If you have zero experience in finance and accounting, as a startup founder taking full ownership of these functions of your business seems very daunting.
Especially for people with humanitarian backgrounds without a predisposition to math, marketing appears to be intuitive, so they are not afraid to enter into the domain. Finance and accounting, however, seem like they require you to learn a whole new language and set of skills, so the barrier to entry looks a lot bigger.
That’s why a lot of new founders hire a bookkeeping company and think that they’ve solved the problem. Fully abdicating from the financial side of your business, however, could be a big mistake. Money is the fundamental layer of business, and finance is the language of money. You don’t need to be a professional linguist, but you need to be comfortable in a basic conversation. If you’re not – your business will inevitably suffer.
While the learning curve of finance and accounting could be steeper if you start from zero, managing the finances of your new business doesn’t require you to become a certified tax accountant. This job best remains outsourced. However, you need to be familiar with basic managerial accounting in order to be able to budget and plan your financial resource accordingly.
And luckily, basic managerial accounting is extremely common-sensical, far more than marketing. In a way, the only required skill is basic arithmetics and the willingness to learn some accounting terminology, and you are good to go.
So, below we’ll break down the basic steps for getting on top of the financial side of your new startup project as a startup founder not familiar with managerial accounting and finance.
Table of Contents:
1. Liquidity Planning for Startups
Liquidity means the availability of liquid assets to the company – or in other words assets that could be converted into cash easily without affecting their worth.
Logically, the most liquid asset is cash itself, and for small startup projects, liquidity basically means planning correctly the availability of cash to the business in time.
Planning your liquidity is important for obvious reasons – you don’t want to end up in a situation in which you cannot pay your employees, partners, or suppliers in time. In fact, while the underlying reasons for a failed business could be many, they all result in insufficient cash to continue running the business.
Proper liquidity planning will help you see potential liquidity problems from far away, allowing you to take measures before they become critical.
While your accountants will produce a cash flow statement for the previous year, this level of resolution is far too low for the day-to-day operational needs of your company.
In practice, in order to be on top of the cash flow management of your business, you need a tool in which you see the cash inflows and outflows on a month-by-month basis (or on rare occasions, week-by-week).
While you can use a business and financial management software such as e.g. caflou for this purpose (or any other alternative that best fits your needs), for early-stage startups this is usually not required. You can achieve the same goal by adjusting any monthly budget Google Sheets template to your needs.
You need to be able to see all expected cash inflows and all expected cash outlaws into the business month by month. By doing this, you will see if you go into the red for certain months, and you’ll be able to work towards securing more inflows or reducing outflows: by attaining new revenues, financing your business with debt or equity, or by reducing costs in order to stay above water.
2. P&L for Startups
Your business needs to be liquid enough to cover its expenses, but it also needs to be profitable in the long run in order for its existence to make sense.
Understanding your revenue model and cost structure is extremely important for growing your startup, especially once it goes into its efficiency phase in which you’ll need to take care of your business model and unit economics before scaling it.
The problem with planning only the cash inflows or outflows is that you don’t have a proper overview of the financial results of your efforts in a given period. The main culprit for this is that you usually don’t get paid on the same day you complete a job. To solve this problem, accountants have introduced the accruals term, which indicates revenues and expenses which have been generated in a specific period (usually a month) regardless if cash has changed hands in this period.
So, the best tool to help you keep track of the profitability of your business is an accruals-based profit and loss statement.
In such a statement, if in January you work on and complete project A, the revenues and costs of this project would go into the January column in your P&L, regardless if you get paid in January or in March, and regardless if you get paid in one or five installments.
The profit and loss statement is great for a retrospective overview, but it is also ideal for planning. You can project your revenues and expenses into the future and plan accordingly where to invest your time and efforts tactically and strategically.
2.1 Understanding the Profit and Loss Statement for Startup Projects
The P&L is in essence quite simple:
Completing this equation for each month in the year would give you your complete P&L.
In order to derive more value from it, however, it’s a good idea to break it down into more details.
First, your income should be broken down by categories/verticals in order to get a better idea of which activities drive your revenue.
Second, the expenses should be broken down as well.
First come the direct expenses (aka Cost of Goods Sold, or COGS for short). These costs are directly associated with the fulfillment of a particular project (in the case of services) or the production of a good (in the case of products). For example, if you are running a retail business, the COGS would be the price of buying the goods which you are reselling from your suppliers. If you are running a service company, the COGS would be the salaries of your employees directly responsible for fulfilling the service.
Second come the indirect costs (sometimes called overheads), which are all expenses that are not directly attributable to a particular good or service – rent, legal and accounting fees, administrative salaries, etc.
This gives you the following breakdown:
This would let you calculate your gross and net margins, and if they are too thin, you can think of readjusting your pricing accordingly.
2.2 Expense vs Capital Investment
Yet, businesses don’t only pay for salaries and rent – they usually also invest in long-term assets. When these assets are expensive and it takes time for them to pay back their cost, it doesn’t make sense to write them off as an expense in the month they are purchased.
For example, if a farmer buys a tractor in February which costs more than the profit she/he is earning in this month, it isn’t correct to say that the business was not profitable in February. Based on the logic of accruals, the cost of the tractor should be accounted for in all of the months in which it is used and generates value.
This is where depreciation comes in. If the farmer expects to use the tractor for two years, then the cost of the tractor should be divided among the 24 months in the P&L in which it would be used.
The tractor in this example is CAPEX, or capital expenditure.
2.3 Financial Income and Expenses and Taxes
Most businesses use financial products in order to help with their liquidity planning and to finance investments in more expensive assets (like the tractor in the example from above).
If a company has too much cash, it can also decide to invest in assets that are not related to its operations – from savings accounts in banks to various financial instruments, etc.
Since the incomes and expenses generated by these financial activities are not related to operating the business, it makes sense to account for them separately.
This leads us to the final iteration of our P&L:
EBITDA (Earnings before interest, taxes, depreciation, and amortization)
Financial Expenses & Taxes
Breaking down your business in this way is a very positive signal to potential co-founders, partners, and investors. It means that you have your affairs in order and that your business is not opaque, which builds trust.
More importantly, however, it would let you analyze the performance of your project and you would notice the obvious problems before they become critical. Finance and math is a great reality check, which for startup founders who are in the job of selling dreams to all stakeholders, including themselves, is sorely needed every once in a while.