To put the early phase of building a small business into context, consider dating. You remember that, right? Daters find each other through different avenues, get together, gauge their respective interest in one another, and then pursue a relationship or go their separate ways.
If you’re an entrepreneur, you’re following a similar path. You court a variety of concepts, products and/or services until the day you fall in love with a strong business concept. At that point, you may need to find employees to join you in your journey, so you network and continue exploring until you click with the right match.
The similarities don’t end there. To obtain capital, you must build relationships with investors and bankers to demonstrate all the best qualities of your business and convince them you are a respectable partner. There is one aspect, however, of this “love” story that often gets ignored and, unfortunately, is probably the most important element: your financial statements and the underlying data.
For a business owner (or financial director) in the early stages looking for an outside investor, maintaining a sound set of financial statements is not only key to securing capital but is important for assessing the health of your business. Equity investors, banks or any other alternative loan institutions use financial statements to calculate the value of your business, predict growth trends and set loan covenant terms. Current shareholders want to know how the business is doing—or to put it another way, they want insight on returns that are being generated on their investment. As an entrepreneur, producing a set of by-the-book financial statements sends a clear message to investors, creditors and shareholders that you are serious about your business and ready to talk investment.
For small businesses, here are four common financial statement hurdles that must be overcome in order to gain attention and traction from investors and lenders:
1. You aren’t producing financial statements on a regular basis: Sales seem to be up and you just received a big order from a repeat customer. Times are good, so why do you need to prepare financial statements on a recurring basis? This is a common thought process for small businesses because, depending on the size of your business, you “just know” everything that is going on and you are “doing fine.”
Despite what your gut feeling is on the success of your company, you need to produce recurring financial statements for several reasons. For starters, they tell you if you are making a profit or a loss, as well as what cash (if any) you have remaining after paying your bills. Generating recurring (at least quarterly, but ideally monthly) statements can highlight trends and show you areas of your business that may be getting out of control.
For example, periodic analyses of your financials may lead you to understand that you are producing too much inventory and not generating enough sales to cover the costs. Or, perhaps you are making too much of Item A and not enough of Item B, hence, not maximizing your profit potential because you are producing the wrong products at the wrong time.
Additionally, banks will require you to produce financial statements for loan covenant purposes. Certain lenders loan with revenue-based financing, meaning that your company’s repayment of the investment is based on a percentage of your monthly revenue. If you don’t have a complete and accurate set of financials, say goodbye to that funding.
2. Your financial statements are not in accordance with GAAP: Producing a complete and accurate set of financial statements means they are compiled in accordance with U.S. Generally Accepted Accounting Principles (GAAP). This is important not only because banks, creditors, and lenders are depending on your financial statements, to tell the truth about the health of your business, but because you may be accounting for items incorrectly and potentially understating the overall success of your business.
If your business is a software as a service (SaaS) startup, chances are you have a subscription-based revenue model. SaaS subscription-based operations generally have a significant amount of prepaid and recurring contracts or up-front setup fees. If you are not applying the accrual basis of accounting properly, you may be understating deferred revenues or inappropriately recognizing revenues too early.
3. You have forecasts, but no real financial data: As much as you think you know your business, forecasted amounts for startups are almost always wrong. Why? Because during early stages, a significant level of uncertainty exists in several key variables, including the need for your product in the public markets, the reliability, and loyalty of customers and the ever-changing political and economic environments in which we live.
Loan underwriters and bankers need actual financial data, principally recurring revenue stream(s) data, to determine the risk of investment and the price at which your business should be valued. If you have ever seen the television show “Shark Tank,” the “sharks” are only looking for data on what entrepreneurs have done, not what they think they will do. You need to let your business speak for itself in the form of concrete data or relevant stakeholders will not take your business, or request for capital, seriously.
4. You can’t effectively communicate how your business is doing: Don’t run out on me here—this one is important. Perhaps your business puts together financial statements; they are clean (read: in accordance with GAAP) and produced on a regular basis. However, you have no idea what to do with them and don’t understand what information is contained within.
Taking your business (and your abilities as a fearless entrepreneur) to the next level means understanding how to interpret and wield these documents to determine the performance of your business, as well as what potential decisions need to be made. Key ratios should be computed to analyze important factors as outlined below.
One important consideration here is that all ratios should be compared against industry standards in order to compare “apples to apples”; an industry with high inventory (such as retail) is probably not best compared against a tech business that will have higher fixed asset costs and minimal inventory. Here are some important ratios to calculate and understand:
- Working Capital: This is calculated as working capital equals current assets minus current liabilities. This basic equation tells you one important thing: Does your business have enough assets to cover your liabilities. This is useful for measuring operational efficiency and short-term financial health. Positive working capital (i.e., assets are greater than liabilities) demonstrates a company holds enough liquid assets to meet short-term liabilities. Investors utilize this formula as a preview of a company’s ability to maneuver difficult financial periods.
- Gross Profit Margin Ratio: This is calculated as gross profit margin ratio equals (revenue minus cost of goods sold (COGS)) divided by revenue. The gross profit margin ratio is an indicator of a company’s financial health; it tells investors how much gross profit is earned on each dollar of revenue. Compared with a relevant industry average, a lower margin could indicate a company pricing its products too low and not maximizing the market’s willingness to pay higher prices. A higher gross profit margin may indicate that a company can make a reasonable profit on sales, as long as it is maintaining controlled overhead expenses. Generally, investors will be more interested in a company with a higher gross profit margin.
- Return on Investment (ROI): This is calculated as ROI equals (gain from investment minus the cost of investment) divided by the cost of investment. This is one of the most important metrics to an investor, if not the number-one metric. Investors, lenders, and shareholders want to make sure they are receiving a return on their investment in your company; if they are not making/expecting to make a profit, they will look elsewhere—fast. This is an extremely useful pro forma tool to determine the expected profitability of certain efforts or campaigns; if your company will make more money generating interest in a bank account than the calculated ROI on a particular decision, the money should stay put until factors change and the return on investment becomes material. Additionally, ROI can be calculated post-op to answer the question, “What did I get for my money?” This can be an effective conversation starter for setting course on future decisions; continue investing as you are or determine an alternate, more lucrative avenue to focus your capital. Either way, calculating ROI on business decisions provides insight on whether specific efforts are an efficient use of capital and rudimentarily gauges profitability.
Financial Statements may not be the most thrilling things to put together when you’re first starting a business. Your accountant can be a beneficial resource to advise on the format and structure of internally produced statements. He/she can also assist with preparing more formal statements, such as a compiled financial statement, required by investors or lenders. Be sure to discuss financial statement preparation options with your accountant. Although you may not fall in love with the process, compiling complete and accurate financial statements will save you a lot of headaches – and maybe even heartache – down the road.
Do you have questions about conquering financial statement hurdles, or other business challenges? Please contact your MarksNelson Smart Entrepreneurial Services Professional at 816-743-7700.