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Lesson 1: Financial planning tools
Chapter 1: Financial planning tools
Nathan Monk, a senior strategist for the MaRS Information and Communications Technology (ICT) sector, guides you through the basics of basic financial tools, such as the balance sheet and income statement.
Financial statements are useful tools for analyzing your startup's financial position and performance. Of these tools, the balance sheet and income statement are essential and you'll need to get familiar with them. These statements are usually followed by the cash flow statement, another important tool for any startup.
The balance sheet is the critical “what-do-we-have?”-statement. It shows what you own, listing assets such as cash, accounts receivable and equipment. It also shows what your startup owes, including listing liabilities such as accounts payable and loans.
The income statement is the “what-did-we-do?”-statement. It's a profit-and-loss record of your startup, showing your financial performance over a fixed time period. The income statement accumulates information over time.
A cash flow statement shows the sources and uses of cash over a fixed period of time as well. This statement will inform you where your startup is receiving its cash from and what you're spending it on. Understanding how these statements work and utilizing them effectively are essential components of running your startup.
Chapter 2: Financial statements
Andrew Graham, Co-founder and CEO of Borrowell, dives into the world of financial statements and metrics.
I think, as an entrepreneur, understanding the key financial metrics that drive your business are really important. What a financial statement is, is sort of just a standardized way of putting some of those metrics together.
So, financial metrics like “are you making money?”, “are you spending more money than you're earning?”, are really important, because first of all, they help you understand if you're actually producing something that customers want. Second of all, they help you
understand how long you have to stay in business. I mean, the nightmare for any CEO is running out of money, and not being able to pay your employees. And you want to make sure that you're looking closely at those kind of metrics to understand where your business is heading. Do I need to raise money? Do I need to raise prices? Am I on-track or off-track with my product strategy?
There are really three key financial statements for any business. You have the balance sheet, first of all, and that's a view at a point in time of assets and liabilities. So, “how much money is in the bank? How much do your customers owe you against liability?” So, how much do you owe, how much have you borrowed. The difference between those gives you sort of a quick sense of what the company is worth, at least by that measure.
The balance sheet is a look at a business at a specific point in time. For example, December 31, these are the assets. So the cash, the receivables from customers that the business has claimed at that period of time, and then it's also the liabilities, the debts that are owed, and the suppliers to whom money is owed at that exact same period of time. So it sort of gives you a snapshot of where this business is at. Does it have more assets than it does liabilities, or not?
An income statement has three key parts. First of all, revenue. That's the money that your business is earning. So, maybe you're selling a service, or you're selling a product customers pay for—that’s your revenue. The next portion is expenses and that's what your business is spending. So, on salaries. If you're selling a manufactured product, it's what you pay to make the product. Finally, what's leftover is your profit or your net income. Those together make up an income statement. So, an income statement tries to match revenue and expenses to the time period in which it's earned. It uses what's called “accrual basis” for accounting.
A cash flow statement cares about where the cash is coming from and going. So, why do these two statements differ? Well, let's take the example of someone buying an online music subscription, and let's say they have to pay for 12 months upfront. You put down your $120 for the year and you put it down upfront. So, the cash flow statement's going to record $120 of cash coming in the business. The income statement though, is going to say hold on, we're not actually earning all of that cash in the first month. We've got to deliver a service for 12 months, so let's spread the revenue out over the 12 month period. That's why an income statement and a cash flow statement will often look different.
The final statement is a statement of cash flows and that looks at the same sort of information as an income statement over a period of time like a year, but does it from a cash perspective. So, what cash has come in the door? Either from revenue or from
financing? And what cash has gone out the door on expenses, salaries, etc? So, cash flow, very simply, is the money that's coming into a business and out of a business on a day-to-day basis, weekly basis, or monthly basis.
The reason it's so important is because cash really is the lifeblood of any business, any organization. You need to be able to pay your rent, you need to be able to pay your employees. If you can't do that, you're going to have really big problems. Even if you're two months away, three months away from a big success, none of that matters if you suddenly go out of business.
So, looking at cash and understanding cash—if you don't take anything else away from the ideas in financial planning—take that away: cash matters the most. It’s the thing you've got to keep the most track of, because if you run out of cash, you're not going to be able to pay your employees, you're not going to be able to pay rent, and you're going to disappear.
And if there's one job that you have to do as a CEO and as a management team, it's stay alive. It's keep yourselves in business. That really is what I think being a startup is ultimately about. You've got to be there to ship the next product, to get the next customer, to survive until the next day.
I think too often there can be a temptation to look at a business and say, “Wow, they've got a lot of employees, or they've got really nice offices, they must be doing really well.” Well, those are all things that take cash. And actually what's most important is, is the business able to generate cash? Is it able to earn cash, at least over the long-term?
I don't think anything ultimately is more important than focusing on that and saying how do we make sure we stay around to be successful? The first financial event that happens in just about every startup is the founder or the founders investing their own time and money in the business. Whether it's a few dollars to get things going, or more importantly, and more often, quitting a well-paying job to work full-time on a business idea. That's typically the first, and in many ways, most important financial event, at an early-stage startup.
From then on, startup founders do what's called bootstrapping, which is sort of making stuff happen with very little resources. I mean, in some ways, that's what a startup is all about. Can you produce great results with relatively modest resources?
As bootstrapping continues, hopefully you're able to start testing product–market fit or “do I have a product that people want/are people willing to pay for my product?” ideally, and then after that, once there's beginning to be some traction, I think founders can start thinking about raising external money. I wouldn't think about raising external
money too early. I think that's a mistake that founders sometimes make. The most important thing is do I have a service or a product that I think people ultimately will want?
Unit 4: Startup financials
Lesson 2: Financial models
Chapter 1: Build your financial model
Nathan Monk, a senior strategist for the MaRS Information and Communications Technology (ICT) sector, discusses the basics of building a financial model for your business.
Let's take a moment to chat about strategies with your personal funds or seed fund capital. Generally, when you deploy an early capital in the startup, it is for building out your product. Later on, it will be for developing a sales team and expanding your marketing channels.
As your startup grows, creating your operational infrastructure with a reporting and accounting structure in place is the next phase of the startup. Depending on your operating pace in the next 12 to 24 months, you'll have to decide how to allocate capital. Your decisions will depend on how your startup is progressing and should be made with members of your co-founding team and board of directors.
In the following unit of this course, we'll get into how to capitalize your startup. We'll look at options such as debt, equity financing and alternative sources of capital. When you're a non-revenue-generating business, you need to develop a financial model that determines your financial needs. This will become a valuable tool when working with outside investors.
The best financial models are those that can scale with the evolution of your startup. The financial planning tools we talked about earlier will become key components of your financial model as we move forward.
Let's hear from Andrew Graham, co-founder of Borrowell, on financial modelling. Chapter 2: Types of financial models
Andrew Graham, Co-founder and CEO of Borrowell, takes a look at financial modelling and explains bottom-up and top-down approaches.
A financial model is a tool that businesses use—anyone can use—when building your organization to try to understand what the future is going to look like. You know, usually in Excel or some other program like that, you type in, you know, "How much money do I
think I'm going to earn every month?", ”What are my expenses going to be every month?” and “What does that leave me at the end of the month?" That's the very simple way of looking at it.
So why do you want to build a model like that? First of all, to make sure you understand what your business could look like in a year or two if you hit your targets, and that's important for yourself. It also becomes part of the story you're going to tell investors. So when you say to investors, you know, "I'm confident I can sell a thousand of these widgets, and look, I've modelled it out. If I sell a thousand of these widgets in the next year that means I'm going to have revenue of a $100 million.” Without having made the model, you just wouldn't know that.
I think it's also important to know if you sell a thousand widgets at a certain price, does that actually cover your cost, or are you going to have to raise a whole bunch more money in six months? And, you know, that's an important difference. I mean, you need to have that in mind as you're operating your business.
When you're doing financial modelling, there's kind of two different approaches you can take. You can take what's called bottom-up or top-down. And, a bottom-up approach means you're actually looking at individual sales or individual customers to build up to your ultimate sales numbers. So that means, you'd say, “Well look, I think customer A is going to buy five units; I think customer B is gonna buy seven units,” and you actually have a real idea of who those different people are and what their sales are going to be.
When you're doing top-down, you start with sort of overall market size. You say, "The market for widgets in Canada is a $100 million a year and I'm going to capture 3% of it. So my revenue's going to be $3 million.”
Top-down can be a very quick back-of-the-envelope way of assessing whether a business is viable; but really, a bottom-up model shows a lot more knowledge and I think should give investors and your management a lot more comfort.
Key financial metrics for a business really depend on which stage it's at. So when you're first starting, what you may care most about is, "Is anyone using my product, how many users do I have?" The next metric after that is, "Are users willing to pay for it? (So: “What's my revenue?”) And I think the next metric after that is, "Well, okay, people are willing to pay for it, but how much does it cost me to acquire each user?" (So: “Am I earning more per user than I'm paying to acquire them?”) And then after that you sort of say, "Am I earning more from all of my users than all of my expenses in the company?" (So: “Is this business fundamentally profitable?”)
So at different stages of a business’ life, different things are going to matter. You'll
often hear entrepreneurs, VCs and others talk about CAC LTV. They'll say, "What's CAC LTV?" Well, CAC is “C-A-C”, which is customer acquisition cost, and that's how much you have to spend as a business to get a customer. So, if you spend a $1,000 on marketing and acquire 10 customers, your CAC is a $100. It's 1,000 divided by 10.
LTV is long-term value. So what's the long-term value of a customer to you? So let's say someone signs up to buy your product for $10 and you know, on average, a customer's going to buy your product six times. Well, the LTV of that customer is $60. Six times ten.
So when you compare CAC and LTV, that gives you a great snapshot of, does this business work? If you have to spend more to acquire a customer than their long-term value, something's not right there. Versus, if you have to spend a lot to acquire a customer, but their long-term value is very high, that's good. You may have to raise a lot of money to fund that business, but ultimately you have some confidence that you're going to get paid back after a period of time.
I think in the early days of a business when you're still formulating your business plan, before you raise money, and when you're really, really carefully watching every dollar, the first thing you're going to spend money on is not a bookkeeper or an accountant. I think Excel and other tools like that are great for tracking your expenses and making
models, and you should be able to, with your team, do most of that yourself.
As you start raising money or after you've raised money, a bookkeeper is going be someone who's important, because you want to make sure that you keep your books properly. I mean, there are a lot of rules in accounting, rules that you have to follow when you're building financial statements to give to investors, for example. So as you get to be a bit more of a mature company, you want to hire a bookkeeper.
Eventually, you may even want to get your books audited and that's where accountants and others come in. You may need an accountant on your team or you may at least go to an accounting firm and say, "Can you audit my financial statements? My investors want to know that everything's being done appropriately in the financial statements.
