Financial landscape for startups — Part 1
Amongst the biggest challenges, faced by entrepreneurs is understanding the finance of a business, especially when one is from a tech or other non-finance background. This article is not to teach finance (let’s leave that to the experts), but to give an overall perspective of the financial landscapes and terms commonly used. It helps to know what you do not know so that you can learn it up or get the right help. This is something I wish I had when I started, and I hope it gets to help another entrepreneur. I’ll split this into 3 parts
Part 1: Finance accounting and analysis
Part 2: Financial instruments in the market: bonds, common and preferred stocks, IPO, etc
Part 3: Forecast & company valuation
Part 1: Finance accounting and analysis
- Accounts vs finance
In the simplest explanation, accounts are your day-to-day transactions, giving you a quick overview of money spent, gained, and cash flow. If you are a small startup, just starting — google spreadsheets work perfectly fine. Accounts will give you a basic idea of how the money is moving but you can’t make financial interpretations, assessments, or decisions. For that, you will need financial statements.
2. What are financial statements?
There are a few things to know under financial statements
a) Working Capital
Working capital cycle or cash flow production cycle depicts the flow of cash from investment (money raised from various sources) to assets and products/services to be sold, to cashback again.
For startups, the return of investments will take a longer time as there is a gap in finding early adapters, and crossing the chasm to early majorities, hence investments have to be factored for a duration of time before there is consistency for returns
b) Balance Sheet
A balance sheet provides a snapshot of the company’s financials at a given time. It did take me some time to appreciate this. The most important formula is
Assets = liability + shareholders equity
Whereby cash at hand, accounts receivable, inventory and fixed assets are classified under assets, accounts payable, loans are under liabilities, and owner’s equity comes under shareholders equity.
Assets and liability are also split into current and long-term, whereby current assets are anything that is converted into cash within 1 year. Account payables are short term and something that would be paid back within a year
c) Income statement
An income statement gives a perspective of funds in and out over a timeframe be it a month or year. Revenue is the outcome of sales made or any other form of earnings. Cost of Sales or Cost of Goods Sold differs for products and manufacturing. Operating income includes your office rentals, wage, administration expenses, etc.
Revenue — COGS — Operating Cost= Gross Profit
Gross Profit — Tax = Net Profit
EBITDA is your earnings before tax, interest, depreciation, and amortization. This number is sometimes favored by investment bankers when EBIT alone is insufficient.
Depreciation is the assets withering value over a certain timeframe. After a length of period, the value of the asset will be nullified.
Taxes depend on which country and state you are in.
d) Cash Flow Statement
This identifies the company’s sources of cash and its uses either via operating activities, investing activities, or financing activities. Cash flows also indicate where dividends are paid, stocks repurchased, and Capex invested upon. Other benefits include providing a health check on the company’s solvency as it absorbs values of account payables, accruals, depreciation, payrolls, and dividends vs net income. The cash flow statement also gives a picture of stock changes such as employee stock options, even if they may not have been paid out as the owner’s equity gets diluted.
A simple formula on cash flow,
Net Cash Flow = Net Income + Noncash items
Based on operating activities,
Cash flow from operating activities = Net cash flow +/- changes in current assets and liabilities
A more inclusive cash flow measurement in determining the value of a business is
Free Cash Flow = Cash flow from operating activities — capital expenditure
One that takes into account the time value of money and commonly used in investment analysis is
Discounted Cash flow = CF1 /(1+r)1 + CF2 /(1+r)2 +……+ CFn /(1+r)n
DCF = discounted cash flow
CFi = cash flow period i
r = interest rate
n= time in years before the future cash flow occurs
NPV or net present value is the difference between today’s value of expected cash and invested cash. This determines the current value of future cash flow.
e) Market Value vs Book Value
Book Value — this is based on the shareholder’s equity. However, this is not the worth of the companies value as financial statements are based on transactions such as assets purchased at different times and changes made on book value for time variation may not be a reflection of the market value and taking into consideration the inflation which impacts the value of a dollar. Furthermore, future income and other intangible assets such as patents, customer loyalty, database, etc are not taken into consideration.
Market value for a public listed company is a simple calculation of market price x common shares outstanding. This is also known as market capitalization or market cap. For smaller businesses and startups, various factors are taken into consideration to get a reliable estimate including a business growth plan and execution team.
This is where intangible assets come into play. When a company is acquired above its book value, the intangible assets such as patents, brand value is labeled under goodwill on a balance sheet.
g) Interconnection between balance sheet, cash flow, and income statement
A balance sheet is also interrelated between income statement and cash flow statement. A cash flow statement identifies cash via operating, investing, and financing means. The financing details are under the assets of balance sheets as well. As for the income statement, the profit (revenue — the cost of sales) is also under the shareholder equity of the balance sheet
3. Assessing financial performance of the company?
Several levers are used to evaluate the financial performance of a company such as Return of Equity or ROE, Return on Assets or ROA, and Financial Leverage
ROE — Return of Equity
One of the popular investors’ yardsticks is Return of Equity.
ROE = Net Income / Shareholders’ Equity
This can also be re-written as
ROE = (Net Income / Sales) x (Sales/Assets) x (Assets/Shareholders’ Equity). Which is the same as
ROE = Profit Margin x Asset Turnover x Financial Leverage
This shows that 3 factors impact ROE.
A. Profit Margin
Profit Margin is the earning squeezed out of a dollar. Under this, you will encounter
a. gross margin: Gross margin (Gross profit/sales) can be used to estimate the number of sales required for a company to reach break-even
b. tax rate
c. Percentage income statement
B. Asset Turnover
This describes how a company manages the assets on the balance sheet. In it, you will encounter
a. Inventory Turnover — how many days taken to complete sales
b. Days’ Sales in Cash — This determines how many days’ worth of sales in cash and securities the company has. Typical S&P 500 companies have 180 days sales in cash or more.
c. Collection Period — This will enable the business to determine if it can hold up for x days (typically between 60 to 90 days) etc
d. Fixed Asset Turnover — companies that require large investments are capital intensive. Fixed asset turnover measures this capital intensity with a low turnover indicating a high intensity
e. Percentage Balance Sheet
C. Financial Leverage
Financial leverage is the management of the liability on the financial sheet. Details include
a. Payable Period — This is based on the credit terms the company has and the payables it adheres to.
b. Debt to Assets ratio = Total liability /Total Assets. This indicates that the amount of money needed to pay for assets that come from creditors
c. Debt to Equity ratio = Total liabilities / shareholders Equity. This indicates the number of money creditors pay you, for every dollar investor invests in you.
d. Times-Interest earned = EBIT/Interest Expense. This shows how much EBIT is earned to service interest obligations.
e. Times-burden covered = EBIT /(Interest + Principal repayment /(1-Tax Rate)). This is one step further in covering both principal and interest payments.
f. Current Ratio = Current assets / current liability . Two common rations to measure the liquidity of company assets. The first is the current ratio that compares the assets that will be turned into cash within a year compared to the payments that must be made within that year. Ideally, the goal is to be 1 and above.
g. Acid Test = (Current assets — Inventory) /Current Liabilities . The second liquidity test is also known as the quick ratio. This is a more conservative version where it assumes inventory could be frequently illiquid whereby in desperate circumstances, the discount on inventory, the practice of norm is up to 40%.
One of the general challenges with Return of Equity as a yardstick is that it relies on historical financial data as opposed to potentials of business growth and future gains.
Another challenge is that is it dependent on book value instead of market value. The latter is more favorable to investors, especially what is known as the P/E ratio (price per share/earnings per share) taking into consideration future earnings.
The 3rd challenge seen is the risk taken in terms of returns on assets (ROA) and assets to equity ratio. A lower ROA but higher assets to equity ratio (higher risks) yields to higher ROE, but a higher ROA with a lower asset to equity ratio by distributing to debt and equity yields to lower risk and lower ROE. Another measure seen to circumvent risk is the ROIC (Return on Invested Capital) = EBIT (1-Tax Rate) /(Interest-bearing debt + Equity). In this equation, dependency on equity and debt is eliminated and the earnings are measured upon taxed.
The above is a very brief overview of Part 1 (Financial accounts and Analysis). To understand further, here are some references I have enjoyed:
- The Finance Storyteller: https://www.youtube.com/channel/UCQQJnyU8fALcOqqpyyIN4sg
- Edspira: https://www.youtube.com/user/EducationUnlocked
- Analysis for Financial Management by Robert C. Higgins, Jenifer L.Koski and Todd Mitton
If you like this and have thoughts of your own, feel free to drop me a note!