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Five Fatal Flaws in Financials

One of the first and most important steps to take before you launch your startup company is to create pro forma financial statements to verify that your company makes financial sense if all the assumptions that you are making end up becoming true.

The three pro forma financial statements we will be referring to are the income statement, cash flow statement, and the balance sheet.

Three types of “financial sense” can be derived from the above financial statements:

  • Fatal flaws: These are conditions in your financial statements that indicate that the company cannot survive. These are the subjects of this blog.
  • Universal non-investible flaws: These are conditions in your financial statements that make it highly unlikely that any right-minded investor would consider investing in your endeavor. The presence of universal non-investible flaws implies that the company could survive but will not produce extremely good financial returns.
  • Situation-specific flaws: These are conditions in your financial statements that may or may not preclude good financial returns, depending on the specific industry or unique situation.

Fatal Flaw 1. Negative Cash

The bottom line of every column of the monthly cash flow statement is always labeled “Cash at End of Period.” It tells you (based on all the assumptions you have made about your company) how much cash you will have in your company’s bank account at the end of every month.

No entry in this row can be negative.

If some column has a negative value in this row, you must do something to your assumptions prior to this month, for example (these are just four of dozens of possibilities),

  • Get a loan
  • Raise money in an investment round
  • Sell more product
  • Spend less money (on expenses)

What you cannot do is just launch the company and hope that things will work out. Hope is not a strategy. The fact is many things will change once you launch, but you have to at least start with a plan that has a fighting chance of working.

Fatal Flaw 2: Negative Gross Profit

Near the top of every column of the annual income statement will be lines for

Revenues
– Cost of goods sold      
Gross profit

Gross margins indicate how efficient the company is at acquiring and using raw mate­rials for its products. Different industries tend to experience radically different gross margins based on (a) inherent cost of goods sold within those industries, and (b) level of price competition.

Your company can tolerate a negative gross profit in its first year while you figure out pricing, find best suppliers, and hone manufacturing and internal processes. However, by year 2, you had better have a positive gross profit.

New companies rarely emerge in industries where gross margins are low. Reasons should be obvious: investors will likely not see a return on their investment based on an ROE calculation.

Here are some ideas on how to increase gross margins:

  • Decrease cost of raw materials. This is the most straightforward method to reduce cost of goods sold, and yet it is the most dangerous because of potential to adversely affect product quality.Some ways are: (a) find alternative suppliers, (b) replace expensive components with less costly substitute components, especially when customers are unlikely to perceive the difference, (c) use less of a raw material in your product, and (d) purchase in larger volumes
  • Outsource, insource, offshore, or onshore. Find the lowest cost source of doing tasks while still maintaining acceptable levels of quality.
  • Increase prices.
  • Change the product. If your product cannot be sold profitably, consider selling a simpler product that solves fewer customer problems and price it lower. Or consider selling a larger product that addresses more customer pains and price it higher. Or maybe you should rent or lease the product instead of selling it?

Fatal Flaw 3: Insufficient Cash from Operations

The top third of the annual cash flow statement captures cash flows in or out of the company that result from the core business of the company. The bottom line of every column of this top third is always labeled “Net Cash Provided (Used) by Operating Activities.” It tells you (based on all the assumptions you have made about your company) how much cash the company’s business is generating without the contributions of loans, investments, or sales of property.

Almost all startups experience negative cash from operations for the first few years. During this time, they rely on infusions of cash from external sources such as investments or loans.

However, a successful company must at some point be self-sufficient; it must be able to sustain itself with being on life support.

It is possible that a high-growth company with a huge market could plan to stay on a high-growth trajectory for many years and continue to need capital infusions to fund its growth. So, I guess the best way to describe this fatal flaw is to ask if the cash from operations would be positive if the cash from financing were set to zero.

Fatal Flaw 4: Current Ratio Less than One

On the annual balance sheet, divide current assets by current liabilities for each year. This current ratio gives you a pretty good indication of whether your company will be in a condition to pay off debt when it becomes due.

A value less than 1.0 indicates that the company is going to have problems, although there could be short-term fixes for short-term problems. As your company evolves, your current ratio should become (and remain) above 1.2.

If your current ratio is less than zero, it means your current assets are negative (current liabilities can never be negative), so this is equivalent to fatal flaw 1.

Fatal Flaw 5: No Profit

Near the bottom of every column of the annual income statement is a row labeled “EBITDA,” short for earnings before interest, taxes, depreciation, and amortization. You can think of it as the company’s profit (without some of the “noise”).

Most startups experience negative EBITDA for the first one or two years, and that is okay. In fact, it is highly unlikely to have positive EBITDA during those first few years.

However, by year three or so, EBITDA should be positive, and stay positive for the remaining years.

Summary

Although many dozens of potential problems can be detected in advance by examining the pro forma financial statements, the above five conditions are easy to detect and are almost always fatal for your company if not fixed. If you find them to be present in your company’s financial statements before you launch, don’t launch! Instead, fix your plan.

After you fix the plan, and know that it is possible to succeed, then launch the company. It is always good to start knowing that failure is not guaranteed.

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money? If you’d like to verify that your great business idea makes financial sense, sign up for www.offtoa.com.

Four Things a Balance Sheet Tells You

BS PhotoWhen you plan to start a company, you need to create pro forma financial statements. Pro forma financial statements include an income statement, a cash flow statement and a balance sheet.

Based on a set of assumptions, a pro forma balance sheet shows all the things your company would own (its assets), all the things it would owe (its liabilities), and their difference (shareholders’ equity).

These are the four questions the balance sheet answers for you and your potential investors:

  1. Will you be able to pay your bills?
    – A current ratio less than 1.0 is a fairly good indication that the company is going to have problems. As your company evolves, your current ratio should become (and remain) above 1.2.
    – Net working capital defines the cash you have available for paying off debt and running your company on a day-to-day basis.
    – A negative value means you have a shortfall, and unless something drastic is done (like securing short-term loans), you will not be able to continue as you are.
  2. Where are you getting capital from? The debt to equity ratio (D/E) tells you what proportion of your capital is coming from loans vs. investments.– A value of 1.0 means that you are getting half from loans and half from investors.
    – A value greater than 1.0 means that more of your money is from loans and less is from investors. The disadvantages of this are that you must continually make payments on loans (this drains cash and decreases profits), and loans are extremely difficult for start-up businesses to secure without collateral. The advantage however is that you will likely be able to maintain more ownership.
    – A value less than 1.0 means that more of your money is from investors and less is from loans. This is more typical for a start-up.
    – 
    There is no single right value for a D/E ratio for a start-up. The two primary drivers of what will be the right value for you are: (a) the standards for your industry, and (b) your comfort level with debt.
  3. How efficiently are you using investors’ money to produce profit? Return on equity (ROE) tells you the answer.
    – Most start-ups will have a negative ROE for the first 1-2 years, and will eventually have a positive ROE.
    – For publicly traded companies, a ROE of 15% to 20% is considered good, but this measure is not so important for a start-up. On one hand, most investors are more interested in the internal rate of return (IRR) on their investment upon an acquisition than the annual ROE. On the other hand, an acquirer is likely to pay a premium price for a company with a high ROE because it indicates a more solid company.
  4. How quickly are you moving your inventory?
    – If higher than industry averages, you run the risk of running out of stock. If lower than industry, you run the risk of spoilage and/or obsolescence.
    – If much higher or lower than the rest of your industry, have you explained what specific strategies you will be implementing to make that happen? One does not achieve such changes without specific actions.

Let’s take a look at a balance sheet to understand how these four questions get answered.

The figure below shows a balance sheet for the first five years of a company.

Sample BS

All balance sheets are organized into two basic parts – (1) Assets and (2) Liabilities & Shareholders’ Equity:

Assets

Assets are a list of all items that the company “owns.” Two kinds of assets exist: current and other. Current assets are those that can be easily converted into cash in a reasonably short period of time, specifically one year.

Assets include:

  • Cash (or cash equivalents) – a statement of any assets that can be converted into cash almost instantly.
  • Accounts receivable – amounts owed by your customers for products they have purchased.  You have booked the revenue, but have not yet received their cash payments.They are considered current because it is assumed that customers will be paying you soon.
  • Inventory – considered current because it is assumed that you can sell it to customers (or if you are a manufacturer, you can transform the raw materials or work in process into finished products, which you can then sell to customers) within a year.
  • Total current assets – the sum of the previous three items.
  • Fixed assets – the major purchases that you have made, less their depreciation. It is shown on a line labeled property, equipment, and improvements, net.
  • Total assets – the sum of the fixed assets and current assets.

Liabilities and Shareholders’ Equity

This section contains current liabilities (i.e., money the company owes that is due within 12 months), other liabilities (i.e., money the company owes that is due later than 12 months) and shareholders’ equity:

Liabilities include:

  • Accounts payable – items purchased from suppliers or vendors, booked as expenses, but not yet paid for. It is considered current because it is assumed that you will pay it soon.
  • Accrued liabilities – expenses (such as salaries for your employees) that you incur on a regular basis but do not pay until the following period. Since most start-ups pay their employees monthly, accrued liabilities at the end of any month (and in fact at the end of any year) will equal one month’s payroll.
  • Short-term debt – the balance of all your loans (both those that are due within 1 year and those payments that are due within a year for longer term loans).
  • Total current liabilities – sums the previous three items.
  • Long-term debt – the balances of all loans due after one year.
  • Shareholders’ equity   – composed of two parts: (a) paid-in capital, i.e., the actual amount that investors paid for their stock, and (b) retained earnings or accumulated deficit, whichever applies, copied directly from the cum net entry of the income statement.

If all calculations are done correctly, the sum of all assets should equal the sum of all liabilities plus shareholders’ equity.

Financial Ratios

Below the balance sheet, some companies report values of some standard financial ratios. These often include:

  • Current ratio. Your current assets divided by your current liabilities; both of these values appear right here on the balance sheet.
  • Net working capital. Your current assets minus your current liabilities (it’s not really a “ratio”!); both of these values appear right here on the balance sheet.
  • Liabilities/equity (aka D/E aka debt-to-equity ratio). Your total liabilities divided by shareholders’ equity; both of these values appear right here on the balance sheet.
  • Return on equity (ROE). Your net income after tax (from the income statement) divided by shareholders’ equity (from the balance sheet).
  • Inventory turnover. Your cost of goods sold (from the annual income statement) divided by the average inventory (from the balance sheet). Average inventory is generally calculated as the average of inventories at the beginning and end of the fiscal year. Inventory turnover is a measure of the number of times during a year that the entire inventory is sold (or otherwise used). It is highly dependent on the industry. Thus, for example, a fresh seafood retail business would expect an inventory turnover of around 365, while an art dealer would expect an inventory turnover of around 2.

The balance sheet differs from the pro forma income statement and the pro forma cash flow statement.  The pro forma income statement, which tells you if you will be making revenues and profit, and the cash flow statement, which tells you where your cash will be coming from and going to, are dynamic reports.  They show you what will be happening over periods of time.

Unlike those reports, the balance sheet shows you the state of your company at a point in time. It shows you what your company would look like if the calendar and clock could be stopped for just one moment; it is like a snapshot, showing you everything the company owns and owes at that moment.

In the case of a person, the difference between what you own and owe is your net worth. In the case of a company, that difference is the shareholders’ equity.

Using your balance sheet is the best way to view everything the company owns and owes at that moment.

 

Other articles you may find helpful in the series:

Al Davis is a Serial Entrepreneur, Angel Investor and Author of six books. He is CEO of Offtoa, Inc., his fifth startup.

Photo courtesy of Simon Cunningham (Creative Commons).

Why My Startup Need Pro Forma Financial Statements

by Al Davis and Nicola Roark

Money launchWhen you plan to start a company, you need pro forma financial statements.  Pro forma financial statements include an income statement, cash flow statement and balance sheet.

Do these really matter or could you take your great idea, score some investment money and get your product to market more quickly without pro formas?

This question puzzles a lot of startups so let’s answer it.  While there’s no wrong answer, each path has its own likelihood of success:

No pro forma financial statements = low probability of success

The reason this path has low probability of success is not because you don’t have a great idea!  Your idea is probably fantastic but it’s even better when you can back it up with financial assumptions that make sense.

The reality is that investors place their bets on startups less than 3% of the time[1].

And when they bet on a startup, they demand pro forma financial statements and at least some kind of detailed plan for the business.

The other 97% of their money goes to businesses that have already been through rounds of funding and have demonstrated that there is a market willing to buy their product.

Pro forma financial statements = high probability of success

Investors take their risks with those that have a reasonable chance at being successful and returning their investment, plus some, to them.  Investors want to know when to expect a return on their money.  Pro forma financial statements tell them that.

Let’s take a quick look at the pro forma financial statements that all investors expect from a startup. Understanding the value of each adds tremendous power to running your business, growing your business, and to the proposition you make to investors.

Your pro forma income statement (also called profit and loss statement, or P&L statement) is the tool used by businesspeople and investors to determine if a company is profitable (or not) over a period of time.

It shows what the revenues, cost of goods sold, expenses, and profits of a company would be, based on a set of given assumptions. Your income statement answers seven questions for you and your potential investors.  To learn more about these questions and their answers, read Seven Things an Income Statement Tells You.

Using your income statement is the best way to find out how efficient your company is in generating that profit from the sales.  These are imperatives for launching and running a viable business.

Your pro forma cash flow statement shows all cash that you expect will come into the company and all cash that you expect will go out of the company during a period of time based on your stated assumptions.

Many new entrepreneurs confuse cash with profit. Your company could be profitable (as reported on your pro forma income statement) and you could still run out of cash.

The cash flow statement answers four questions for you and your potential investors.  To learn more about these questions and their answers, read Four Things a Cash Flow Statement Tells You.

Your pro forma balance sheet shows all the things your company would own (its assets), all the things it would owe (its liabilities), and their difference (shareholders’ equity), based on your assumptions.

The balance sheet answers four questions for you and your potential investors.  To learn more about these questions and their answers, read Four Things a Balance Sheet Tells You.

Understanding the value of your pro forma financial statements is not only a benefit to you and your business, it’s an expectation from investors.  They are the compass on your business journey and without them you’ll quickly start drifting.

Using your pro forma financial statements to chart your course, demonstrate your business acumen, and recommend course changes is the most reliable compass you, and your investors, can have.

Al Davis is a Serial Entrepreneur, Angel Investor and Author of six books. He is CEO of Offtoa, Inc., his fifth startup.

Nicola Roark is a Marketing Consultant and Strategist working with entrepreneurs and startups. Her business allows her to do two things she loves; collaborate with businesses who have a dream and develop the strategy and content to take it to market. Visit her website: www.exhilarationmarketing.com or email her: nicola.roark@exhilarationmarketing.com for more details.

How to read a balance sheet for a startup

How to read a balance sheet

When you plan a start-up company, you will need to create pro forma financial statements, including the income statement, cash flow statement and balance sheet. A pro forma balance sheet shows all things the company would own (i.e., its assets), all things it would owe (i.e., its liabilities), and their difference (i.e., shareholders’ equity), based on a set of assumptions. Unlike the income statement and cash flow statement, which report data over a period of time (like a month or year), the balance sheet reports data at a snapshot in time. The figure below shows a balance sheet for the first five years of a company. It is organized into two basic parts:

Assets

A list of all items that the company “owns.” Two kinds of assets exist: current and other. Current assets are those that can be easily converted into cash in a reasonably short period of time, specifically one year.

  • Current assets always start with cash (or cash equivalents), namely a statement of any assets that can be converted into cash almost instantly.
  • If any customers have purchased products, or services and you have booked the reve­nue, but have not yet received their cash payments, the amounts they still owe you are called accounts receivable. The total value of all your ac­counts receivable is the next current asset to be reported. They are con­sidered current because it is assumed that customers will be paying you soon.
  • The next current asset listed is the total value of your inventory. It is considered current because it is assumed that you can sell it to customers (or else, if you are a manufacturer, you can transform the raw materials or work in process into finished products, which you can then sell to customers) within a year.

The next line of the balance sheet shows the total current assets, i.e., it sums the above three items.

  • Finally, the only other assets we will be discussing are the residual value of fixed assets, i.e., those major purchases that you have made, less their depreciation. It is shown on a line labeled property, equipment, and improvements, net.

Following this is a line called total assets, which adds the fixed assets to the current assets.

Liabilities and Shareholders’ Equity

This section contains current liabilities (i.e., money the company owes that is due within 12 months), other liabilities (i.e., money the company owes that is due later than 12 months) and shareholders’ equity:

  • If you have purchased items from your suppliers or vendors, booked these as expenses, but not yet paid for them, the amounts you still owe are called accounts payable. The total value of all your accounts payable is reported as the first current liability line. They are considered current because it is assumed that you will pay them soon.
  • Accrued liabilities are expenses (such as salaries for your employ­ees) that you incur on a regular basis but do not pay until the following period. Accrued liabilities are reported on the next line of current liabilities. Since most start-ups pay their employ­ees monthly, accrued liabilities at the end of any month (and in fact at the end of any year) will equal one month’s payroll.
  • The last current liability listed is the current short-term balance of all your loans (both those that are due within 1 year and those payments that are due within a year for longer term loans).

The next line is a subtotal line called total current liabilities, which sums the above three items.

  • The next entry is long-term debt, i.e., the balances of all loans due after one year. The sum of this entry and the entry referred to in the previous bullet should equal the balance due on all outstanding loans.
  • The final entry in this section, called shareholders’ equity is composed of two parts: (a) paid-in capital, i.e., the actual amount that investors paid for their common and preferred stock (sometimes this appears as two entries, one for common and one for preferred), and (b) retained earnings or accumulated deficit, whichever applies, copied directly from the cum net entry of the income statement.

Summary

If all calculations are done correctly, the sum of all assets should equal the sum of all liabilities plus shareholders’ equity.

Financial Ratios

Below the balance sheet, some companies report values of some standard financial ratios. These often include:

  • Current ratio. Your current assets divided by your current liabilities; both of these values appear right here on the balance sheet. It gives a pretty good indication of whether your company will be in a condition to pay off debt when it becomes due. A value less than 1.0 is a fairly good indication that the company is going to have problems, although there are often short-term fixes for short-term problems. As your company evolves, your current ratio should become (and remain) above 1.2.
  • Liabilities/equity (aka D/E aka debt-to-equity ratio). Your total liabilities divided by shareholders’ equity; both of these values appear right here on the balance sheet. It tells you what proportion of your capital you are getting from loans vs. investments.
    • A value of 1.0 means that you are getting half from loans and half from investors.
    • A value greater than 1.0 means that more of your money is from loans and less is from investors. The disadvantages of this are that you must continually make payments on loans (this drains cash and decreases profits), and loans are extremely difficult for start-up businesses to secure without collateral. The advantage however is that likely you will be able to maintain more ownership of the company for yourself.
    • A value less than 1.0 means that more of your money is from investors and less is from loans. This is more typical for a start-up.

There is no single right value for a D/E ratio for a start-up. The two primary drivers of what will be the right value for you are: (a) the standards for your industry, and (b) your comfort level with debt.

  • Return on equity (ROE). Your EAT (from the income statement) divided by shareholders’ equity (from the balance sheet). It tells you how efficiently the company is using investors’ money to produce profit. Although the official definition of ROE excludes preferred shareholders’ equity from the calculation, I would include it for start-ups because so much of equity raised in a typical investor-backed start-up is in the form of preferred stock.

For the first few years, most start-ups are not profitable, so ROE will be negative, and that is okay. If the company has accepted investor money, and plans to share profits with those investors (as opposed to having an exit strategy such as an acquisition or IPO), then ROE will become important once the company becomes profitable. For publicly traded companies, an ROE of 15% to 20% is generally considered good.

  • Net working capital. Your current assets minus your current liabilities  (it’s not really a “ratio”!); both of these values appear right here on the balance sheet. It defines the cash you have available for paying off debt and running your company on a day-to-day basis. A negative value means you have a shortfall, and unless something drastic is done (like securing short-term loans), you will not be able to continue as you are.
  • Inventory turnover. Your cost of goods sold (from the annual income state­ment) divided by the average inventory (from the balance sheet). Average inventory is generally calculated as the average of inventories at the beginning and end of the fiscal year. Inventory turnover is a measure of the number of times during a year that the entire inventory is sold (or otherwise used). It is highly dependent on the industry. Thus, for example, a fresh seafood retail business would expect an inventory turnover of around 365, while an art dealer would expect an inventory turnover of around 2.

Pro Forma Balance Sheet for NewCo, Inc.

End of Fiscal Year
1

End of Fiscal Year
2

End of Fiscal Year
3

End of Fiscal Year
4

End of Fiscal Year
5

Assets

   Current assets:

 

 

 

 

 

      Cash and cash equivalents

104,157

262,084

403,487

1,100,033

2,045,941

      Accounts receivable

833

56,875

141,875

222,824

322,108

      Inventory

26,577

38,257

69,777

138,338

371,875

   Total Current Assets

131,567

357,216

615,139

1,461,195

2,739,924

   Property, equip’t & improvements, net

41,672

33,344

50,012

123,342

88,338

   Total Assets

173,239

390,560

665,151

1,584,537

2,828,262

 

 

 

 

 

 

Liabilities and shareholders’ equity

 

 

 

 

   Current liabilities:

 

 

 

 

 

      Accounts payable

8,402

13,017

20,898

40,823

65,118

      Accrued liabilities

52,917

66,675

58,345

61,258

64,320

      Current short- & long-term debt

0

0

0

0

0

   Total Current Liabilities

61,319

79,692

79,243

102,081

129,438

   Other long-term debt

0

0

0

0

0

   Total Liabilities

61,319

79,692

79,243

102,081

129,438

   Shareholders’ equity:

 

 

 

 

      Common and preferred stock

830,000

1,295,000

1,295,000

1,295,000

1,295,000

      Retained earnings (accum deficit)

(718,080)

(984,132)

(709,092)

187,456

1,385,824

   Total Shareholders’ Equity

111,920

310,868

585,908

1,482,456

2,680,824

 

 

 

 

 

Total Liabilities and Shareholders’ Equity

$173,239

$390,560

$665,151

$1,584,537

$2,810,362

 

 

 

 

 

 

Ratios:

 

 

 

 

 

   Current ratio

2.15

4.48

7.76

14.31

21.26

   Liabilities/equity

0.55

0.26

0.14

0.07

0.05

   Return on equity

(6.42)

(0.86)

0.47

0.60

0.45

   Net working capital

$70,248

$277,524

$535,896

$1,359,114

$2,610.486

   Inventory turnover

0.06

1.04

2.18

3.31

3.29

The above is extracted from my latest book, Will Your New Start Up Make Money? Buy your copy in Kindle at http://www.amazon.com/Will-Your-Start-Make-Money-ebook/dp/B00JOOZQNE or paperback format http://www.amazon.com/Will-Your-Start-Make-Money/dp/0996028307