Accounting Statements and Basics for Startups
Unfortunately for founders, there’s nothing memorable about Accounting for your business - unless your business is Accounting. However, the magnitude of the rewards for building a successful organization - namely an exit - are largely a byproduct of your company’s Accounting Statements, making Accounting impossible to ignore.
A few of the major reasons to master your Accounting early are:
- Understanding the financial statements positions business owners to calculate, confidently talk through, and align on the metrics that matter to investors (Gross Margin, CAC, and Burn to name a few).
- Mastering cash flow allows founders to know what levers they can pull in order to scale the business up or down.
- Understanding your major expenditures allows you to benchmark yourself against peer organizations. This can help you ask tough questions about your business (should we be spending more on Marketing or less on back office functions?).
These are just snippets of why you need to know the three statements and the role they play in the mosaic of a business’s financials. What are the three statements?
The Income Statement shows the revenues and expenses of an organization over a given period of time. The final line item is net income, which after subtracting dividends passes through to the…
Balance Sheet, which shows the financial position of the business at any given point in time. That snapshot breaks down the assets (value generators), liabilities (future obligations) and owners equity. Perhaps you’ve heard the most common equation in accounting? Assets = Liabilities + Equity. Close examination of the balance sheet helps illustrate how well positioned the company is to invest for the future.
The last is the Statement of Cash Flows. This categorizes all of the cash inflows and outflows of an organization by either operating, investing, or financing. ****People often look at the income statement for an organization's results but the cash flow statement can provide a useful contrast to the income statement if an organization consistently posts a positive net income but negative cash balance.
So now you know what the statements are, let’s talk next about how they connect. We begin with the income statement: where revenue minus expenses equals net income. But what happens with that net income? It gets passed through to the balance sheet by way of a line item in the equity section called retained earnings. The exact mechanism for getting there is net income minus dividends paid to shareholders equals retained earnings, which is then added (or subtracted) to the retained earnings from the prior snapshot. It’s important to note that retained earnings can be negative.
This might seem like a lot, but luckily there’s no need for you to reinvent the wheel. There are tons of good resources available for founders if they need a place to start. The SaaS CFO has excellent templates that can help you create your first financial model. If I was asked to present a financial plan for the first time, the SaaS CFO is the first place I would go.
You might be asking, ‘do I really need to do this or can I outsource?’ Great question! Whether or not to outsource is a decision that should be made taking into consideration the needs of the business at that point in time. If there’s someone on the team competent in bookkeeping, then maybe all you need to speed up the process is software. If no one on the team has any familiarity with Accounting and you’re already pretty small (3 to 5 people), the cost of an outsourced bookkeeper may be well worth it during tax season or a raising process.
Now we’ve gotten the technical stuff out of the way, so what are some simple things that you can do to position your company for future growth.
Categorize your expenses early: Be honest, do you really know how you’re spending your money? Do you know how much you spend monthly on office supplies, headcount, travel, subscriptions, or hosting? If you’re not coding your expenses properly, it’s easy to lose track of exactly where your boat might have leaks.
Don’t try and reinvent the wheel: This might seem obvious, but if you think you have a unique or innovative way to manage your costs that your peers aren’t using, there’s probably a reason they aren’t. Benchmarking is important because it provides a framework for you to plan your business around in areas that are not your core competency. This can be incredibly valuable when thinking about something like Sales spend, if you know the average SaaS organization spends roughly 10% of revenue on sales, try planning around that benchmark. Deviations from what other successful organizations are doing might be a red flag that something is amiss in your business.
Work Backwards from $0: When you tell someone, ‘I have 15 months of runway left,’ how do you know? A useful exercise is to work backwards from month 15 and ask what that month’s expenses were. This is especially useful when you’re planning to increase headcount. Unforeseen expenses arise, but you should be able to draw a straight line from your runway ending to today. If you have an idea of where every dollar is going between now and then, you’re close to mastering cash flow. ******
That last point is paramount, and to understand how to work backwards requires being able to calculate your burn rate. Fortunately, this is pretty simple! The formula for doing so is:
Burn Rate = (Starting Cash Balance - Ending Cash Balance) / # Months in the period.
It’s a good idea to choose a time period that will allow you to average your costs (3 or 6 months for example). Once you’ve calculated your burn, you’ll know how much money is leaving your business monthly. Divide your total cash balance by that amount, and you’ll know how many months of runway you have left.
It’s important to close with this thought, do accounting the right way as early as possible. It will be easier to grow your organization by orders of magnitude (and less expensive) if you do. The start-up graveyard is filled with promising companies that didn’t have a handle on their cash expenditures and burned out. Don’t be one of those companies; be scrappy, not sloppy.
Here are some helpful resources for familiarizing yourself with Finance & Accounting
www.Khanacademy.com (finance & capital markets section)