Running out of cash is a Number 2 reason for startup failures. So how to keep track of your company’s finances and avoid cash disappearing into the void?
Even if you are bad with numbers and find mathematics exhausting, you can use two simple tools to organise your finances: P&L and Cash Flow statements. Profit and Loss (P&L) statement shows If your business is making money or losing it. Cash Flow statement tracks all the movement of your cash.
Although normally associated with bookkeeping and accounting, these statements can help your business a lot. So let us look at the P&L and Cash Flow, compare them, and do some counting to get the hang of the tools.
Keeping Financial Accounts vs. State Reporting
In this article, we will not be talking about financial reporting, or taxes, or any other aspects of your company’s relationship with the state.
Instead, we will be talking about keeping track of your finances for your own benefit, so that you can see how healthy your business is, understand its strong and weak points, and avoid running out of cash.
Good knowledge of the finances is also a significant benefit when presenting your company to investors.
And as an added bonus, the financial information you record can be a great help to your accountant when time comes to pay taxes and submit financial reports.
Profit and Loss (P&L) Statement
The P&L statement shows your revenues and expenses for a period of time: a month, a quarter, or a year. The bottom line of the P&L statement is the difference between the revenues and expenses over a period of time. If the difference is positive, it is profit. If the difference is negative, it is a loss.
As a general practice, the revenues are reported when earned, and expenses — when incurred. For example, the revenue from a sale is reported as soon as goods and services are supplied, even if the buyer has not paid you yet.
If you buy an advertising service for October — you report it in the P&L statement for October, even if you pay to an advertising company in September.
Let us take a look at the P&L statement of “ChocoLife”. “ChocoLife” is a small company with two employees which produces chocolates in a rented kitchen space. Here is their P&L for March:
In Revenues, “ChocoLife” recorded monthly sales of chocolates. In March, one batch was returned due to quality issues. This is indicated in “Returns, refunds, etc” and is to be subtracted from the revenue. Revenues minus refunds give us the Net revenue:
$10,000 – $500 = $9,500
Cost of goods for “ChocoLife” includes the costs of cocoa and other ingredients used to produce chocolates. In March, “ChocoLife” used $2,500 to purchase these ingredients. What you include in Cost of goods depends on what you produce. For instance, if you are running a SaaS (software as a service) company, your cost of goods will mainly include server maintenance and hosting expenses.
Gross profit is the difference between Net revenue and Cost of goods:
$9,500 – $2,500 = $7,000
If you sell several products, it is convenient to include separate lines of revenue, cost of goods and gross profit for each product. This way you can clearly see which product brings you more money.
Expenses are “operating costs” of the company which include all costs of running a business on a day-to-day basis, e.g. rent, salaries, advertising, supplies for the office, accountant fees, and business travel. For “ChocoLife”, operating cost consists of salary ($1,500), rent of the kitchen space ($800), supplies like chocolate forms ($100), travel to Chocolate Fairs ($150), and advertising ($200). In March, all that cost $2,750.
In P&L, you should include the expense categories according to the needs and structure of your business. The goal here is to cover ALL the operating expenses.
EBITDA concludes the P&L statement. EBITDA stands for “Earnings before Interest, Tax and Depreciation” and is calculated as Gross profit – Expenses:
$7,000 – $2,750 = $4,250
Positive EBITDA shows that the company is making a profit. Good job, “ChocoLife”!
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What You Can Learn from P&L
EBITDA shows if a business is capable of making profits. The changes in EBITDA over time indicate if the business is going in the right direction: reducing the cost and increasing the revenue.
“ChocoLife” made a profit of $4,250 in March. Now they know they can invest some of this money into better supplies to produce better chocolate.
What else can you learn from looking at a company’s P&L statement? First, you can calculate gross margin and net margin of a business. Margins show by how much company’s revenue is higher than the cost of producing the goods (gross margin) and the total costs (net margin).
Larger margins usually mean a viable business model. An entrepreneur can also look at the margin to decide if the price is correct and provides a sufficient profit.
How to figure out if the margin is large enough? By comparing your company’s margins to the industry average and to the margins of companies similar to yours. Be sure, potential investors will do it.
Gross margin is calculated as Gross profit/Net revenue, and net margin is calculated as EBITDA/Net revenue. Margins are expressed at percents.
In March, “ChocoLife” had a gross margin of 75% and net margin of 49%. If the average margins for chocolate-making industry are 60% and 30%, “ChocoLife” has an attractive case to present to potential investors.
You can also use a P&L statement to make projections for the future profits using expectations of sales and cost. Realistic P&L projections are a great tool to help in business decision making, for example, deciding if you can afford to invest in a new software, or if you can hire more people.
Finally, with the P&L statement, you can see the structure of the expenses and how they affect the revenues.
The owner of “ChocoLife” Emily sees that advertising cost share is growing over time, while the revenue stays the same. This might indicate that the company is using wrong advertising channels or a wrong advertising partner.
Looking into advertising budget, Emily understands that a lot of money is spent on contextual ads on the news websites which do not bring any new customers. Chocolife also produces expensive videos for Youtube that only get about 50–60 views each. Emily solves the problem by changing the contextual ads targeting and testing Instagram stories instead of Youtube.
Cash Flow Statement
Cash Flow statement tracks how much money came into the business during a period of time and how much money was paid out during the same period. As a result, Cash Flow statement shows how much cash is available to the company at the end of each period.
Even if your P&L statement consistently shows nice profits, you can still end up having no cash to pay taxes at the end of the year.
Even if your P&L statement consistently shows nice profits, you still can end up in a situation when you do not have enough cash to pay taxes at the end of the year. P&L and Cash Flow include different items and serve different purposes: P&L shows the viability of the business model, and Cash Flow reflects the financial health of the company. That is why it is important to pay attention to both.
Here are the main things to keep in mind when making a Cash Flow statement:
- In a Cash Flow statement, all revenues and expenses are registered when they are actually paid, i.e. when money came into the company’s account or left it. So if you sold a batch of goods in April but the money was only transferred to you in May, this operation will appear in the Cash Flow statement in May, but in the P&L this will be in April.
- Some expenses do not appear in the P&L statement but should be included in the Cash Flow. For example, loans and investments (for example, a purchase of a new 3D printer) are recorded in the Cash Flow but are not indicated in the P&L.
Let us look at the “ChocoLife” Cash Flow statement for March.
Opening balance is the amount of money the company has at the beginning of the period. This is money available for use (on a bank account, in cash, or any other form of money). At the beginning of March, “ChocoLife” had $500 on its bank account.
Cash incoming is all the payments the company received during the period. This includes payments for goods and services, loans received, payments from debtors — all the money transferred to the company. For “ChocoLife”, cash was coming from the sales of the chocolates and from a $1,000 loan:
$6,000 + $1,000 = $7,000
From the P&L, we can see that in March “ChocoLife” sold chocolates for $10,000. However, the buyers delayed the full payment and paid only $6,000, which is shown in Cash Flow. We also see that the loan of $1,000 is recorded in Cash Flow but not in P&L.
Cash outgoing includes all payments that were actually made by the company. “ChocoLife” made payments for its purchases, salaries, rent, and advertising:
$5,000 + $800 + $1,500 + $50 = $7,350
“ChocoLife” purchases included $2,500 paid for the ingredients (Cost of goods in P&L) and $2,500 of the investment in a new technology of diet chocolate production. Also,“ChocoLife” purchased advertising services for the amount of $200 (appear in the P&L) but paid only $50 (in the Cash Flow).
Monthly balance is an increase (if positive) or decrease (if negative) of cash on the company’s accounts by the end of the period. It is calculated as Cash incoming – Cash outgoing. In March, “ChocoLife” had a negative Monthly balance:
$7,000 – $7,350 = – $350
Closing balance shows the amount of money the company has at the end of the period. This value travels to the Opening balance of the next period. Closing balance is calculated as Opening balance + Monthly balance. “Chocolife” had a negative monthly balance, so there is nothing to add up, and we deduct instead:
$500 – $350 = $150
What You Can Learn from Cash Flow Statement
Build good habits.
Keeping your papers in order will also help in making your accounting more accurate.
The main purpose of the Cash Flow statement is to show you where the money comes from and where it goes. The Cash Flow statement is also a good tool to use for future projections, for planning your investments or tax payments, and for understanding if you need new loans or external financing.
If you see that your Cash Flow balance is often negative while the P&L statement indicates profits, your business might have a problem with delayed payments. Or you are investing too much without sufficient financial basis, or spending money on some activities that do not bring profit.
“ChocoLife” P&L shows a nice profit of $4,250 in March. At the same time, the company ended up with a negative Monthly balance in Cash Flow. This happened because some of the payments were delayed by byers, and because the company made investments in a new technology.
Negative Monthly balance is not a reason for concern if it happens once in a while. However, if “ChocoLife” is experiencing a negative cash balance for some time, it should look at the reasons and adjust the investment strategy. For instance, frequent delays of payments can be solved by updating the contract, and new investments can be funded with external financing.
If you present your company’s Cash Flow and P&L statements to investors, they will look both at your profits and cash generation. If the incoming cash consistently does not cover your monthly cost, the business model might not be sustainable in the long run and the company will need significant external inflows of money.
Cash Flow projections can be used for company valuation, as well as the EBITDA projections. Valuation of a startup is not straightforward and different methods can be applied. Investors might prefer using expected cash flows or profits, depending on the business model, industry, and the stage of the business development. In any case, they will appreciate it if you have transparent financial statements and realistic projections.
How to Organise Your Financial Records
Start tracking your money the moment you spend the first dollar. This way you will have the full picture at any point of time.
Many entrepreneurs, especially at the early stages, organise their financial records in Excel. To do that, you will basically need two tables: one for P&L and one for Cash Flow. You can also use free or premium online accounting software (like FreshBooks, Xero, ZohoBooks). The choice will depend on your Excel skills, preferences and the complexity of your business model. If you are using Excel, keep your files in a cloud service (Dropbox, Google Drive, or similar) to avoid losing them.
In Excel, you might find it convenient to have all the operations with money in separate tables, where you can put them in as soon as they happen. This way you can always double-check if some weird number pops up in one of the statements. You can also easily arrange that your P&L and Cash Flow tables are filled in automatically as you fill the tables with your revenues, expenses, and cash operations.
Generally, you will need to update your P&L statement every month. If you are running a business where the number of transactions is high, you might consider updating your Cash Flow statement more frequently than your P&L (for example, every week instead of every month). This way you will minimise the risk of unexpectedly running out of money. Even if your statement tables are filled in automatically, it is a good practice to look at them regularly to see how your business is going.
To avoid any mistakes ask your online accounting services provider to explain all the details.