Financial Statement & Startup Financial Model
The financial statements are at the heart of any business. The startup’s past, present, and future financial position tell a story of where the company came from, where it stands today, and where it could be headed. Each financial statement tells a different part of the company’s story. At a high level, the financials are tools the startup founders will use to monitor performance, make projections, determine liquidity needs, seek financing, and measure value.
Financial Statement Basics
Financial Statement Elements:
At the most basic level the 5 main elements of financial statements are:
(1) Assets – anything of value or a resource of value that can be converted into cash
(2) Liabilities – an obligation to pay another party (“paying” can take many forms)
(3) Equity – the book value or value to the owners of the company
(4) Revenue – the income generated by the company, also referred to as sales
(5) Expenses – the costs involved with operating the business
The elements of the financial statements are viewed in relation with each other through fundamental accounting formulas:
Assets – Liabilities = Equity
Revenues – Expenses = Net Income (Loss)
1. Financial Statements:
The basic accounting formulas are built out in greater detail in the form of financial statements. There are 3 key financial statements that every entrepreneur should understand. These financial statements are interconnected and serve different purposes. The 3 key financial statements are:
(1) Balance Sheet
(2) Income Statement
(3) Statement of Cash Flows
2. Balance Sheet (Assets – Liabilities = Equity)
This statement illustrates the company’s total assets, liabilities, and equity as of a single point in time. This statement is also commonly referred to as the statement of financial position. An example of how a balance sheet would be dated is “As of December 31, 2023”.
The most common high-level accounts found on the balance sheet include:
- Accounts Receivable
- Prepaid Expenses
- Buildings / land
- Machinery / equipment
- Intangible assets (patents, trademarks, goodwill)
- Accounts Payable
- Wages Payable
- Loans Payable (Principal & Interest)
- Bonds Payable (Principal & Interest)
- Capital (shareholders’ and/or owners’ equity)
- Retained earnings
3. Income Statement (Revenues – Expenses = Net Income (Loss)
This statement illustrates the company’s earnings over a period of time, based on the revenue minus expenses equals net income (or loss) formula. This statement is also commonly referred to as the profit & loss (P & L) or statement of revenue & expenses. An example of how the income statement would be dated is “For the twelve months ended December 31, 2023”.
The most common high-level accounts found on the income statement include:
- Revenue– Operating Revenue (i.e., Product or Service Sales minus discounts and/or returns)
– Non-Operating Revenue (i.e., Interest Income, Dividends, Commissions, Gains)
– Cost of Goods Sold (i.e., Cost of Goods Purchased and Sold, Cost of Goods Manufactured and Sold)
– Operating Expenses (i.e., Selling, General, and Administrative (SG&A))
– Non-Operating Expenses (i.e., Donations, Fines, Interest, Taxes, Losses)
4. Statement of Cash Flow
This statement illustrates the starting cash balance, the movement of cash into and out of the company, and the ending cash balance over a period of time. This statement is important as it captures cash actually received on sales and cash actually paid on expenses (credit card purchases are an immediate expense; however, the cash does not until you pay the credit card bill). An example of how the income statement would be dated is “For the twelve months ended December 31, 2023”.The most common high-level accounts found on the statement of cash flows include:
- Operating Activities Cash Flow
- Investing Activities Cash Flow
- Financing Activities Cash Flow
The format of this statement may vary depending if you choose to use a direct or indirect method to compile this statement.
5. Statement Financial Model
As mentioned above, the financial statements are interconnected. The connected nature of the financials is typically manifested in the 3-statement financial model. The 3-statement financial model is a common term in business for the dynamic model (usually in the form of a spreadsheet for early-stage startups) which illustrates the company’s financial position in terms of the Balance Sheet, Income Statement and Statement of Cash Flows simultaneously.
This integrated model is the tool that startups will use in some form for scenario modeling, forecasting, financing strategy, performance monitoring, financial reporting, and taxes.
The components of the 3-statement model include details that sit behind the Balance Sheet, Income Statement and Statement of Cash Flows.
The key elements of the 3-statement financial model include (1) Inputs, (2) Assumptions, (3) Calculations, and (4) Outputs.
Pro Forma Financials (Projections)
While the financial model is a tool to help the entrepreneur understand the startup’s past performance and current financial position, it is also used to create performance projections. It is hard to make projections for a company with a short (or no) track record, but it is important to create your projections based on reasonable and supportable assumptions for the business.
Creating supportable projections is a crucial activity for the entrepreneur. Why? This is because projections help the entrepreneur envision and quantify potential future outcomes. For those seeking external funding, projections may also play an important role in communicating to potential investors the prospects for future growth and return on investment.
Creating supportable projections for the startup is a challenging undertaking. Why? This is because a startup has no history. There is no past experience or performance baseline. Fortunately, the entrepreneur has many tools to consider that can facilitate the determination of reasonable projections. A few of these are spelled out below:
1. Market Analysis
From a top-down view, the entrepreneur can project potential future sales by first determining a total addressable market (TAM), then determining the Serviceable Available Market (SAM) and ultimately estimating the Serviceable Obtainable Market (SOM) which is the reasonable percentage of the SAM the startup can expect to attain. Based on this analysis, the entrepreneur will be enabled to estimate either a customer number or a total annual dollar value per each customer, for example, to inform sales projections.
2. Customer Analysis
Once the entrepreneur has a fundamental understanding of the TAM – SAM – TOM of the company, the next step is to understand the customer. Market research or consumer insights research is used by entrepreneurs to get an intimate understanding of their customers.
A better understanding of the customer can help the entrepreneur understand customer preferences, values, attitudes, biases, and, of course, spending habits. This understanding can help inform considerations such as the pricing strategy (which could drive sales projections) or the product strategy, which could require notable investment to allow for prototype iterations and/or feature testing.
3. Operational/Financial Analysis
Knowing your market and your customers are both crucial to any startup. In addition, you should consider how you plan to operate the business and track its financial performance. How can you know how to operate your startup if you have never done it before?
From a financial perspective, one way to get a sense of whether you are on the right track is by benchmarking to peer companies or companies which operate in the same industry. The data points used for such benchmarking are commonly referred to as key performance indicators or KPIs.
KPIs will vary by company and industry, so it is important to know which are most important for your startup. For example, KPIs for tech startups include recurring revenue, gross merchandise value (GMV), average monthly users, daily active users, customer acquisition cost (CAC), lifetime value (LTV), and gross profit margin.