Who keeps track of your business numbers? It’s easy to just say, “I’m a craftsperson and I know my craft and that’s all I need to know. I’ll just hire someone to take care of the numbers for me.”
The truth is, if you are in charge of making decisions about your business, then you need to understand the basics of accounting and what each of the financial reporting statements you receive as a small business owner means. In other words, even if you let someone else keep the books for you, you need to understand the meaning behind the math.
Here are a few reasons why you have to keep accurate books; and you’ll notice that tax reporting is at the bottom of the list. Keeping accurate books will help you:
The important thing in accounting is to not let the terms and formatting of the financial information intimidate you. All you need to remember is that you need three basic financial statements to keep track of your money:
Let’s take a look at this, broken-down in simple terms.
As mentioned above, your balance sheet outlines your business assets, both current and fixed. Current assets are cash or other assets that can be converted into cash within one year (things like accounts receivable, inventory, prepaid expenses, etc.). Fixed assets are property and equipment owned by your business—things that you don’t intend to sell (furniture, manufacturing equipment, real estate, etc.).
As you create your balance, remember that the left side will always equal the right side. If they do not equal, then you have made a mistake. It is that simple. This is called the “accounting equation.” It’s what makes your balance sheet always equal on both sides. The equation is this: Assets = Liabilities + Owner’s Equity
Here’s a sample balance sheet:
Owner’s Equity covers the share of the business that you or other partners own.
The second piece of essential accounting information you need is an income statement (or profit and loss statement), which is used to track sales and expenses. The difference between these two is your net profit. The formula for calculating this is: income minus cost of sales equals gross margin, and gross margin minus fixed operating expenses equals net profit. Remember, larger assets may be depreciated so that those bigger expenses don’t skew your profitability numbers.
It is important to remember that your income statement presents sales and expense activities over a period of time as opposed to your balance sheet which shows your financial condition at a point in time.
A cash flow statement is the financial document that presents income actually received and expenses actually paid. This statement (usually modified for a small business) generally shows beginning cash balances, cash inflows, cash outflows and ending cash balances. In its simplest form, a cash flow statement is presented in the following format:
Sample cash flow statement for a new business (beginning cash balance is $0):
There are many free resources available to help you prepare your financial statements and understand the basics of business accounting. For a deeper dive into this topic, SBA offers a free online course: Introduction to Accounting through its Small Business Learning Center. The course also includes automated financial statement templates.
You can also discuss your financial statements and any accounting questions you have with a business mentor (such as those available through SCORE) or get assistance from your local Small Business Development Center.
Last week, I went over the first five sections crucial to a financial plan. The next four sections are just as important and include fundamental information you will need to present when you meet with potential investors. Remember a financial plan is necessary when you want to attract outside funding but it is also an adaptable plan that helps you set profit milestones, gauge your business’ future progress and set up your company’s ideal financial trajectory. Here are the final four parts you’ll need in your financial plan:
The Use of Funds section shows how you will use the money that you’re raising to get to your next step, whether it’s a product launch, the next fund-raising push, or another milestone such as profitability. Almost every investor will want to know how much money a startup is looking to raise, the milestones it hopes to achieve, and generally, how you plan to use that money to meet a particular milestone.
The discussion between entrepreneur and investor regarding use of funds needs to be very open and detailed. Just stating “it’ll be used for marketing or hiring staff” doesn’t suffice. It is absolutely crucial to know the details of how much money you need to raise to get you to the next big step and exactly how you intend to use it.
Valuation is the worth of your business concept today. It’s a relatively arbitrary concept based on perceived value. You as the business owner are going to have a higher perceived valuation relative to an investor, who will set a much lower value since the business is most likely unproven. If you’re going to be selling equity in your business to raise capital, you will need to determine a valuation for your company.
First off, while the “friends and family” group may be more lenient in terms of expected returns, most sophisticated investors aim for a 10x return on their investment within five years. This means if they were to put $10,000 into a company, they would want to exit with at least $100,000. Projected investor returns depend on a future valuation, which depends on the sales forecast or income forecast or both. Most investors look hard at the sales and profitability projections so that’s why your assumptions are critical.
Second, and more important, investors tend to care more about the product-market fit, management team, and other factors to determine whether the company is going to make it. If you’re going to be selling equity, keep these considerations in mind as you document what you’re willing to give up in exchange for financing.
An exit strategy is exactly that: the method by which an investor or business owner intends to “cash out” of the investment. Examples include an initial public offering (IPO) or being bought out by a larger player (trade sale). It could be you don’t plan on exiting, that you have found the job you want to stick with. In that case, if you do have outside investors, you may want to make a plan for buying them out. Either way, having a clear exit strategy is key.
The financial plan section of your business plan is the key variable that investors will use to evaluate your company. This area is how investors will know whether or not they stand to make any money in investing in your company. This section should be approximately four pages; you can skip around in presenting different areas but make sure that you retain a cohesive set-up. Make sure to focus on statistics, back up your numbers with relevant evidential research and present with compelling facts. Be as precise and realistic as you can be and be ready to explain why you chose the values you did.