Financial Modeling for Start-ups
Being from a tech background, understanding finance and other parts of the business was difficult for me. But now I am trying to learn all aspects of the business. I happened to attend a session on Finance by Srikant from Qapita. Notes below from that session. Hope you find this useful
Understanding financial statements from a founder perspective.
Financial Statements :
- The end product of the accounting process
- Prepared following accounting policies and standards in accordance with the company’s act
- Represents Business Activities and Financial Performance of a company
- Financial statements are means to communicate financial performance to a company’s stakeholders : ( Owners or shareholders, Board of directors, employees, tax authorities, government, auditors)
Main instruments of financial statement
- Balance sheet ( Statement of financial position of the company, how financially sound the company is. It is a snapshot, as of date. )
- Income statement (Statement of operation/profit and loss, it's a periodic statement, a time series of sort. )
- Statement of Cash Flows (Books of records )
Balance Sheet (Financial Position as of a particular date)
- Balance sheet statement of a company’s assets, liability, and equity
- Gives a sense of the net worth of the company in terms of book value
- Magic Formula : Assets =Liability +Equity
- Book Value = Assets — Liabilities (Value that shareholders would get if the company were to be liquidated today)
- Current Assets ( Expected to convert to cash in short term, eg. Accounts receivable, inventory). Anything that says current has short-term, something like 12 months.
- Current Liabilities ( Expected to be paid out in short term eg. Accounts payable, Accrued expenses).
- Non-Current Assets ( Held greater than 1 year, Property, Equipment). Something that is held more than 1 year. Not easy to liquidate.
- Non-Current Liabilities ( Term loan etc). For a longer period of time.
Income Statement or Profit and Loss Statement ( Periodic)
- Indicates profitability of the company
- A statement of income and expenses leading to profit/loss (Monthly on an accrual basis)
- How is P&L different from Cashflow? Also includes non-cash items such as depreciation/amortization. Exclude certain cash line items such as CAPEX, principal payments
Cashflow Statement ( Nothing but the truth !) ( Periodic)
Cashflow statement( For a particular period): Overall flow of money(cash) into and out of a company
- Indirect Method: Mostly followed in financial statements of companies (Operating, investing & Financing activities): Start with net income and make non-cash adjustments: Depreciation, Payable, Receivables, Tax Liabilities, etc
- Direct Method: Same classification as the indirect method. The cash flow from operative activities arrives directly from operating line items adjusted to a cash basis
- Simplified Cashflow Method: Relevant for startups and investors ( A simple statement of inflows and outflows month on month). This should ideally reflect the bank statement of the company. Ideal for early-stage startups with limited inflow and outflow items. Classification and bucketing at the author’s discretion (which best represents the cash situations giving the right amount of detailing for analysis)
An enterprise can go down due to cash flow, as a business can pivot.
Why is cashflow important
- Cash is the ultimate truth: Balance sheets and P&L can be engineered by creative accounting practice but not cashflow
- Cash is King
- Startups fail more because of cashflow issues than because the business model is not profitable => A startup might be profitable from an accounting point of view, but might still run out of cash!
- Ensure visibility of 6 months cashflow at all times with high confidence
- Ideally, ensure 6 months of runway at all times, else plan, adapt
Seeking the right source of capital
Thumb Rule: Use equity capital for the highest leverage items — spends that give them maximum ROI for the longest period of time.
- Product Development, Hiring Leadership Team, Fixed assets, etc
- Operating Costs
Thumb Rule for Grants: Forget the thumb, just grab it with both hands! :)