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. From an operational standpoint, the most simple level for finance is cash in, cash out, and net cash flow. 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.
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.
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.
The three common statements are the Income Statement (also called the Profit and Loss Statement), the Balance Sheet and the Statement of Cash Flows. The Income Statement shows 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. 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 is how much the company is worth, which is called “Shareholder Equity”. Shareholder Equity = Value of Assets – Value of Liabilities.
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:
- Cash Flows from Operations: This is what you make and spend in the normal course of doing business, which comes from your Income Statement.
- 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.
- 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.
Summary – 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.
Courtesy of Bill Aulet (pictured above), Managing Director of the Martin Trust Center for MIT Entrepreneurship and author of Disciplined Entrepreneurship: 24 Steps to a Successful Startup, one popular new venture planning method.