So You’re a Startup: How to Deal With Financial Statements
If you’ve been following the So You’re A Startup series, thanks for sticking with us! If you’re new, welcome! This is the series where we address pressing startup issues every week – we’ve covered pitching, interviewing for accelerators, networking, raising funds, and writing a one pager so far. For SYAS number 6, we’ve decided to tackle financial statements.
So you’re a startup, why should you care about financial statements?
If you have shareholders, they need to know how you’re doing and financial statements are the cleanest way to show your progress.
If you’re looking for investors, they’ll want to look at your financial statements to assess the viability of investing in your company.
Why do you need to understand your financial statements?
It’s easy to just hire an accountant and hope for the best. But it’s in your best interest to understand what you’re telling shareholders and potential investors with your financial statements. You want to make sure that they aptly represent your company.
Let’s start with the balance sheet.
The balance sheet shows your company’s financial condition at a point in time. It’s a snapshot of where you are right now. This statement isn’t the most exciting to investors because it doesn’t show revenue, but it’s still necessary.
The essential equation for the balance sheet is Assets = Liabilities + Stockholders’ Equity. If you’ve taken any accounting courses, this equation has been drilled into your head already. If you haven’t, start thinking about it.
The balance sheet shows what a company owns (assets) and what a company owes (liabilities). The difference between those two is shareholder’s equity (how much the company is financed by shares).
Assets
Current assets are assets that can be converted into cash within a year (cash, inventories, accounts receivables).
Cash: Investors definitely want to see how much cash you have. More cash = more cushion, more opportunities for growth and a better chance of getting out of a crisis.
(Worried you don’t have enough cash? Here’s some advice on raising funds)
Inventory: Investors will also be curious about how much money you have tied up in inventory – but if you’re a startup in the tech space (selling apps or access to an online platform), you probably won’t have or need that much inventory (this is good). Lots of inventory often makes it look like you aren’t moving product fast enough.
Accounts receivable: This tells you how much money you’re owed (money that hasn’t been collected yet). Your accounts receivable turnover ratio (Net Credit Sales/Average Accounts Receivable) will tell your investors how good you are at collecting payments (how quickly you turn the receivables into actual cash, aka the liquidity of your accounts receivable). The better you are at this, the better you are at generating cash flow, which is something that investors want to see.
Fixed assets (aka non-current assets) include things like property, land, and equipment. They’re things that probably won’t get converted into cash any time soon so investors tend to overlook them.
Liabilities
Current liabilities need to be paid within the year, fixed liabilities within a year or more (ie. bank debt). It’s ideal if your company has less assets than debt – you might have trouble finding investment if not.
If your quick ratio, (Current Assets – Inventories)/Liabilities, is higher than 1, congrats! You’re showing investors that you have enough capital to pay off your short term debt.
Stockholders’ Equity
Capital stock is the money stockholder’s first paid for their shares when they were offered to the public (how much money you got when you first sold shares).
Retained earnings are an accumulation of net income year over year.
What investors will want to know more about is your debt to equity ratio (Total liabilities/Shareholders Equity). This ratio shows what proportion of equity and debt your company is using to finance your assets. The higher the ratio, the more financing you’re doing with debt. These financing decisions are part of your company’s strategy that investors will want to know more about.
Cash flow statements are produced quarterly and they show the flow of cash – how much money goes in and out of your company. Actual cash exchanges are recorded on this statement (cash accounting) and it shows your company’s true cash profit rather than the transactions it has made (transactions are shown on the income statement).
The cash flow statement is an extension of the cash portion of the balance sheet; it explains the changes in your cash balance throughout the year. Investors want to look at your cash flow statement because they want to know what you’re actually doing with your money.
Operating activities: This shows investors how you get your cash – how much money you’re making from selling your product. Investors want to see that your product is actually making money, so it’s great if your net cash flow from operating activities is positive.
Financing activities: This also shows investors how you get your cash, money raised from selling stocks or getting loans.
Investing activities: This is how you spend your cash – on equipment and other things you need to run your company.
It’s great if your income statement shows you have revenue but investors want to see that you have that cash cushion just in case. They like to see that you have lots of free cash flow, which is
Net Income + Amortization/Depreciation – Changes in Working Capital – Capital Expenditures
Free cash flow shows that you can pay what you owe (debt, dividends), buy back stock if necessary, and just generally grow your business. It’s the excess cash you have just in case, which shows that you can pay for your own operations. It makes it seem like you know what you’re doing.
The income statement uses accrual accounting, which means that you record revenue and expenses when transactions occur (vs. when cash is actually exchanged). This statement basically shows investors whether or not you’re making money which will weigh a lot on their decision to invest in your company.
The income statement shows revenue (the money you’ve generated), expenses (the money you’ve spent), and your net income (profit), which is the revenue you’ve made minus your expenses. It’s pretty straightforward – investors want to see that what your selling is making money (positive revenue), that you’re not spending too much (expenses), and that overall your company is profitable and viable to invest in (net income).
There you have it, a summary of your basic financial statements.
One more thing –
When you’re just starting up, there might be some temptation to manipulate your financial statements in order to make your company look like it’s doing better than it actually is – after all, nobody knows you yet. It’s pretty easy to do and hard to resist – it seems like if you add a couple of extra zeros, Investor X will suddenly give you the break you need. But we’ve all heard about Enron – do you really want a documentary made about your company’s collapse? This is fraud and if you do this, someone will find out and you will go to jail.
Financial statements may not be the most fun thing to put together when you’re first starting up – who wants to report that they’re not making any money? But we all know that keeping your finances in order will contribute to your eventual success and save future successful you from a lot of headaches.
Tune in next week to learn about creating and keeping up with your advisory board!