How not to die because of finance: the basic accounting foundation for your startup

TL;DR: Felipe Mansano, from EquitasVC, shared the minimum that you should know to be able to focus on growing your business, while not letting finance be a problem now and in the future:
1. Understand the big three financial statements: income statement, cash flow statement, and balance sheet;
2. Dominate financial concepts such as accrual vs cash basis, contributing margin, LTV, CAC, working capital, and burn multiple
3. Have cash predictability by applying fourpractices to keep your finances in order when scaling your startup.

A startup is like a soccer team. The marketing, sales, and product teams are the stars, the ones who score goal after goal. And then there's the finance team. You know, the defenders who are always trying to control the game. 

Whenever you think they're overreacting, remember: you can't win a game if you suffer too many goals. The finance team is the necessary foundation so that the stars can shine and the whole team is able to achieve victory.

I found out that a lot of startups don't consider basic finances from the start. When they grow and even become unicorns, the lack of foundation becomes more visible, and the risk of the whole building falling apart only increases.

We don't want your startup to face that same risk either right now, or when it becomes a unicorn. At the first Latitud Nights, I walked founders through what they need to know to not kill their startups. Here are the basics of finance needed to build a strong defense – and win the match.

First, understand the big three financial statements

1. Income statement 

The income statement starts with how much money you made from sales (also known as gross revenues). Each line you go down in the income statement, more expenses are taken from your sales. At the end of the statement, you reach the net income (also known as net earnings or net profit/loss).

The important thing to know about an income statement is that you use it when you need to analyze the profitability of your startup. Use the income statement to review financial indicators such as  contribution margin of your company – we'll talk more about it in a minute.

2. Cash flow statement

A cash flow statement starts where the income statement ends: at the net income of your company. The net income must go through some adjustments, such as capex (money spent on things like equipment and properties) and debt repayment, to get to the last line of the statement: free cash flow. 

That's basically the variation in the amount of money in your bank account: how much you've earned or burned at the end of the period analyzed in the statement, such as a month or a quarter. Your cash flow can be positive or negative.

You used the income statement to check your startup's profitability. Now you can use your cash flow statement to check your startup's runway, or how many months do you have left considering how much you're burning per month.

(If you haven't noticed yet, that's very important. Please don't run out of money.)

Here's how to do the math. Take how much cash you have and divide it by your current or projected burn. Then, you have your runway. If your startup just got a US$ 1 million Pre Seed round, but also burns US$ 100k every month, you only have 10 months left if you don't change your cash burn.

A final observation here. You might be wondering: we're talking about runway considering my startup's burn rate. But what if my business is actually cash flow positive? Well, you have a double-edged sword in your hands. While yeah, life is good, you also start to wonder: could your startup be using that excess money to grow at a faster rate and invest in initiatives that could bear fruits in the long-term?

3. Balance sheet

The balance sheet is the statement that people know the most. On your left, you have your assets, also known as the stuff that you own. On your right, you have both your liabilities and your equity. Stuff you have to pay, and what's left for the shareholders.

The sides must be equal. Which means:
Total assets = total liabilities + total equity

You used the income statement to assess profitability. Then, you used the cash flow statement to assess you runway. Now, you can use the balance sheet to go one step further and assess the health of your business. Some concepts that we see inside the balance sheet and that we'll talk about below are cash position, total debt, and operating working capital.

Dominate these fundamental concepts of startup finance

Accrual vs cash basis

Accrual basis or accrual accounting is when you record your income when you earn it, and an expense when you incur it. On the other hand, a cash basis is you record income when you receive it, and you record an expense when you pay it. 

Basically, cash basis takes into account the fact your customer might pay you in the future, and that your startup might pay suppliers also in the future, through installments and intermediaries such as credit card companies. These are account receivables and account payables. 

In the income statement, all the accounting is made on a accrual basis. On the cash flow statement and on the balance sheet, the accounting is made on a cash basis. 

Remember: companies go bankrupt on a cash basis, not on an accrual basis, because that's how you can see when the money goes in or out and what's left in your bank account.

Contribution margin 

Everybody talks about how the contribution margin is sooo important. But why is it, really? 

The contribution margin answers a simple yet fundamental question: when your revenue is big enough, will you actually have a healthy business? 

You can answer that with a simple calculation:

Contribution margin = net revenues - (variable costs + variable expenses)

Let's explain. Net revenue, also known as net sales, sits right between your gross revenue and your net income, back in the income statement. It means means your sales minus adjustments like refunds and discounts. Some examples of variable costs and expenses are raw materials, shipping, marketing expenses and credit card fees. 

Then, the contribution margin shows how much money remains after you have covered all variable costs and expenses. 

Let's assume you sell a very cheap water bottle. You pay 20 cents to buy it from a wholesaler, then pay 20 cents more in variable costs and expenses such as shipping and marketing, and then sell it to the consumer for US$ 1. Your contribution margin in that case is 60 cents (US$ 1 - US$ 0.40).

The problem is that your payments aren't over. You also have fixed costs and expenses, such as rent and salaries. They're there every month, whether you sell zero or a million bottles. But if your startup has a positive contribution margin, you can calculate how many products you need to sell to also cover those fixed expenses and have a profitable business. 

Yeah, you can't sustain a business with 60 cents. Now imagine that you actually sell 1 million bottles per month. Then, you have US$ 600k in contribution margin. If all your fixed costs amount to less than that, you're golden.

That's when your startup shows a positive contribution margin. When you have a negative contribution margin, you're broke. No matter how many bottles you sell, you will never have a healthy business.

Why would I even dare to scale a business with a negative contribution margin?, you might be asking. Well, it happens all the time and for several reasons. 

Here's how some entrepreneurs think: I have to grow and dominate the market. I have pressure from my investors and need to reach a certain milestone for the next round. And so on. I will fix the contribution margin later.

The problem is that, the later you try to adjust your contribution margin, the harder it is. I compare this struggle to trying to stop a very big and heavy train/plane: you can't make it stop in a short distance. For it to come to a full stop, you'll need a runway (a-ha!).

Even it you want to spend money to grow, figure out how to have a positive contribution margin before scaling you business. Otherwise, your startup will be one more victim on the negative contribution margin hit list.

LTV

‍Now that you know what a contribution margin is, we can talk about lifetime value (LTV). That's how much one of your customers contributes to your company during his time with your business. The enemy of LTV is churn: how much of your customers decide not to be your customers anymore in the same period.

Here's the deal:

LTV = Monthly or annual contribution margin per client / Monthly or annual churn

A very important point here, in terms of LTV calculation, is that you should calculate your LTV not based on revenue. You should consider your variable costs and expenses and calculate the LTV based on the contribution margin. 

CAC 

If you've met LTV, you gotta meet his good mate CAC. CAC is the customer acquisition cost, and that's how you find it in a certain period:

CAC = Total marketing and sales expenses / New customers acquired 

It's good to know that there are several different ways to calculate CAC. (To consider or not consider headcount, that is the question.)

But the important stuff here is to be consistent over time. If you decide on a way to calculate your CAC, don't change it later because you'd like to show better numbers to your investors. They will eventually discover your inconsistency. Bad, bad founder.‍

Working capital

Your operating working capital is the amount of money that you need to run your business. Loud and clear. But very few entrepreneurs know how to actually calculate it. 

We've got you covered:

Operating working capital = (account receivables + inventories) - account payables

We touched upon account receivables and account payables when we were talking about accrual and cash basis. Account receivables are things you sold but your customers still haven't paid you. Account payables are things you have bought from suppliers but still haven't paid them. You need to know your position on both fronts. Inventories is simple: it's the cost of the things you have in stock. If you pay 20 cents per water bottle and have 100 of them in your stock, yout inventories are worth US$ 20.

Burn multiple

To end, we'll talk about a concept dear to software as a service (SaaS) companies. Burn multiple is how much cash you have to burn to grow. The less cash you burn, the better, of course. And this is how you calculate it:

‍Burn multiple = net burn / net new annual recurring revenue

This is heavy, doc. Nah, not really, Marty.

Net burn is another name for burn rate. That's the amount of money your startup loses in a certain period of time, draining your cash reserves and shortening your runway. Remember that?

Now there's net new annual recurring revenue (NNARR). That's the yearly value of new accounts added to your business + new upgrades in value you had in existing accounts - value lost in reduced or closed accounts.

But what even is a good burn multiple? If you're adding more value than burning it, hey, you're doing amazing. Now, if you're getting further and further away from that, we have a problem. 

Check out this summary for burn multiple, or how much did you burn to grow, and see where your startup stands. (You know what you did last summer.)

Ok, so how to have cash predictability?

We know. This is a lot to remember. So, what do you actually need to do daily? Here are some practices to keep your finances in order when scaling your startup: 

1. Keep track of your accounts payables and accounts receivables – especially at the end of month.

2. Send a daily email with finance KPIs to the C-Level executives. The email can feature indicators such as accumulated revenue in the last 30 days; revenue in the previous 30 days and in the same period of last year; projected revenue for the next 30 days; number of clients; and CAC. The constant communication gives a sense to all the leaders on how the operation and the sales are running.

3. You should also send them a weekly KPI email, with 5 to 15 weeks visibility in terms of accounts payables and accounts receivables. This is real data on what's going to happen with your startup's bank account.

3. Discuss projections with co-founders. It's really important to project the following 12 to 18 months, not only to forecast the cash variation and then find out how much money you need, but also to prepare your startup's fundraising efforts. 

4. It's worth remembering: do not scale your business before having clarity of your startup's unit economics, specially its contribution margin. I know that's hard – but it will be even harder harder if you don't work on it.