Chapter 4. Using monthly financial data to make decisions

Financial statements mainly refer to a Profit and Loss statement and Balance sheet, and are one of the most reliable data sources founders can use to make decisions. Here’s how to read those financial statements, utilize the information and help you make better decisions.

What’s a financial statement?

Financials (shorter and easier to say) include profit and loss statements, balance sheets, statement of cash flows, forecasts, and budgets. Let’s talk about how to read and use financials.

How to Read a Profit and Loss Statement

What’s a Profit and Loss Statement?

These show a company’s revenue and expenses during a given period. They’re also known as Income Statements, but most people call them P&Ls.

P&Ls are used for:

1) Investor’s financial package: View a company’s performance.

2) Business decisions: Shows managers where money is spent (expenses) relative to the revenues.

3) Bank loans: Lets lenders see a company’s performance.

4) Tax returns: an important starting point for filing tax returns.

Consider the time frame of each P&L. You can see a snapshot of your finances by looking at the year, month or week. We will use monthly P&Ls as an illustration, for example, the month of January, from Jan 1st 2020 to Jan 31st, 2020.

P&Ls are composed mainly by two parts:

1. Revenue/sales

Revenue/sales is the first section on a P&L. It shows the total sales your company has made in the month of January. If you sell your services/products on a platform like Amazon, make sure the sales number there matches with QuickBooks. If not, you’ll need to find where the difference comes from and fix it. Any discrepancies between sales platforms and accounting platforms might lead to the risk of being audited.

Cost of Goods Sold (COGS): are the expenses related to your sales typically seen in retail businesses. The more you sell, the higher your COGS are. COGS can be found right under Revenue/Sales. It’ll show how much you spent on getting the products/services you sell.

2. Expenses

All the costs related to running the business are called operating expenses (SG&A expenses short for Selling, General and Administrative expenses). They are different from COGS, as these expenses relate to your business operation. An easy way to think about it is if you’re not selling products/services today, you still need to pay operating expenses.

The main expense categories are:

- Employee salaries and wages and other payroll costs

- Marketing and sales costs (e.g. marketing, advertising, etc.)

- Office rent, supplies, utilities and software

- Fixed asset depreciation expenses

3. Net income

Net income = sales – expenses.

Net income is what your company actually earned and can be distributed to shareholders. Basically, it’s the number you also pay taxes on.

Ways to understand your P&L

How often should you read P&L?

Keeping track of your revenues (money coming in) and expenses (money going out), is critical for any household and applies to any startup too. If you can’t read your financials daily, try to read it at least once a week. Monitoring your sales and expenses frequently helps you adjust your strategy accordingly. P&Ls can be used to compare how well you’re performing in relation to expectations (like a budget).

How important is cash flow to a startup?

The short answer is, incredibly important. Dozens of research articles and publications report that “lack of cash flow” is one of the top reasons startups fail. Cash (or access to cash) is like oxygen for a business. When startups run out of cash, bankruptcy is inevitable. So knowing how much cash is coming in vs. going out is one thing startups should always know. Cash flow is not the same as profit because customers may take time to pay you and if your bills can’t be deferred, you’ll run out of cash at some point. The speed at which a startup spends cash is called burn rate. Investors consider this heavily if they’re considering lending money.

Can you determine the burn rate from a P&L?

Yes! The expenses show roughly what your burn rate is. If your profit and loss statements reflect your monthly costs, then that’s what you’re spending per month. However, if your statements aren’t accurate, you’ll need to do some cleaning before using those reports to calculate your burn rate.

How do you use P&Ls to control cost (or stick to your budget)?

It helps to put people in charge of different areas of your business. Let’s say you’re figuring out budgeting for the coming year. You can delegate tasks and put different disciplines in charge of managing budgets for those areas. Your HR Manager or Chief Financial Officer would be in charge of hiring budgets. Your Chief Marketing Officer would manage expenses for marketing and sales, etc. That frees you up to focus on other aspects of the business.

All parts of your P&L should have a person or department responsible for it. The person who is responsible for those areas needs to stick to the budget, monitor spending and ensure the company is not overspending (e.g. using too much money on unnecessary activities).

How to increase net income?

Everyone wants their company to have the highest possible net income. The higher it is, the more you can potentially get to take to the bank.

There are two ways to increase your net income: sell more or lower expenses. But the best way is a combination of both. However, as we all know, that’s easier said than done. It takes a tremendous amount of effort to increase sales and cut costs. Companies that focus on keeping costs low and amplifying benefits to their customers usually have a better chance of getting there.

How to Read a Balance Sheet

While P&Ls show your revenue and expenses, Balance Sheets indicate the true financial health of a company.

What’s a Balance Sheet?

This provides insights on what your business owns (assets) and owes (liabilities and equities), at a specific point in time. It is a snapshot of your company’s financial condition. Compared to an P&L, the Balance Sheet shows your financial condition at one moment, where an P&L shows what happened over a period of time.

What are the different parts of a Balance Sheet?

Assets = Liabilities + Shareholder’s Equity.

Keep this equation in mind when you’re going through your balance sheet. It’ll come handy when you’re figuring out how to balance your debits and credits. A Balance Sheet always balances out. The only times it won’t is if your accounting software has a problem or there’s a mistake. If your total assets don’t equal your total liabilities and shareholder’s equity, it must be fixed ASAP.

Now, let’s focus on how you can use a Balance Sheet to make smarter business decisions for your startup.

What do you use a Balance Sheet for?

Getting investors

Investors ask for balance sheets before making investment decisions. From it, savvy investors can spot key things about a startup that would otherwise be hidden. For example, they can tell if your company has the ability to pay operating expenses, meet future debt obligations, and make distributions to shareholders. They can also tell how frugal a founder is by how fast they spend and what they spend on. Investors like to see low levels of short-term and/or long-term debt. They also like to see assets that have strong values. For example, assets such as bonds are more valuable than invoices because payments from a government agency (bonds) are more likely to be paid than those from a small business (invoices).

Spotting potential cash problems

Cash flow is oxygen to every business. Without it, your business can’t breathe. That’s why keeping tabs on your cash reserves is a matter of life and death for your startup. A good founder always makes sure there’s enough cash on hand to cover costs while carrying out company initiatives. Cash in the bank, money owed from customers (accounts receivable), short- term and long-term investments are accessible sources of cash. Not having enough cash will keep you from being able to spearhead new initiatives or lead you to bankruptcy. One of the easy ways to spot potential problems is to closely monitor cash reserves and speed of payments to make sure there’s enough cash on hand.

Tightening up your operations

A Balance Sheet shows current and long-term assets and liabilities. You can use the info on each chart of accounts to uncover operational issues. For example, if you have large clients (accounts receivables), you may experience challenges with getting paid and you’ll want to start collecting your outstanding invoices soon so that you have more cash on hand. If your inventory doesn’t match your purchasing record, you will need to find what the problem is and then fix it. Here’s some specific tips.

How to clean up your balance sheet:

Total Cash Amount

Your total cash amount is listed on the top of your balance sheet. It’s the first thing people will notice. Make a great first impression by keeping a healthy cash reserved. It’ll impress potential investors and bank officers which could give you a significant advantage in the startup game.

Accounts Receivable (A/R)

This indicates how much money your customers owe you. This could get tricky so it’s critical to manage your A/R carefully. Giving customers a long time to pay might sound appealing to them, but it puts pressure on you to have enough cash for other expenses. In some cases, it can stimulate sales but that all depends on timing and, again, how much cash you have on hand to cover other expenses.

The period of time you allow customers to pay you is called a Credit Policy. Balancing what customers want (more time to pay) and what you want (payment now) can be challenging.

When deciding on your Credit Policy, consider your cash needs now, total expense costs and when you need to pay them, industry norms (e.g. Net 15, 30, 45 or due today), and customer expectations. That might sound like a lot, but you can start by reviewing unpaid invoices and creating email/text templates for reminders (sent weekly). The sooner you collect payment, the better. Long outstanding or unpaid invoices eventually become uncollectible, which results in bad debt. No one wants that.

Inventory

If you sell physical products, inventory could become one of your biggest headaches. Having too much or too little can cause problems.

Having too much, you’ll run the risk of tying up cash which leads to cash flow challenges. inventory can also get stolen, expire, lost or become obsolete. There are many risks to having too much inventory.

Having too little runs the risk of not being able to make sales or meet customer demand. Finding an optimal level of inventory means balancing the cost of ordering, shipping costs, storage/insurance costs with your physical space.

Remember, there are different ways to record your inventory value: FIFO, LIFO and Average Cost. You also want to link inventory cost to Cost of Goods Sold (COGS) on your P&L for an accurate inventory count. It’s not easy so it’s important to consult with your CFO or CPA to capture inventory accurately right from the start.

Depreciation for fixed assets

Do you own fixed assets? Have you been recording the monthly depreciation expenses? Make sure to record monthly depreciation expenses and remove assets that have been fully depreciated. Most assets depreciate on a straight line (same amount every month), some depreciate on an accelerated basis (amount increases every month), or units. GAAP has clear guidelines on the type of depreciation method to use.

Investors’ equity

This represents how much money your company has currently borrowed from investors. Try not to make any mistakes on recording investors’ equity on your balance sheet against the cap table. Investors won’t be very happy.

Retained earnings

Retained earnings show how much money your company has made over time, but this is NOT cash. If your startup is running losses, this number will be negative. Your goal is to grow the retained earnings number overtime, from negative, to breakeven, to eventually positive. The sky’s the limit!

A CPA’s 2 cents

A balance sheet is a snapshot of your startup’s financial health. It tells a story of what your company owns and owes. Your balance sheet can really come in handy if you use it wisely. It’s a useful tool for tightening up your operations, preventing mistakes, and helping take your startup to the next level.

How to read a Statement of Cash Flows

As they say, “cash is king”. This saying rings truer the deeper you get into the ever-changing startup world. We mentioned cash flow as oxygen, but the infusion of cash itself, is jet fuel for your startup. You can’t go anywhere without it.

A Statement of Cash Flows is used to manage cash for your startup. At first, all startups have losses on their P&Ls (negative profits). The idea is that as time goes on, greater sales and expense efficiency will turn losses into profits. But it’s critical to have access to cash. You can do this by increasing sales but for startups this usually comes from investors. It helps keep your startup running until you can start scaling growth. So in short, a startup can be unprofitable for a long time (as long as it has access to funds) but if you run out of cash, you run out of oxygen. In other words, it’s over.

What is a Statement of Cash Flows?

A Statement of Cash Flows shows how much money is coming in and going out of a startup during a statement period. There are three parts to a Statement of Cash Flows:

1. Cash flow from operating activities

2. Cash flow from investing activities

3. Cash flow from financing activities

Here are some examples:

Cash Flow from Operating Activities: the net financial change from everyday business activities such as invoice payments, bill payments, employee payroll, etc.

Cash Flow from Investing Activities: the net financial change from investing activities include purchases or sales of fixed assets, merger and acquisitions, market securities, etc.

Cash Flow from Financing Activities: financing activities related to borrowing from a bank, issuing bonds or new stock, paying off loans, distributing dividends, etc.

Why managing cash flow matters

Running out of cash is a common reason why startups fail. Even if you have plenty of sales, if you don’t have enough cash in the bank, your startup won’t be able to stay afloat. That is where cash flow management comes into play.

The Statement of Cash Flows can help you plan for the best time to make a big purchase, like a new piece of equipment or a company vehicle. Monitor cash flow closely and frequently so you can spot trends and catch activities that could lead to a cash shortage.

If you’re thinking about getting a loan or investment, it’s a lot easier to get help from a bank or investor before a cash crisis than after one. If you wait until you’re in trouble, lenders may see you as too risky. Apply for loans or a line of credit while your cash flow looks good. It’ll increase your chances of getting approved

No matter what stage your startup is in, a Statement of Cash Flows can help you see things ahead and stop a cash crisis from happening.

Using Statement of Cash Flows to get ahead

Your P&L may show net income, yet you may not have cash in the bank. Why is that? There could be many reasons but the two most common are because of long standing accounts receivable (A/R) and inventory cycles. Here I will teach you how to utilize Statement of Cash Flows to manage your operation so that you won’t run into any major cash problems.

Get paid upfront

There’s nothing wrong with asking for payment right off the bat. By asking, you can gage how willing the client is to pay. This will help you proactively manage cash flow and make sure your startup has enough cash to thrive and survive. Let your clients know your company asks clients to pay upfront but be ready to negotiate the terms if it helps close the sale.

Manage clients (accounts receivables)

If you must wait to get paid, just make sure you’re managing that relationship. A/R is the money you earned but haven’t received so it’s not yours—yet. Make sure the money is in your bank account before closing the loop.

Manage inventory

Inventory is another thing that can tie your cash up. It may be a long cycle (time) from buying raw material, assembling them into finished products, marketing them, selling them, and collecting payment. You need to know how much time it takes from the beginning of the inventory cycle to the end. Consider mapping out the cash flow cycle for inventory so you can plan ahead on when and how much to spend at each stage.

Manage seasonality

Seasons and holidays impact sales, fluctuating sales means you’ll need more inventory to cover the ups and downs. Trying to keep up with the appropriate number of employees can be tough. There are many hidden costs for hiring, firing and layoffs. Bear in mind every dollar in inventory is a dollar less in the bank. You can use industry and company historical data to include seasonality into your inventory forecast and budget, in addition to managing cash flow.

Create a buffer and plan for the unexpected

Manage the risk before it becomes a threat. When you’re forecasting and budgeting, it’s good to have extra cash as a buffer. You don’t want to be in a position where you’ve allocated every single penny because a small, avoidable problem could balloon into something irreversible.

Startup founders can’t predict the future, in fact, no one can. If a piece of expensive lab equipment breaks and needs to be replaced right away, or a data breach results in a forced increase in IT spending, it takes money, and more than you might expect. Part of the analysis behind a Statement of Cash Flows is considering the impact of any potential risk, and the effect an unexpected expense will have on your available cash—and ultimately, your ability to pay your bills.

A CPA’s 2 cents

With a Statement of Cash Flows, founders can figure out whether enough cash is being generated, and whether pending payments and inventory are getting too high. It’ll help you see how much cash is getting absorbed and how much is too when your business is still growing. Cash flow management makes it easier to make decisions and get access to capital investment on property and equipment. It also helps businesses plan how much cash it needs to rise from debt and raise equity finance

Burn Rate and Runway – How Long You Can Survive Without Additional Funding

One of the key things to watch, for a successful startup, is cash! Two measurements related to cash are the runway and the burn rate.

So how do you get to your company’s burn rate and runway? After successfully raising initial funds, you now have cash sitting in the bank. With cash on hand, the next step is for founders to find their burn rate and runway.

Burn rate – How much you spent monthly

To keep it simple, a burn rate is how much your startup spends per month. Your burn rate lets you know how much you need to have in the bank to keep your company running. Your burn rate reflects how long you can operate before you run out of cash and how much needs to be invested or reached with sales.

How to calculate burn rate?

Burn rate = cash ending balance - cash opening balance of the same month

For example, say that your company has only one bank account, and on Jan 31st you end with $0.9M, and on Jan 1st you started with $1M. This makes your burn rate for the month $0.1M.

A CPA’s 2 Cents

Try using multiple months of financial data to calculate your burn rate. This will help you get an overall average. The average burn rate is a more accurate indicator of your monthly spending and incorporates fluctuations from month to month. The more data you’re able to collect per month, the more accurate your burn rate will be.

Runway – How long you can last without additional funding

Runway is the number of months your startup can survive without any additional funding.

How to calculate runway

Runway = Total cash in the bank ÷ Average burn rate

Let’s stick with the example above: Your average burn rate is $0.1M and the total cash in the bank this month is $0.9M. Your runway is $0.9M ÷ $0.1M which is equal to 9 months. You have 9 months to either raise the next round of funding, start generating enough revenue to cover your monthly spending, or worst-case scenario, you run out of cash, which is bankruptcy.

Knowing the number of months your startup can sustain without any additional funding pushes you to watch your spending and feel a sense of urgency as time passes. Founders need to create budgets that allocate spending on the areas that can yield profits, and cut spending from areas that are not profitable.

How often do you need to calculate these two rates?

Most startups do it on a monthly basis, right after they close last month’s accounting books.

A CPA’s 2 Cents

Burn rate and runway are the two numbers that investors ask for the most. Why? Being able to use burn rate and runway effectively is a staple skill of any great founder. Again, the focus on cash flow is crucial, and founders need to plan ahead to stay ahead.

Use KPIs to keep your business performance on track

Investors believe successful startups obsessively focus on their KPIs and on improving them.

KPIs – Measurement of performance

Key Performance Indicators (KPIs) are the data points that objectively measure your startup’s performance. You can only improve something if you’re able to measure it accurately. With data over time, you can see trends on how data changes and get an understanding of your company’s overall performance.

Why do KPIs matter?

Two reasons to be exact:

To keep all the employees on the same page about how to improve. It pin points specific metrics all employees can reference and track towards. Goals need to be specific, clear, and concise so nothing gets lost in translation.
Measurable data is the only way a startup knows if it’s improving. Financial statements are one way, KPIs are another. Financial statements give you an overall picture of your company’s performance. However, if you want to dig deeper and are a data-driven business, KPIs are the way to go. They translate a large amount of financial data into simple, concise “Key” indicators, and track it over time to evaluate your performance.

The most important KPIs to track

Depending on the industry, there are different sets of KPIs you should be tracking. Here are some you can count on no matter your industry:

· Burn rate: how much your startup spends each month.

· Runway: how many months your startup can last without additional funding.

· Customer acquisition cost: how much you spend to acquire a new customer.

· Conversion rate: indicates company’s ability to convert non-paying customers to paying customers.

· Customer retention rate: percentage of customers you keep from one month to the next month.

· Churn rate: percentage of the customers you lose during a given period of time. Churn rate is the opposite of customer retention rate.

· Lifetime value (LTV): the net value of an average customer over their lifetime with your product/service.

· Monthly active users (MAU): the number of active users during a 30-day period. This indicator is used frequently for apps, online games, or social networking sites.

A CPA’s 2 Cents

KPIs help you track company performance and keep employees on the same page. Communicating your KPIs improves the overall startup’s performance.

Next Section:
5. Forecasts and Budgets