It’s fantastic to change the world with a startup and the experience can be intoxicating, especially if there is growth.
But this creates the temptation to ignore details like startup finance, which can then lead to the startup graveyard. Before changing the world, first a company has to survive. And survival requires an understanding of basic startup finance.
Some people believe that this means using large and complicated spreadsheets and a team of financial experts. But these supposedly sophisticated approaches can result in more confusion than clarity.
Forget spreadsheets, think napkins. Better to focus on the basics, the ABCs of startup finance:
A is for Accruals
B is for Balance Sheet
C is for Cash Flow
A is for Accruals
If you are running a software as a service company with a customer who prepays a one year contract for US$1,200, that’s great for your cash flow. Your revenue, however, is US$100 for that first month because revenue can only be recognized in line with the business services provided.
This example highlights the essence of accruals, which match revenues with costs when calculating profits. This is the core idea underlying the income statement, otherwise known as the P&L (you can technically use a cash based P&L but very quickly you will run into the need to understand accrual based accounting, so better to start sooner rather than later).
Because accrual profits are not exactly cash, the P&L is like a movie based on a true story. The core message of the P&L is usually similar to the underlying reality of what happened, but typically the details are changed for the sake of maintaining the story. At the extreme, even the core message can be distorted to the point where the P&L does not represent reality in any way. It is possible to be a profitable company and still run out of cash.
B is for Balance Sheet
A startup with a cash position of US$50 million may appear healthy at first glance when looking at the balance sheet. If, however, that cash was generated solely from selling equity to investors, then the cash by itself does not actually give much context about the level of health.
Thus, although the most important number on a balance sheet for an early stage startup is the cash balance, it is only the starting point for thinking about the company’s financial position. Cash must be placed in context as part of the overall balance sheet and also cash flow changes over time.
If the P&L is like a movie based on a true story, then the balance sheet is like a photo. The star of this photo is the cash balance but the balance sheet also captures many other details, some more important than others, at a specific point in time. Moreover, to truly understand a business, these snapshots in time needed to be connected together.
C is for Cash Flow
Accounting can get very complicated but at the end of the day everything is related to cash flow. A fast growing company with US$1 billion in revenues may actually have negative cash flow because of high working capital needs.
There are different categories of cash flow, and it is important to not get confused by things which sound like cash flow but are not. EBITDA, EBITA and other acronyms are not cash flow, even though some people refer to them by that name. True cash flow includes all cash in and cash out, with no exceptions.
If the P&L is like a movie based on a true story and the balance sheet is like a photo, then the cash flow statement is like a documentary. It’s raw and messy, which means that sometimes it can be difficult to keep track of the key themes. At its core, however, the cash flow statement usually does the best job of capturing the reality of a company.
Connecting the ABCs
Accruals, balance sheet and cash flow are not independent of one another; they are fundamentally connected. Changes in the P&L are reflected in each balance sheet and the cash flow statement can be reconciled by comparing the P&L to changes in the balance sheet.
The typical approach to accounting is to start with the details and ignore the underlying structure, which results in an incomplete understanding. Instead, take a holistic approach, being with the key concepts, and then the details will naturally become easier to appreciate.
Start with the ABCs and then, once you understand them, you can move on to other metrics.