Chapter 2: The Basics of FinanceFeatured 

In this chapter, we will teach you the basics of finance without all the details. Think of this as Financial Literacy which is not going to earn you a degree in finance but it will give you the fundamentals so you know how to run and keep track of your business. We will dive into these high-level concepts as we move forward, especially in the modeling phase which will come next but for now, let’s just level set on the most foundational concepts and then build up from there. We will focus on operational concepts as opposed to accounting concepts for now.

From an operational standpoint, the most simple level for finance is cash in, cash out, and net cash flow.

The simple link between these is

cash in – cash out = net cash flow

Notice I am not yet using terms like profit, sales, expenses because these all have very specific accounting meanings and we will get to them but for now, as we said in chapter 1, cash is oxygen and if don’t have cash, we die. As an entrepreneur, you always need to understand the cash first. Cash is the ultimate measurement you must be concerned with. We will talk about many specific financial statements for a business in this chapter (the three most popular are income statement, balance sheet, statement of cash flows) but I always say the most important statement for an entrepreneur is the bank statement. This is because; while incomplete for sure, it is very real and tells you how much cash you have in the bank. That is a good starting point. As you will see, each financial view of your business has strengths and weaknesses. The bank statement is very easy to understand and it is very real which is it strength. Its weaknesses are that it is just one point in time and even then it does not give you insights into obligations and assets that you have at that point in time. It does not tell you the rate at which you are gaining or losing money either because it is just one point. The trend, or rate, at which you are gaining or losing cash is captured most simply in the statement above when we add the implied assumption that it is for a period of time (often a year but it could be a month or a quarter or whatever is chosen):

cash in – cash out = net cash flow for a period of time

You now might say that this would represent profit, but that is not correct. You might say it represents your company’s cash burn rate which would be closer to the truth but still not correct. Cash burn rate would be the rate that your business would expect to be running at without an extraordinary transactions related to cash.

As we have defined cash in so far, it is all cash that comes into the company – which could be from normal operations and continual sources of money. What would not be normal would be a onetime transaction where you received money. This cash that resulting from fundraising, a sale of an asset of the company, money received in a legal settlement or any other unlikely to recur event. Likewise, the same is true for cash out where onetime transactions might be things buying a significant asset like a computer, a legal settle you had to pay out, non-recurring marketing campaign, a signing bonus that you don’t think you will have to pay in the future to hire people, severance package and the like.  If you can take all of those onetime transactions out, you will get to what is often referred to as operational net cash flow or cash burn rate which is something very important to know. Let me explain more.

Cash burn rate is a rate of change so it is important to define the period of time, as it is for any rate. So if we can estimate that our cash burn rate per month is $50K (i.e., $50K/month) and I know I have $500K of cash in bank (unencumbered of net liabilities), then I can estimate I have enough cash to last me approximately 10 months. That is very important information to know – and you should know it for sure.

But again, this number has it strengths and weaknesses. The reality is that while it is technically true, when you have employees and other obligations, and you start to run down to less than 3 months (for a general rule) of cash left relative to burn rate, you are flying awfully close to the sun and strange things start to happen. Strange things like employees freaking out and the good ones leaving. However, at the beginning it is very common to fly very close to the sun and everyone just doesn’t get paid but as you get bigger, it is not as well accepted.

That is the simplest explanation of new venture finances but now let’s dive a little deeper on all of these.

Cash In

Cash in is made up of two major components – one-time transactions and recurring. Let’s take a look at each of these and define them for you.

One-time transactions

• Net proceeds from a fundraising effort: If you raise money in a period from selling stock in the company (called “equity”) or even if you get money from taking out a loan, that is cash into the company but it is not from operations and it is not something that should be expected for the next time period.
• Sale of an asset: Similarly, you might sell off an asset that either you don’t need or because you have a keen need for cash. That could even be something like computers that you then leaseback. For whatever reason, this inflow of cash likewise cannot be expected to happen in the next time period so it should be called out as one time.
• Legal settlements: You might get paid for a legal settlement that someone wanted to settle with you to avoid further litigation or gain access to your Intellectual Property. Again, this is a one-time payment and should be called out as such.
• One-time payments not expected to recur: There could be others ones that we have not listed above but at this point, you should recognized the nature; they are one time and cannot be expected to happen on a predictable basis.

Recurring

• Sales to Customers (OTC or Subscription or Licensing/Royalty): What is something that you can expect and forecast, is revenue from customers who buy your product. The best type of revenue (which is the same as “sales”) is subscription revenue because it is highly predictable and, hopefully, contractually obligated. Purchase of products that is a one-time upfront charge are also predictable because we can forecast sale unit and price volumes for a time period. While something that we can forecast with confidence, they are less assured than subscription revenue. Licensing/Royalty revenue is like subscription revenue for the most part but it is a mix that depends on how much our partner sells. This (Sales to Customers) is for the most part, the more interesting cash in to a business. It is the starting point for determining the all important “cash flow from operations” calculation.

Cash Out

This section is very similar in structure to cash in so let’s look at the underlying components of the two big components.

One time transactions

• Buying capital assets: A big use of cash for many businesses, especially those with a hardware component in their product, is the acquisition of big equipment/computers. Even software and data businesses need strong computer platforms to make the businesses run. Many companies, to preserve their cash, will lease this equipment which can make sense. However, if you have access to cash, it is easy to do the calculations and see that you can save a lot of money in the long term if you buy rather than lease. The leasing companies are making money in financing, which may be a premium you are willing to pay because it is the cheapest way to getting capital. It is damn hard, expensive and time consuming to get capital when you are a startup so leasing may be a good option to offset this use of cash but you are going to pay for it. No free or even cheap money anywhere.
  Note: When you buy a “capital” asset, it means it is big enough to “depreciate”.  Depreciation means that because you are going to use that asset (e.g., a computer, a manufacturing machine, etc.) over many years, you can spread the expense over the number of years it has a useful life. That useful life is not something you determine but it is predetermined by accounting standards. It is usually 3 or 5 years. The “expense” however is a non-cash measurement that accounting uses to show the estimated profitability of your organization in a certain time period (e.g., a year, a quarter, etc.).  This makes sense so people can understand pro-rated profitability of your business but it does not explain the cash flow situation – and as any entrepreneur know, CASH IS KING! The same thing can be done for software development or other investments that are expected to pay off over many years and for them, the term “amortization” rather than depreciation is used. This is one of the biggest differences between a “Profit and Loss Statement” and the operating cash flow view that an entrepreneur has to be hyperfocused on.
• Finder’s Fee/Signing bonus (not expected to repeat): The rest of this list is simply one time fees that can change significantly or disappear from one time period to the next. One common example is that you have to pay a one time finder’s fee to get a key position filled and/or a one time signing bonus. You do not expect this to be a recurring use of cash.
• Legal settlements: More often with legal settlements in my experience, they are “cash out” rather than “cash in” where you pay a settlement fee to make a situation go away so you can focus on your business. This might be the purchase of a trademark or some other Intellectual Property.
• Severance: This is really just a legal settlement and the reverse of the signing bonus, but it requires a one time cash payment.
• One time programs/initiatives not to be repeated:  By now you should see the pattern and this could be a big campaign, tradeshow launch or something that you are confident will not be recurring.  Becareful that before you put things into this category, they are not things that actually will recur each year – like a yearly marketing campaign or tradeshow.  Website rebuilds are another tricky example. It is likely that you will need to make continual investments in websites and digital marketing campaigns so don’t put them in this bucket too easily.

Recurring

These are the items that require a lot of attention and are difficult but very important to get a good estimate on. Even more important, is to develop a model that makes clear what is driving the cashing going out of the business (“expenses” is an approximation here but not exactly the same); what are the key items and assumptions?

• Cost of Goods Sold (BOM plus direct labor): This is actually pretty straight forward. It is all of the items listed on the BOM (Bill of Material) which can be priced out easily by calling a few vendors. The BOM is a list of all the items required to produce your product. Sometimes people interpret “items” as being parts and do not include the incremental or “direct” labor required to build one more of the product. The direct labor costs should be estimated and absolutely be included too. Your Cost of Goods Sold (often shorten to “COGS”) will likely go down as volume goes up so when you give a COGS estimate, you should tie it back to a volume estimate. In the reporting of past finances, the COGS is known and determined so no estimate is needed. Obviously COGS is affected by the pricing of the components and the companies ability to negotiate good deals for itself with vendors.
  Note: “Gross margin” is a term that is often used. This is the amount of money the company makes from the sale of its products before non-product (i.e., Marketing and Sales, Research and Development, General and Administration) expenses are taken out.  So if a company sells 100 products at $1,000 each netted to the company (a total revenue of $100,000) and the COGS for each product is $333 (total COGS of $33,300), then the Gross Margin is $66,700 for that period of time. The Gross Margin Percentage is 66.7%. You can think of this as the Product Profit Margin.
• Marketing and Sales (M&S): This is all the cash required to create the demand (i.e., marketing) and then fulfill the demand by getting customer to buy the product (i.e., sales).  All the many elements of this, marketing people, campaigns, consultants, systems, collateral, etc, will be spelling out in the model later and similarly for the sales function.
• Research and Development (R&D): This is all the expenses associated with the development, acquisition and refinement of the “technologies” (used in the broadest definition possible) needed and possibly needed for our product and its evolution. That is the research component. The development component is all the expenses to develop the product that marketing and sales will sell. Again, all the various components of this like people, computers, systems, training, research materials, etc. will all be detailed in the model later.
• General and Administration (G&A): These are all the expenses needed to run the business that are not in the M&S or R&D buckets to make a viable business. This includes legal, financial, rent, utilities, insurance, payroll, office equipment and supplies, board of directors, top leadership, etc.
  Note: In each of these salaries, you should consider how much of your expense is related to salary and benefits for employees, which does not mean consultants. The employee salary line is so important to know because it is not an expense that you can cut back in quickly or easily, despite what you might think. Hiring should be a significant vetting process as you will be taking on a commitment to someone. Don’t do it too quickly or take it lightly. Getting rid of employees is a time consuming and costly process that has significant ripple effects if not done properly. This is not always understood by first time entrepreneurs (including myself at the time) and it is why I call this out. Just ask any experienced entrepreneur.

Assets That Cause Your Bank Statement to Be Understated

The cash in and cash out over a period of time, gives us a very important sense of the needs of the business, we also need to know our position at any time. The bank statement gives us a picture of the finances at a specific time whereas the cash flow over a period of time gives us a video picture of how this are trending. The technical words from systems analysis is that a bank statement is a stock (analogy, the level in the bathtub at any time) and the cash flows give us the flow (or the rate at which water is going out the drain combined with the rate water is coming in via the faucet).

That being said, just looking at the bank statement can give you an imperfect impression of your financial snapshot position at the time it is issued.

There are other things that you should also consider.

The biggest asset by far that valuable to you is money you are owed. This is call “Accounts Receivables” or “Accounts Receivables Outstanding” and it represents the amount of money you are owed at that time. Often another measurement is the “averaged days sales outstanding” of your receivables, which indicates how long these receivables have been due to you. A good company collects their receivables promptly but the terms you may offer your customer could be 30 days upon receipt of the invoice. That gives the customer a grace period of 30 days to pay which a smart customer will take. You will pay a price by not having this cash immediately and that is call “float,” the amount of time the customer has money due to you.

It is certainly in your benefit to collect the money as soon as possible because you have already paid your suppliers most likely and you are having to subsidize this float, likely with money that is very difficult, costly and time consuming to get.

Still, understand Accounts Receivables is an asset that is not included in your bank statement and it means your bank statement cash position is understated by that amount or some percentage of it that you are very confident you will be able to collect.

Liabilities That Cause Your Bank Statement to Be Overstated

Like with Accounts Receivable that cause your bank statement to understate your current cash position, there are liability that mean your bank statement cash position is overstated.

The first and probably biggest of these is the money you owe to others including suppliers  and employees in salary which is called “Accounts Payables” or “Accounts Payables Outstanding” at the time. This is a liability that you will have to pay off. Likewise to Accounts Receivables but now you are on the others side, if you pay these later, that give you the cash longer and you get the float.

Another liability that you should be aware of an track is customer that might default and never pay, which would result in bad debt. These means that your Accounts Receivables should be cleaned up to not include customer that will never pay you.

The amount of time you pay your vendors and the amount of time your receive cash from your customer is usually material so you have needs to float this cash for a period of time. For instance, you may have to pay your vendors within 15 days for the parts to build your product. You may well have to buy the parts on average 90 days before they are finally assembled and set out to a paying customer.  That means you will have to pay for the materials in a product, on average 75 days before it ships to a paying customer. That customer then has 30 days to pay for the product.  Assuming they pay right on time at 30 days, that is 105 days between when you had to carry the expenses of the COGS to when you actually got paid. That time requires cash to hold you over. That cash requirement is called “working capital”.  It might not seem like a lot but any cash is important for a new venture. It also turns out to be a requirement for a lot of cash when you volumes go up as your business scales. The irony being, the more you succeed, the more you need cash. A nice problem to have but a problem nonetheless.

Accounting

The above explains the fundamentals of a business that you really need to know to operate it. There are others however who will want to understand the financial strength or weakness of your business (e.g., banks, investors, partners, acquirers) and they would like standard formats with agreed upon standards that can be certified by people they trust.

These standards are define by a field called accounting. They provide a rigorous standardize outline of a business’s financial health. They are financial dashboard for your new venture. They specifically indicate where your money is going, where it’s coming from, and how much you’ve got to work with. It gives you all the information to operate your business in a comprehensive manner but it just is more difficult to get than the manner in which was explained earlier in this chapter. It is, however, the standardize way to do it and it is what people expect to see from your top financial officer.

The three common statements are the Income Statement (also called the Profit and Loss Statement), the Balance Sheet and that Statement of Cash Flows. Let’s have a quick, high level look at what each is.

Income Statement

This statement show you how “profitable” was over a specified time, such as a month, quarter, or year. It gives you an indication of what the cash might be but it is different first of all because of non-cash expenses. When a big asset or expense is made the can be depreciated or amortized, it will only show the amount of expense it allocates to that time period not the amount of cash that went out the door for that asset. This can either overstate your profitability relative to cash flow (if you paid for the asset in that time period) or understate your cash flow relative to profitability if you did not buy that assets in the designated time period. A very important second area that creates a difference between profitability and cash flow is the recognition of revenue. Specifically, a customer may agree to purchase your product and it may be install and the customer formally accepts it. At that point the revenue can be recognized and accounted for in your Income Statement. The customer however may not have to pay, as we discussed above, for 30 days as per your agreement and, in fact, they may not pay for 60 days. The difference would be that your profitability would be higher than your cash flow, until the customer pays and the cash is received in your account.  Likewise, you may have to pay for something in your product (like COGS) and not recognized the expenses at the same time the cash has to go out of your company which can be another cause for discrepancy between profitability and cash flow. You must understand this limitations of the Income Statement but also understand that is still is one valuable indicator of the financial health or your business. All of these financial statements have strengths and weaknesses and they are used together as a suite to give a multidimensional view that is valuable.

Net Profit is the Gross Margin minus the M&S, R&D and G&A expenses which is very important to know as well but is much different than the Gross Profit which is another name for Gross Margin so be careful with your terms like Profit. Be specific and ask questions if you are confused.

Balance Sheet

An Income Statement is a view of the venture’s finances over a period of time while the Balance Sheet is a snapshot of the financial position at one given time. It tells you within the strict rules of accounting, what assets you have and what liabilities you owe to others. Inherent in this is to point out how much the company is worth, which is called “Shareholder Equity”. Shareholder Equity = Value of Assets – Value of Liabilities.

That may sound simple but it gets more complicated very quickly.

Assets can be broken down into short term assets, like cash and assets that can be quickly translated into cash, like Accounts Receivables as we talked about already. So it deals with that adjustment that should be made when trying to translating the bank statement into your real short term cash position. Short term is generally consider something that could be converted into cash within a year easily which may include inventory but that is also something that would be discounted a lot more than cash. Short term assets are also often called current assets.

In addition to short term assets, there are long term assets which are things like inventory (could be in either depending on nature and context), computers, other equipment, furniture, land, buildings, notes receivable that are not short term, and even intangible property such as patents and goodwill. As you can imagine, as you get into things like patents this gets less precise and when you move into the area of “goodwill,” even with strict account rules, it can get pretty abstract.  Long term assets are also called fixed assets.

Banks and most experience entrepreneurs significantly discount longer term assets, especially ones that are not hard assets that have a significant remaining useful life.

Liabilities are very similar to what we discuss in the section previously in this chapter title “Liabilities That Cause Your Bank Statement to Be Overstated.” At the risk of repeating, let say there are short term liabilities and longer term liabilities very similar to the Assets. These would be Accounts Payables but also potentially interest payments due on loans or mortgages. It could also be expenses you have accrued, meaning owe but not yet been invoiced for or accounted elsewhere, such as utilities, taxes, or wages owed to employees.  Similar to Assets, short term liabilities are often called current liabilities and long term are called non-current (as opposed to “fixed”). Long term liabilities is the principal on a loan that is outside of 12 months. The interest would be in short term liabilities. The dividing line for these groups of liabilities is likewise one year as you probably deduced from the preceding example.

Equity is a trickier concept because it shows some history in it that might surprise you. The will be an indication of the value of the company (not the “market value” but the “book value”). The book value is the equation above is a result of how much money was put into the company to begin with, how much has since been put into the business by investors who bought stock (or equity), how much money has it made and how much has been taken out of the business. These things will determine the book value. The market value is a completely different calculation for another time depending on factors such as growth rate, gross margins, capital efficiency, intellectual property, investor interest in the field, competitive strength and many other tangibles and intangibles. That is for later in the program when we discuss valuations for companies.

The first thing people look at in a balance sheet is the short term assets (essentially the cash and cash equivalents) and then subtract the short term liabilities. This gives the reader a sense of how much cash or “dry powder” does the company have.

The next question they are trying to figure out is the “burn rate” then. This is how much cash the company is losing each month (assuming it is losing cash). They then take the amount of money the company has and divide it by the burn rate to figure out how long the company has to go on the cash it has today without raising more money.

For example if from the balance sheet, it appears the company has $1 million dollars and it monthly burn rate is $100k per month, we know it has an estimate 10 months until it runs out of money without a further injection of cash. If the same company has a burn rate of $10K per month, it has a runway of 100 months, which all thing considered, is a lot better.

Statement of Cash Flows

The Cash Flow Statement sounds like exactly what we want but it can be complicated and is meant to integrate with the Income Statement and Balance Sheet so can, in my humble opinion, can more confusing than the simple explanations (I hope) I gave you above. There are also very strict rules about how to define parts of it.

Fundamentally, the Statement of Cash Flows tells you how much cash entered and left your business over a particular time period.

This statement has three parts:

1. Cash Flows from Operations: This is what you make and spend in the normal course of doing business, which comes from your Income Statement.
2. Cash Flow from Investing Activities: This is money you invest in capital assets as we discussed in the Income Statement section, by purchasing new equipment or investing in major projects that can be amortized for your business.
3. Cash Flow from Financing Activities: As this title says, this is money that comes in or goes out of your company not related to the operations of the business but because of investors putting money in, getting money from loans, debtors getting money out or owners paying dividends. It also might be from one-time activities that don’t fit into the first two buckets but add or subtract money from the company.

Tip: Get your customers to pay you upfront for your product and it will give you a big advantage on cash flow. Instead of working capital being a drain on your cash, it will be a positive contributor to cash. This is another reason why a subscription business is attractive.

Summary

This is a very simple view of finances and there are thousands of books and courses on this topic and each sentence above, but now you should know enough to see the full landscape and not be daunted by this topic. At the end of the day, it is very simple math clothed in contextual complexities and definitions but it comes down to, do you have enough cash to run your business and grow it? How much and when?

Key points of chapter 2:

• Cash is what matters and that is not clear from standard accounting statements and you should generally know the difference.  That difference is cash flow for assets that are depreciable and working capital – the difference of when you have to pay and when you receive payments not when the expenses and revenue is recorded from an accounting standpoint.

• Revenue and expenses come in two varieties: one-time and recurring. All things being equal, recurring is much preferred for revenue whereas one time is preferred for expenses.
• As a startup, always know your cash balance in the bank and your monthly burn rate so you know how many months of runway you have. Don’t let that runway get too short otherwise bad things can start to happen that will cause it to decrease even faster.