MBA Mondays - Business 101 for startups by Fred Wilson

Accounting: Analyzing Financial Statements

This topic could be and is a full semester course at some business schools. It is a deep and rich topic that I can't cover in one single blog post. But it is also a relatively narrow skill set at its most developed levels. If you are going to be a public equity analyst, you need to understand this stuff cold and this post will not get you there.

But if you are an entrepreneur being handed financial statements from your bookkeeper or accountant or controller, then you need to be able to understand them and I'd like this post to help you do that. I'd also like this post help those of you who want to be more confident buying, holding, and selling public stocks. So that's the perspective I will bring to this topic.

In the past three weeks, we talked about the three main financial statements, the 'Income Statement', the 'Cash Flow', and the 'Balance Sheet'. This post is going to attempt to help you figure out how to analyze them, at least at a cursory level.

In general, I like to start with cash. It's the first line item on the Balance Sheet (it could be the first several lines if you want to combine it with short term investments). Note how much cash you have or how much cash the company you are analyzing has. Remember that number. If someone asks you how much cash you have in your business, or a business you are analyzing, and you can't answer that to the last accounting period (at least), then you failed. There is no middle ground. Cash is that important.

Then look at how much cash the business had in a prior period. Last month is a good place to start but don't end there. Look at how much cash went up or down in the past month. Then look much farther back, at least a quarter, and ideally six months and/or a year. Calculate how much cash went up or down over the period and then divide by the number of months in the period. That's the average cash flow (or cash burn) per month. Remember that number.

But that number can be misleading, particularly if you did any debt or equity financings during that period (or if you paid off any debt facilities during that period). Back out the debt and equity financings and do the same calculations of average cash flow per month. Hopefully the monthly number, the quarterly average, the six-month average, and the annual average are in the same ballpark. If they are not, something is changing in the business, either for the good or the bad and you need to dig deeper to find out what. We'll get to that.

If cash flow is positive for all periods, then you are done with cash. If it is negative, do one more thing. Divide your cash balance by the average monthly burn rate and figure out how many months of cash you have left. If you are burning cash, you need to know this number by heart as well. It is the length of your runway. For all you entrepreneurs out there, the three cash related numbers you need to be on top of are current cash balance, cash burn rate, and months of runway.

I generally like to go to the income statement next. And I like to lay out a few periods next to each other, ideally chronologically from oldest on the left to the newest on the right. For startups and early stage companies, a 12 month trended monthly presentation of the income statement is ideal. For more mature companies, including public companies, the current quarter and the four previous quarters are best.

Some people like to graph the key line items in the income statement (revenue, gross margin, operating costs, operating income) over time. That's good if you are a visual person. I find looking at the hard numbers works better for me. Note how things are moving in the business. In a perfect world, revenues and gross margins are growing faster than operating costs, and operating income (or losses) are increasing (or decreasing) faster than both of them. That is a demonstration of the operating leverage in the business.

But some early stage companies either have no revenue or are investing in the business faster than they are growing revenue. That is a sound strategy if the investments they are making are solid ones and if they have a timeline laid out during which they'll do this. You can't do that forever. You'll run out of cash and go out of business.