure to keep this common issues in mind. If you feel uncomfortable with your own projections, but don’t want to spend $250 an hour for your CPA firm to review what you have created, feel free to shoot me an email at firstname.lastname@example.org and I would be happy to review your pro forma financials for you.