You would be surprised how many entrepreneurs don't truly understand the financials of their business. Yes they are creating them out of Fresh Books or Xero, and they most likely focus on high level numbers like total revenues and total profits. But, they don't dissect everything in between. And, more often than not, when it comes to managing the finances of your business, the devil is in the details. This post will help you learn the basics of formatting, interpreting and reporting your financials, so you will look like a pro with your investors or whoever else may be asking for them.
The Key Financial Statements
There are typically three financials statements that are prepared: (i) the income statement (or often called the P&L statement); (ii) the balance sheet; and (iii) the cash flow statement. The income statement measures all inbound revenues and outbound expenses of the company, for whatever date range you are interested in studying. This is the most studied of the financial statements, as all companies are striving to grow their revenues and profits over time. The balance sheet lists all the assets, liabilities and equity in the company at any single point in time. As the name suggests, the asset values, must balance with the liability and equity values. The cash flow statement gives you a true sense to how your cash balance on the balance sheet are moving up and down with any operating, financing or investing activities that may not be entirely clear from the profit levels shown on the income statement. For example, the cash flow statement will adjust for non-cash items like depreciation and show how cash was used other than for paying expenses on the income statement.
Optimizing The Income Statement
To me, these are the key numbers to study on the income statement: (i) revenues; (ii) gross profit margin (revenues less cost of goods sold); (iii) EBITDA (gross profit less all expenses, resulting in earnings before interest taxes depreciation and amortization); (iv) return on ad spend or ROAS (revenues divided by sales and marketing costs); and (v) return on staff spend or ROSS (revenues divided by total payroll investment including salaries, bonuses, commissions and benefits). There may be others depending on your industry or business model, but these are a few of the bigger ones that apply to most all companies.
Optimizing for revenues is pretty simple to understand--more is better than less!! The bigger revenues grow, the better. So, you are always trying to improve your revenues from the preceding period, either the prior week or the same week of the prior year if there is any seasonality in your business.
Optimizing for gross profit means that you want your gross profit margin (gross profit divided by revenues) to be improving, or at least staying flat in every future period. Said another way, you want your cost of goods sold as a percentage of revenues to be staying flat or improving. Rising costs will obviously hurt your bottom line profits. And, looking for opportunities to lower your costs, either with new vendors or more efficient processes will help you here. Gross margins can vary wildly based on your business model, but often end up in the 20%-80% range, with most in the 30-40% range.
EBITDA is obviously benefitted by improvements in revenues and gross profits, but it is also benefitted by keeping all of your other expenses as a percentage of revenues flat or improving over time. In terms of which expenses you need to focus on optimizing--focus on the big ones. For most companies that is typically sales and marketing expenses and payroll expenses. Those should clearly be broken out as separate line items. The minor expenses can be bundled into "other expenses", but they too should be optimized where they can. You are doing well if EBITDA is growing in dollars, and the EBITDA margin (EBITDA divided by revenues) is improving over time. Worth noting, some expenses are fixed one-time expenses (e.g., your CEO's salary), so they will become less as a percentage of growing sales. And, other expenses are variable recurring expenses that scale as you grow (e.g., shipping costs), that will most likely stay flat as a percentage of sales. So, know the differences here. EBITDA margins typically end up in the 10-30% range, depending on your business model.
ROAS is probably the most important metric you are managing for. You can't grow revenues without growing your sales and marketing investment. And, you want to make sure you are acquiring new customers as cost effectively as possible. ROAS typically ends up in the 3x to 10x range, and the higher the number, the more effective your advertising investment is. Worth noting, it is okay if your ROAS slightly declines over time as you scale, as your initial marketing spend is typically more effectively invested than your tactics used at scale. But, it always has to end up in a profitable return on marketing investment.
ROSS is another important metric to measure. It helps to measure that your investment in human resources is maintaining or improving its efficiency over time. ROSS typically ends up in the 5x-10x range depending on your business model.
Optimizing The Balance Sheet
To me, the key numbers to study on the balance sheet are: (i) cash; (ii) debt ratio (total debt divided by total debt plus invested equity); (iii) current ratio (current assets divided by current liabilities); (iv) inventory turnover ratio (cost of goods sold, divided by average inventory); and (v) return on capital or ROC (net profits divided by total invested capital).
Optimizing for cash is pretty straight forward, more cash is better than less! You always want to have enough cash on hand to ensure you can at least manage your business needs for the coming 12 months or more. If not, it may be time to consider a financing or lower your expenses and cash burn rate to extend your "life line".
Debt is typically a bad thing for early stage businesses, given all the risks and uncertainties of a startup environment. And, most debt for small businesses comes with personal guarantees from the owners, which means if the business can't pay its debts, the individual owners are backstopping the liability, and you can personally bankrupt yourself with any business failings. But, if you are going to take on debt, never let your debt ratio exceed 50% of invested capital. And, seek-asset based funding sources that can secure your assets or inventories, without requiring any personal guarantees, where possible.
Your current ratio is basically measuring if your current assets exceed your current liabilities or not, and that there isn't any immediate cash squeeze needed to fund working capital needs. So never let this ratio go below a 1:1 ratio, or there may be some short term capital needed to fund immediate liabilities.
Your inventory turnover ratio is measuring how fast you are moving product in and out of your warehouse. It is calculuated based on your average inventory levels in the studied period, not necessarily the point in time balance on a specific date. The faster you are turning inventory the better, to reduce your out-of-pocket cash investment in inventory. I would say an average business is turning inventory 3-4x per year. If you are turning less than that, you may need to write off inventory that is not selling or change your product and sourcing decisions to help the business become more efficient.
Your ROC is helping to illustrate that you are getting your investors a good return on their investment. Depending on how large your business and how fast you are growing, I would say ROC needs to be in the 15% to 35% range, on average, in order to attract and retain your investors.
Optimizing The Cash Flow Statement
The cash flow statement is simply another way of studying your cash inflows and outflows, where you obviously shouldn't be spending more than you have to spend. But, this statement is helping your CFO know whether cash was spent or generated from operations (e.g., capital expenditures for replacement equipment); investing (e.g., took an equity stake in a supplier) or financing activities (e.g., closed a new equity investment into the company).
Reporting Timing
To me, every business needs to be studying its business on at least a monthly basis. Bigger companies tend to study their businesses on up to a weekly, or even a daily basis. But, no less frequently than monthly. So, at a minimum, when you get to the 1st day of any month, it is time to study the financial results of the preceding month.
Reporting Analysis
In your financial statements, I would be reporting results for: (i) the current month; and (ii) the year to date period. And, I would be comparing them to; (i) the original budget; and (ii) the same results for the prior year period (e.g., compared March 2022 to March 2021). And, the reports need to include: (i) dollar amounts; (ii) percentages of sales; and (iii) percentage growth rates, for every line item. These reports need to include each of the important datapoints and metrics discussed in this post, so you can track their progress over time, and study if the business is doing better or worse than budget, and better or worse than last year, and to what extent.
Here are example column headers for your income statement for the month of March: (i) March Dollars; (ii) March % of Sales; (iii) March % Increase; (iv) January to March YTD Dollars: (v) January to March YTD % of Sales; and (vi) January to March % Increase.
Once the reports are created, now you or your CFO need to study the data and metrics, and produce a Management's Discussion and Analysis document, that discusses the key trends and why the numbers are moving in the direction they are, and why they are better or worse than last year or the plan. That "WHY" is the most important thing here, make sure you have a firm grasp on the reasons behind any movements in your results or metrics, so you can manage them accordingly. So, build the monthly discipline of actually studying this when allocating your time.
Closing Thoughts
I was a finance major in college, so financial statement analysis is a pretty basic skillset of mine. But, if you never studied finance, it can be a daunting exercise. So, hopefully, this post can help point you in the right direction to truly mastering the numbers of your business.
For future posts, please follow me on Twitter at: @georgedeeb.
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