The basic financial statements
There are three basic financial statements: the BalanceSheet, Income Statement (often referred to as Profit & Loss or P&L) and the Cash Flow Statement. If you are putting together a financial statement model for your business, this is the output referred to as the “three statement model.”
Balance sheet
The balance sheet presents the assets and liabilities of its business as of a specific date. Think of this as a “snapshot” of the resources and commitments of the business. The basis accounting equation for the balance sheet is:
Asset = Liabilities + Shareholder’s Equity
This equation highlights the meaning of the term “balance”in the financial statement name. Another way to think of this equation is Debits = Credits.Assets (cash, inventory, receivables, machinery and equipment, prepaids, etc.) have a debit balance. Consequently, liabilities (payables, accrued expenses such as payroll and credit card balances, loans and other debt) and equity(stock, owner contributions, retained earnings) have credit balances.
The balance sheet also addresses timing, as it organises the company’s assets and liabilities into current (those expected to be converted into cash or paid within a year) and long-term (those that will be used or not come due for over a year).
Important Balance Sheet Ratios
With this framing of the balance sheet in mind, you can quickly derive important insights into the health of your business using a few key ratios:
Current ratio: Current Assets / Current Liabilities
The current ratio is the best determinant of a company’s financial stability as it measures the ability to meet short-term obligations.
For most CPG startups, the current assets of the business are going to be cash, inventory, and possibly receivables (depending on your client base and invoicing terms). Your liabilities will likely consist of payables to vendors, outstanding credit card balances and payroll. If you have debt, then only the short-term portion will be included in current liabilities.Working capital loans, revenue sharing notes and other debt instruments thus often qualify as these have monthly repayment obligations.
If your current ratio is greater than 1, then the business has the necessary assets to meet these short-term liabilities. If the ratio is less than one, then this is an indication that the company is going to need a cash infusion. This could mean a contribution from the owner, outside investment, taking on new debt or possibly re-negotiating terms with vendors. If your current ratio is very large, then that could also be an indicator that you are not using your assets efficiently, such as holding too much inventory[PD1] .
Note the importance here of timing, this is focused on the near term, what is needed to “keep the lights on” and does not necessarily address the long-term implications of debt or consider other capital expenditure needs for new machinery or equipment. To gain insight here you can utilize the Debt-to-Equity Ratio or the Debt-to-Asset ratio:
Debt to Equity Ratio = Total Debt/ Total Shareholders’Equity
Debt to Asset = Total Debt/ Total Assets
Both ratios tell a story about the business’ leverage.Higher values indicate more risk as the company is relying on debt to fund itsoperations and may already be stretched thin when it comes to the ability torepay this debt as it comes due. Investors will consider these ratios whendeciding the riskiness of future capital contributions.
Income Statement
The income statement details the revenues and costs of a business over a specified period of time: monthly, quarterly, annually. The income statement starts with revenue and from there breaks out costs between direct and indirect. Direct costs are those that are directly related to your product offering (commonly referred to as Cost of Goods Sold). Indirect costs are those administrative and selling costs that are necessary for running the business (commonly referred to as overhead). After revenue and all costs are accounted for you are left with Net Income (or the bottom line).
With this basic framing, you can begin to identify opportunities for your business. Starting with your gross margin (often just margin):
Gross Margin = Revenue – Cost of Goods Sold
Investors love to see a healthy margin, it is the driver of long-term success. As customer and sales volumes increase, the bottom line improves as the company’s margin overcomes the early struggles of large overhead. This is an essential part of scaling the business and the success of that scaling can be derived from some important profitability and efficiency ratios that rely on information from both the balance sheet and the income statement.
Asset Turnover Ratio = Net Sales (revenue)/ Average TotalAssets
The asset turnover ratio is a measure of efficiency by calculating how well a company uses its assets to generate sales.
This ratio is a great example of the relationship between income statement and balance sheet data. Net sales are the company’s revenue after discounts and other adjustments. Average total assets refer to the balance sheet information over the same specified time period. For example, if you are looking at your annual asset turnover ratio you would take Net Sales for the year and calculate Average Total Assets by adding your total assets on day 1 of the year to your total assets on the final day of the year and dividing by 2.
Explained simply, a ratio of 1 means that the company is generating $1 of sales for every dollar invested in assets. This can be benchmarked against other similar companies as well as monitored over time to provide management with important indications of areas that require attention and possible improvement in efficiency.Turnover ratios can be focused on more specific areas such as inventory efficiency.
For more detail, refer to “Understanding the flow of your product from Inventory to Cost of Goods Sold (COGS)”.[PD2]
Statement of Cash Flows
The cash flow statement details how the company used cash over a period of time, by breaking down the in-flows and out-flows into three major categories: operating, investing, and financing.
Operating activities include the day-to-day standard payments and receipts made to and from vendors, customers, and employees. Think of these, generally, as the movement over time in your current assets and liabilities. Investing activities are typically cash outflows related to the purchase of equipment or intangible assets such as patents or trademarks. Financing activities detail cash inflows received from investors or new debt, such as from the issuance of stock or cash received from a loan, as well as the related outflows of cash paid for debt service or dividends paid to investors.
The cash flow statement will also detail important non-cash activities that may be relevant during the period, such as depreciation and amortisation, or stock-based compensation. The cash flow statement can thus be thought of asa summarised reconciliation of the company’s cash as shown on the balance sheet to other financial items from the balance sheet as well as income statement activity.
Key Takeaways
Financial statements are a vital source of information for startups as they tell a story about the business, highlighting strengths, flashing warning signals and revealing opportunities for improvement. The good news is that you don’t need a technical background in finance or an MBA to be able to read these statements and interpret them.
Financial statements are only as good as the data that goes into them and thus it is vital to design a team and partner with advisors that produce both accurate and timely reports for your business. MyPocketCFO takes care of this prerequisite by providing a technology-driven approach that improves accuracy, speeds up monthly close and gives you access to reports that you can confidently rely on.
