How To Forecast Financial Statements:

Balance Sheets, Income Statements

Small businesses perform financial forecasting by analyzing historical data
and using it to predict the company’s future financial performance. Preparing
financial statement forecasts helps small businesses plan their future growth
and manage cash flow. How to Forecast Financial Statements
Small businesses forecast financial statements by looking at relevant
historical data and using the information to make future predictions about the
financial state of the company.

There are three fundamental financial statements that small businesses

typically issue: income statements, balance sheets and cash flow statements.

The three financial statements can be looked at holistically to understand the

overall financial health of your business. Forecasting can be done for a
business’s income statements and balance sheets. A cash flow forecast can
then be derived from the data in your income statement and balance sheets.

Documents showing your business forecasts are called pro forma financial
statements. Together, these documents can provide valuable accounting
insights to help you better plan for your business’s future growth.

What Are Pro Forma Financial Statements?

Pro forma financial statements are based on certain assumptions and
projections about the business. Pro forma statements allow you to compare
actual financial events to your financial plan and make any necessary
adjustments throughout the year. Most small businesses tend to prepare pro
forma financial statements for periods of six months or one year.

Pro forma financial statements are usually required if you need a bank loan or
other form of business financing.

How to Forecast an Income Statement

Small businesses can develop a pro forma income statement to forecast the
company’s profits or losses for a specific time period. Here are the steps for
forecasting your income statement:
Analyze Historical Data
To accurately forecast your company’s profits or losses, you’ll first need to
understand its past performance and use that data to predict future financial
outcomes. Make sure you’re using comparable data. If you’re developing a
pro forma income statement for a one-year period beginning January 1, 2020,
you’ll want to look at historical data from the same period in previous years.
Best practices suggest analyzing at least two periods worth of historical data,
so you would want to look at income statements from January 1, 2018 and
January 1, 2019.

Forecast Your Revenue

The easiest way to create a revenue (or sales) forecast is to input your annual
growth rate. Look at the percentage growth in revenue over previous periods,
and use that information to make an informed assumption about your future
revenue.

Predict Cost of Goods Sold

As a service-based business, cost of goods sold might not seem to directly
apply to your company. But service-based businesses should think of their
costs related to labor, employment tax and benefits as their cost of goods
sold. Sometimes, this is called the cost of services instead.

Determine Your Operating Expenses

Analyze your past operating expenses and compare them to your expected
revenue to determine what your expected operating costs will be in your
forecast. Operating expenses include office rent, business insurance, office
supplies, salary and benefits for employees, and more.

How to Forecast a Balance Sheet

Forecasting your business’s balance sheet involves estimating your
company’s assets and liabilities for a future date. A balance sheet is a
financial document that gives a summary of your business’s financial position
on a specific day. Balance sheet forecasts, or pro forma balance sheets, are
used to project how your company will manage its assets in the future.

To create a pro forma balance sheet you’ll follow the following steps:

Input Your Short-Term and Long-Term Assets

Begin by inputting your short-term assets, which includes your current cash
assets and your accounts receivable. Then, input your long-term assets,
which would include things like: buildings, property and vehicles.
Include Your Current and Long-Term Liabilities
Account for your current liabilities, which include all liabilities that your
business must settle in cash within the next year. You’ll also include long-term
liabilities, which are all your liabilities due in more than one year. Liabilities
include payroll, labor services and loan payments.

Calculate Your Final Figures

To figure out your final projections, just subtract your liabilities from your
assets. This final forecast of your balance sheet will give you important
insights into how secure your business’s financial position will be at a future
date and can help you decide if you need to consider cutbacks or apply for
loans.

How to Forecast Cash Flow

To forecast your business’s cash flow you’ll estimate the amount of cash
flowing into and out of your company for a specific future period. A pro forma
cash flow statement can help you identify where your business may
experience cash shortfalls in future, so you can plan accordingly to offset lean
times.

Here are the steps to forecasting your cash flow statement:

Estimate Your Anticipated Sales by Month

Use at least two years of historical sales data to calculate what sales you can
anticipate by month. Make sure to look at seasonal data to see if there are
patterns to your sales. You’ll also want to factor in any future plans, like if you
know that a big new client will sign on to your business in the coming months.

Predict When You’ll Receive Payments

Estimate when you’ll receive future payments by relying on historical data. If
you invoice clients using a 30-day billing cycle, you can predict when you’ll
receive payments based on those due dates. If one of your clients frequently
pays you after the due date, you’ll want to factor that into your projections.

Estimate Your Costs

Most small businesses have both fixed and variable costs. Account for your
fixed costs, including rent and utilities. Your variable costs fluctuate based on
how much work you’re producing. For a service-based business, variable
costs could include printing, postage and travel costs related to business
meetings.
How to Forecast Depreciation
The most straightforward method of forecasting depreciation is the Straight-
Line Method. For small business accounting, depreciation is used to allocate
the cost of a purchased asset over its useful lifetime.

If you use the Straight-Line Method for forecasting depreciation, the

depreciation of an asset is recorded evenly across the span of its useful
lifetime. The equation used to forecast depreciation is:

(Cost of Asset - Residual Value of Asset) / Estimated Useful Lifetime of Asset

So, let’s say you bought a work vehicle for $10,000. The vehicle has a
residual value of $500 and an expected lifetime of five years. Here’s the
calculation:

($10,000.00 - $500.00) / 5

= $1900.00 per year or $158.33 per month.

What Are Profitability Ratios? Definition,

Types & Importance
A profitability ratio is a financial measurement. It measures the relationship
between revenues and costs. The ratio quantifies the cost levels required to
achieve these revenues. They can be applied at different levels within an
organization or industry. This depends on the situation that needs to be
analyzed. There are many types of financial ratios. This article will discuss
many of them.

Here is an important thing to note. Profitability ratios are just one aspect of the
business situation. It is not enough to look at only profitability ratios. When
analyzing a company's future, there are many factors involved. It's important
to keep this in mind during your financial analysis. Profitability ratios can be
used in combination with other financial information. Some other examples
are asset utilization, liquidity, capital structure and return on assets. Other key
metrics include return on equity and return on investment.
What is a Profitability Ratio?
A profitability ratio is a measurement. It measures the profitability, efficiency
and effectiveness of an organization. The ratio of profitability is an efficiency
ratio. It measures the percentage of revenue available after all operating
expenses are deducted. Profitability ratios differ from other balance sheet
ratios in one keyway. They are specific to income statement items.

The current ratio can help you understand if a company can convert sales
revenue into net income. The primary purpose of profitability ratios is to
measure how a company uses its assets. It signifies how well it generates
profits.

High profitability ratios are desirable. They mean that the company has
generated high levels of profit with fewer assets or lower asset use.

Low profitability ratios are undesirable. This means the company has missed
opportunities. These opportunities could increase profits through better asset
management.

High profitability ratios are always good. They show a high level of efficiency.
Low profitability ratios are usually bad, but not always. Low profitability can
suggest that the organization is in a growing phase. It may be operating in a
very competitive industry.

It has quite a few uses. Some of these include:

 Profitability ratios can be used to compare many companies.

 It can help decide if someone should invest in a company.
 Business owners or managers can use it to determine how much money
should be invested.
 They can help determine how you use your cash flows
 They can help determine your cash return
 And more
What Are the Three Main Profitability Ratios?
Profitability ratios can be classified into three types. These are operating
profitability, asset use and contribution. Business performance profitability
ratios focus on the income generated by a company. They provide information
about what part of sales revenue is available for expenses. This is an
important number in your expense ratio. This is after all production costs of
goods sold have been deducted from total revenues.

Operating Profitability Ratio

This profit ratio determines how well a company is able to generate sales
revenue. This is after deducting the cost of goods sold. The operating
profitability ratio can be calculated as follows. Divide net income by sales.

Operating Profitability Ratio = Net Income/Sales

Asset Use Profitability Ratios

Asset use ratios focus on assets. This includes total assets and fixed assets.
These are used to generate sales revenue. They're calculated after all
operating costs have been deducted from revenues. There are two types of
asset use profitability ratios. These are the fixed asset turnover ratio and the
inventory turnover rate.

 Fixed Asset Turnover Ratio. This measures how effectively a company

uses its fixed assets. This is calculated by dividing total revenue by total
fixed assets.
 Inventory Turnover Rate. The inventory turnover rate measures how
effectively a company uses its inventory. This is calculated by dividing
net sales revenues by average inventory.
Contribution Profitability Ratio
The contribution profitability ratio helps companies measure the effectiveness
of their marketing efforts. The contribution margin is also known as gross
profit or revenue less cost of goods sold. This is what's leftover after deducting
the cost of goods sold from total revenue.

Contribution Margin = Revenue - Cost of goods sold/Revenue

Divide net income by contribution profit margin to get the contribution

profitability ratio. This will tell you how much is available for distribution as
dividends per share.

Which is the Best Profitability Ratio?

Profitability ratios measure a company's ability to convert sales revenue into
net income. It's important to take other factors into consideration. An example
is gauging which profitability ratio is best.
The operating profitability ratio is often considered the best one out of the
three. It tells an organization how well it manages its costs. This is after all
operating expenses have been deducted from sales.

The contribution profitability ratio is useful for marketing purposes. Most

companies use it to measure effectiveness. This includes marketing efforts
and marketing budgets.

What is Considered a Good Profitability Ratio?

Net income before taxes is the norm when it comes to measuring a company's
profitability. Average net earnings keep increasing. This is often because
companies adopt cost-saving strategies and new technology.

As a rule of thumb, a good operating profitability ratio is anything greater than

1.5 percent. The industry average for most countries around the world hovers
closer to 2 percent. A good net income ratio hovers around 5 percent.

For a contribution margin, it's best to use as long as the percentage is

increasing overtime periods. The more efficient a company becomes, the
better its profitability will be.

A business often has to choose between increasing sales revenue and

increasing profit. Doing both is very difficult. It requires too much of a strain on
operating expenses. Some examples are marketing, distribution, inventory
management and administration. This is why it's important to know the best
profitability ratio for your company.

Focusing on the Wrong Types of Profitability Ratios

Using one kind of profitability ratio over another can be a disadvantage.

One example is if your business is one of many companies in the industry.

Using operating profit margin as a measure for profitability can be counter-
productive. This is because you're comparing yourself with different
organizations. They may have access to different types and quantities of
assets and labor.

It's best to use contribution margins as a measure for profit as well as

productivity. Compare your profit to the rest of the industry's when competing
with other companies.

Using this profit margin ratio will give you insights about the direction your
company is moving.
Key Takeaways
Profitability ratios help any business measure the differences between income
and expenses. It's a good measure of financial performance. When used
correctly, this makes it easier to identify where a company can reduce costs. It
can also help identify areas to increase revenue. This is particularly useful for
smaller businesses. This is because they do not have access to as much
capital as larger ones.

Profitability ratios allow companies to better understand their short-term and

long-term prospects. It allows them to build a better business plan. It also
helps make the difficult decisions needed at all stages of a company's
lifecycle. It is important to take other factors into consideration. This helps
when gauging which profitability ratio is best. Operating margins help measure
a company's ability to convert revenue into net income.

This article discussed profitability ratios in depth. You learned what profitability
ratios are, which ratio is best and much more. Hopefully this guide answers all
of your questions about profitability ratios.