We went to the British Library’s world-renowned Business and Intellectual Property Centre on Tuesday morning to learn more about startup accounting. Johnny Martin, a man who has made his name by demystifying accounting jargon and debunking finance myths, led the seminar.
This blog will focus on the nitty gritty of Profit and Loss forecasting. If you have any other queries, feel free to get in touch with the man himself!
What is a Profit and Loss Forecast?
A profit and loss forecast is a spreadsheet that estimates the profits and losses that your business will encounter in a year. The document is extremely useful if you are pitching for investment. If you, as a startup looking for funding, can produce a sound Profit and Loss Forecast to a venture capitalist, angel investor or a bank, they will be buoyed by your understanding of accounting.
A profit and loss forecast works with this equation in mind:
Sales - Cost of Sales = Gross Profit. Gross Profit - Total Overheads = EBIT. EBIT - Interest = Profit Before Tax.
Before you get your answers by using this formula, you need to understand eaxctly what each heading means. In other words, you need to the acute differences between a 'cost-of-sale' and an 'overhead', for example.
It is useful to note that the same structure and formula can be used when you’re up and running for your Management Accounts.
Sales are the hardest part of your profit and loss to forecast. It is, by definition, difficult to estimate the sales that you are likely to make.
First off, you need to identify all of your different sales channels. You need to include a monthly estimation for each sales channel. If your single product is t-shirts, for example, you need to project sales made from a market stall, from wholesale supply and online.
Your Sales section also includes any other income except funds raised by selling equity. Equity investments are not sales, they are funding agreements. If you win any competitions or receive any business grants, these need to go into your Sales column.
Also, it would be extremely wise to include 'assumptions' in your spreadsheet. Assumptions are simple formulas that can be built in that allow for variations in your predictions. For example, what happens if you make 15% more sales than you estimate? Or 15% fewer sales than you estimate? If you build in a formula that multiplies all of the sales estimations by a fraction (x 1.15 for 15% more or x 0.85% for 15% fewer), this will blow the socks off potential investors. They will appreciate that you understand the volatility of starting up.
Cost of Sales
When you have worked out a figure for your sales, you need to subtract the cost of sales from your sales sub-total to work out your Gross Profit. Or, to return to the formula:
Sales - Cost of Sales = Gross Profit.
To work out your 'costs of sales' you need to add together all of the costs that are incurred to make your product. For t-shirts, this would be materials and printing costs. For sandwiches, this would be bread, butter, cheese and pickle, for example.
It is best to carry out substantial research into the cost of sales before you make your predictions. It is wise to ask questions of experienced professionals in your industry.
When you have estimated your cost-of-sales, subtract this number from your Sales. The resulting number is your Gross Profit!
Gross Profit is, as you will have worked out, the money you have made before you subtract your overheads and interest! Your gross profit is useful to know as it gives you the value of your product.
Furthermore, If you express your gross profit as a percentage of sales, this enables you to quickly recognise a downturn (or upturn!) in sales. Viewing your Gross Profit as a percentage of Sales is know as your 'Gross Profit Margin'. The percentage demystifies number, you could have made £300, £300, £600 and £2000 in Months 1, 2, 3 and 4; however if the GPM trend is: Month One: 50%, M2: 50%, M3: 50%, M4: 12% - it becomes apparent that there is an aberration that you need to analyse!
Overheads is a term that we’re all familiar with. The term 'Overheads' refers to all of the 'indirect costs' that your business incurs - any cost that isn’t included as a 'cost of sale'.
Including within Overheads are things like: Labour (or, your current salary), marketing, accommodation and office space. Furthermore, If you have purchased a computer, or a similar piece of expensive technology, for your business, you also need to include a column similar to 'Computer Depreciation'.
Johnny explained that you include a depreciation column for several reasons: your Profit and Loss spreadsheet is a tool that calculates the value of your business at a given time. ^ months from M1, your new Mac isn’t going to be worth what it once was. If it depreciates at a rate of £10 a month, this is what you need to include, as an overhead, in your 'Computer Depreciation' column.
Depreciation is also a method that spread the cost on a single purchase over a longer time. A £360 purchase could be recorded as 36 £10 installments in a depreciation column, rather than one hit.
When you subtract your Overheads from your Gross Profit you are left with your EBIT, or Operating Profit.
EBIT, Interest and Profit Before Tax
After subtracting your Interest from your EBIT, you are left with your profit before tax. The profit before tax is the last sector of your Profit and Loss forecast! I hope the figure that falls out of the bottom is far larger than you first estimated.
Thank you to Johnny for sharing his wisdom, and thank you to the BIPC for being so welcoming.