The most important thing for entrepreneurs.
A wise man once told me that he had never met a successful entrepreneur who didn’t understand their finances.
He’d seen many a profitable business fail due to not keeping an eye on their cash flow, whilst others were dropping like flies by selling products that were never going to break even.
It’s all well and good having a product / service that people want, but unless you understand how money is moving around your business, it’s not going to survive.
This post is going to quickly (and very simply!) explore some important financial statements and concepts to help you avoid this pitfall.
Part one: when you're starting out exploring an idea and you want to assess it’s viability (is it going to be commercially worth while?)
The market size
Unit economics
Part two: When your business is up and running
Profit & loss
Balance sheet
Cash flow forecast
Part one: exploring an idea
Market sizing:
Looking at the total addressable market will give you a start point for understanding the value/size of the opportunity and if it is worth pursing in the first place. Below shows how you can calculate this:
Number of customers = A
Average revenue per customer = B
Total addressable market = £A x B
Unit economics:
Looking at the unit economics allows you to understand the contribution per customer, in essence, this looks at how much it costs for you to acquire a customer vs how much they are worth to you. The formula is below:
Contribution per customer = unit revenue - variable costs(*)
(*)variable costs are those costs that change with the amount of products you produce, such as: production costs, component parts, customer acquisition costs and distribution
Part two: business up and running
Profit and loss account:
Your profit and loss account is a view of your business over a period of time and will show you if it is generating wealth or not. In essence, it shows you a view of your companies profitability.
I’ve included an example of a very simplified P&L below:
Sales: £2,000
Cost of sales: (£1,000)
Gross profit: £1000
Overheads / operating costs / fixed costs: (£200)
Net profit: £800
In reality, profit and loss accounts are a little more complicated than this. Your overheads would be split out into the various costs (e.g. advertising costs), depreciation(*) would be taken into account and, as you show a period of time, the matching principle(**) has to be adhered to. But despite the simplicity of the example above, it’s a good starting point!
(*)depreciation: spreading the cost of an asset over its useful life
(**)the matching principle: costs are shown over the period of time that they are incurred rather than when a payment has gone out, i.e. you may pay 3 months rent up front, but that cost would be shown split over the 3 months that it covers in your P&L.
As you delve deeper into P&L statements there are five different levels of profit that are likely to be shown, these are:
Gross profit: profit made on the product
EDITBA: earnings before interest, tax, depreciation and amortisation
EBIT: earnings before interest and tax
Net profit: profit made after interest
Net profit after tax: profit after all other costs, and tax
As is probably clear, there is a lot that you can explore through your P&L and while you don’t need to be an accountant, it is a vital statement for you to understand in order to look at the profitability of your business.
What can you do with your profit and loss?
Track your profitability
Review the component parts for trends
Use to benchmark the performance of your business against other organisations
Support future investment proposals
A basis for ratio analysis around company performance
Cash flow forecast:
Cash flow shows you how money is flowing in and out of your business. It is split into three sections; money in, money out and adjustments. It is key to note that your cash flow does not show the profitability of your company and that profit is not cash.
Money in:
In a really simplistic form of a cash flow statement, you can start your money in with the net profit before tax figure, while profit and cash are not the same thing, but in this instance it works and saves you repeating every revenue item under ‘money in’ and every cost item in ‘money out’.
Money out:
This includes all of your capital items (such as machinery), these items don’t come up in your profit and loss (except for later on in depreciation) as they are not related to profit in those months, where as they are cash flow issues and so appear here.
Other items such as loan repayments also feature in the ‘money out’ section of your cash flow.
Adjustments:
The adjustments section is important as it puts significant items in their place from a cash flow point of view.
An example of this would be cost of sales, you add this back in on a monthly basis (where you have previously spread it out over the period of time it is relevant for in the P&L) then you take of the full amount at the point where the cash actually left the business (when the bulk payment went through).
Net cash flow = money in + money out (shown as a negative) + adjustments
What can you do with your cash flow forecast?
Ensure you have the cash in place to support your growth plans
Support funding proposals
Help you make working capital decisions (decisions around debtors / creditors / stock etc.)
Help with the timing of major capital investment decisions
A basis for ratio analysis around company performance
Balance sheet:
The balance sheet, unlike the P&L, shows a snapshot in time. It is a view of what your business owns, owes and its ownership equity in that moment.
The underlying formula behind the balance sheet is:
assets - liabilities = shareholders’ equity
Again, there is more to explore when it comes to the balance sheet, but the above provides a start point in terms of the basics. Hopefully this gives you something to go off to start better understanding your business’ finances.
What can you do with your balance sheet?
See a summary of all your assets and liabilities at a period in time
A basis for ratio analysis around company performance
