You’d be amazed how many entrepreneurs don’t fully comprehend their company’s finances. Yes, they are created using FreshBooks or Xero, and they will most likely focus on high-level figures such as total revenues and total profits. They do not, however, examine everything in between. And, more Financial often than not, the devil is in the details when it comes to handling your company’s finances. This post will teach you the fundamentals of preparing, interpreting, and reporting your finances so you can look like a pro to your investors or anybody else who may want them.
The Important Financial Statements
Typically, three financial statements are prepared: the income statement (also known as the profit and loss statement); (ii) the balance sheet; and (iii) the cash flow statement. The income statement tracks all of the company’s inbound and outbound revenues and expenses for the period you’re interested in. This is the most closely scrutinized of the financial statements, as many businesses want to increase their revenues and profits over time. A balance sheet describes a company’s assets, debts, and equity. As the name implies, asset values must be balanced with liability and equity values. The cash flow statement provides a true picture of how your cash position on the balance sheet is changing in response to any operational, financing, or investment activities that may not be evident from the profit levels given on the income statement. For example, the cash flow statement will account for non-monetary things such as depreciation and illustrate how cash was spent in ways other than paying expenses on the revenue statement.
These are the numbers I look at on the income statement:
The following metrics are used to evaluate a company’s performance:
revenue, gross profit margin, EBITDA, return on ad spend, ROAS, and return on staff expenditure (revenues divided by total payroll investment including salaries, bonuses, commissions, and benefits).
Others may exist depending on your industry or business strategy, but these are the most common.
Revenue optimization is simple: more is better than less!! More revenue is great. So, if your business is seasonal, you are continually seeking to better your revenue from the previous quarter.
Profit maximization refers to the goal of improving or at least maintaining your gross profit margin (gross profit divided by revenues) throughout your time in Financial. Alternatively, you want your cost of goods sold to be flat or improve. Increasing costs will reduce profitability. Looking for ways to reduce expenses, whether through new vendors or more efficient processes, will help. Depending on your business strategy, gross margins can range from 20% to 80%, with most being around 30%-40%.
Increasing revenues and gross profits enhance EBITDA, but so does keeping all other expenses as a percentage of revenues steady or improving. Focus on the major expenses to optimize. Typically, they are sales and marketing expenses and payroll costs. Those should be separated. Minor expenses can be combined under “other expenses,” but they should also be optimized. EBITDA growth and EBITDA margin (EBITDA divided by revenues) improvement are signs of success. Notably, some expenses (like your CEO’s compensation) are fixed and will not grow in proportion to sales. Other expenses, like shipping costs, are changeable recurrent expenses that will likely remain flat as a percentage of sales. Know the distinctions. According to your business strategy, you can expect EBITDA margins of 10-30% in the long run.
The most critical measure you manage is ROAS. Revenue growth requires increased sales and marketing investment. And you want to get new consumers as cheaply as possible. The higher the ROAD, the more effective your advertising investment. Notably, it is acceptable if your ROAS decreases over time as you scale, as your initial marketing spend is often more effective than your scaled strategies. But it must always result in a profitable marketing return
ROSS is another vital metric. It ensures that your human resource investment is efficient over time. Depending on your business strategy, ROSS can be 5x-10x.
Optimum Balance Sheet
On a balance sheet, I look at cash, total debt, current ratio, inventory turnover, and return on capital (net profits divided by total invested capital).
Cash optimization is simple: more cash is better than less! A year’s worth of business expenses should always be covered by cash reserves. Or reduce your costs and cash burn rate to lengthen your “lifeline”.
Given the risks and uncertainties of a startup environment, debt is usually a negative thing. Also, most small business debt comes with personal guarantees from the owners, meaning if the business can’t pay its debts, you can personally bankrupt yourself. If you must borrow, never exceed a debt-to-capital ratio of 50%. Also, look for asset-based lending providers that can secure your assets or inventories without personal guarantees.
You can use your current ratio to determine if you have enough cash on hand to meet working capital demands. Never let this ratio fall below 1:1, or there may be a requirement for short-term capital to fund liabilities.
The inventory turnover ratio measures how quickly a product moves through a warehouse. It is based on your average inventory levels throughout time, not necessarily a specific date. The faster you turn inventory, the less money you have to put in it. An average business turns inventory 3-4 times per year. With less than that, you may need to write off unsold inventory or adjust product and sourcing decisions to improve efficiency.
Your ROC shows your investors that they are getting a decent return on their investment. To attract and retain investors, I believe your ROC should be between 15% and 35%, depending on your company’s size and growth rate.
Optimizing Cash Flow
The cash flow statement is simply another way to track your cash inflows and outflows. That said, this statement aids your CFO in determining if cash was spent or generated by operations (e.g., capital expenditures for replacing equipment), investing (e.g., ownership holding in a supplier), or financing activities (e (e.g., closing a new equity investment into the company).
Every business should study its business at least periodically, in my opinion. Larger organizations tend to study their business weekly, if not daily. But not less than monthly. So, on the first day of every month, at the very least, review the previous month’s financial results.
I would publish outcomes for the current month and the year to date in your financial statements. As well as the initial budget and the previous year’s results (e.g., compared March 2022 to March 2021). It should provide dollar amounts, sales percentages, and percentage growth rates for each line item. These reports must include all of the data points and KPIs outlined in this post so you can watch their progress over time and determine if the business is performing better or worse than budget, and by how much.
It is now up to you or your CFO to analyze the data and metrics to develop a Management Discussion and Analysis paper that examines the important trends and why the statistics are moving in the direction they are, and whether they are better or worse than last year’s plan. Keep in mind that the “WHY” behind any changes in your outcomes or KPIs is critical to managing them effectively. So, create the monthly discipline of actually learning this.