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 Balance Sheet, and the Cash Flow Statement. 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.
From this analysis, you may see why the business is burning cash or burning cash more quickly or less quickly. You may see why the business is growing its cash flow rapidly. I am most comfortable when the monthly operating income (or losses) of a business are roughly equal to its cash flow (or cash burn). This does not have to be the case for the business to be healthy but it means the business has a relatively simple economic architecture, which is always comforting. From Enron to Lehman Brothers, we’ve learned that complex business architectures are hard to analyze and easy to manipulate.
One thing that bears mentioning here are “one time items” on the Income Statement. They make your life harder. If you go back to the Income Statement post and look at Google’s statement, you’ll see that in the first year of their presentation Google made a one-time contribution to the Google Foundation. That depressed earnings in that period. You need to back that one time charge out for a consistent presentation, but you also need to be somewhat suspicious of one-time charges. Companies can try to bury ongoing expenses in one-time charges and inflate their earnings. You don’t see that much in startups but you do in public companies and it’s a “red flag” if a company does it too often.
If the monthly operating income (after backing out one-time charges) doesn’t come close to the monthly cash burn rates, then something is going on with the balance sheet of the business. Many of these differences are normal for certain businesses. My friend Ron Schreiber told me about a software distribution business he and his partner Jordan Levy ran in the mid 80s. They would buy software from Microsoft, Lotus, and others in bulk and sell it in small quantities to mom and pop businesses. Microsoft and Lotus wanted to be paid upfront when the shipped the software but the mom and pop businesses were running on fumes and could not pay until they sold the software. So Ron’s business, called Software Distribution Services (of course), was always out of cash. In Ron’s words, they were a bank and a distribution company and weren’t getting paid for the banking part of their business. All during this time the revenue line and the operating income line was growing fast and furious as desktop software went from a niche business to a mainstream business. Eventually Ron and Jordan had to sell their business to Ingram, a large book distributor who had the financial resources to provide the “banking services”. They made a nice hit on that company, but not anything like what Microsoft and Lotus did even though they grew their topline just as fast as their suppliers.
Ron and Jordan’s business was “working capital intensive.” Working capital is the non cash current assets and liabilities of the business. When they grow rapidly in relation to revenues, it means you are financing other parts of the food chain in your industry and that’s a great way to run out of cash.
So if monthly income and monthly cash flow aren’t in the same ballpark, look at the changes in working capital month over month. We went over this a bit last week in preparing the cash flow statement. If working capital is the culprit soaking up the cash, you need to look at two things.
The first is if the revenues are real. A great way to inflate revenues is to “ship product” to people who aren’t going to pay you. A company that is doing that is operating fraudently so you don’t see it very often. But if someone is doing this, cash will be going down while profits are steady and accounts receivable are growing rapidly. I always look for that in a company that is supposed to be profitable but is sucking cash.
The second is the availability of working capital financing. If a business can finance its working capital needs inexpensively, then it can operate successfully with this business model. In times when debt is flowing freely, these can be good businesses to operate. When cash is tight, they are not.
The final thing to look for on the balance sheet is capex. If a business is operating profitably, and growing profits, but its capex line is growing faster than profits, it’s got the potential for problems. Hosting companies are an example of a set of companies that might be in this situation. Again, the availability of financing is the key. Local cable operators operated profitably for years with big negative cash flows because of capex. The fiancial markets like the monopolies these busineses were granted and consistently provided them with financing to buy more capex. But if that party ends, it can be painful.
This post is three pages long in my editor so it’s time to stop. There is more to discuss on this topic so I’d like to know if I did this topic justice for most of you or if you’d like another post that digs a little deeper. My preference is to move on because I’m getting a bit tired of writing about accounting every Monday, but most of all I want to cover the stuff you want to learn or freshen up on. So let me know.
Great post!But hoo boy, do I have a lot to say here. (Not to contradict you, but to add.)- I think that before looking at cash (agreed, cash is king) or anything else, if you want to look at financial statements, the first thing you need to look at is the accounting *choices*. Accounting is an art and not a science, and the accountants can sometimes record the same event in different ways. It doesn’t mean there’s any fraud but it does mean you need to be aware of it. A great example was an etailer from the 90s, which had booked expected carried back taxes over the previous year’s losses as revenues, and so was showing a “profit”. If you hadn’t read the auditors’ statements regarding that, you would’ve thought that they suddenly became profitable from operations. Not so.- I also think the #1 thing to remember about analyzing financial statements (and the one that b-school students with a “check the box” mentality tend to forget) is that you need to look at the trends OVER TIME. No matter how detailed, a statement for one period is basically useless if you want to *analyze* how a business is doing. Looking at one period is fine if you want to understand the financial statements themselves, but if you want to understand the *business* you need to figure out what are the trends over time. Obviously this isn’t always easy when you’re dealing with a startup’s numbers but even three months’ worth of data doesn’t give you 3 times better insights as one month. It gives you 10 times.By the way, this is why I love using Tracked.com to check out a public company, because the statements are broken out in an easy to read year over year or quarter over quarter format, and you can toggle between absolute numbers and ratios. Yahoo! Finance and others are great if you want to look at *stocks* but before I look at a stock I need to understand the *business* behind the stock and for that I need to look at the financial statements.- You mention working capital without clearly explaining what it is, beyond the accounting notion. I’ve said it before under an earlier post: I think working capital deserves its own post (as does probably, but maybe that’s a bit too technical for what you’re doing here, EBITDA, and how that’s a very useful notion but how it can also trick you sometimes). It’s just a crucial notion. Your example of a working capital heavy business, typically software distribution, is just perfect. It’s great that they got a good exit because if you’d told me about that business, without even thinking I would’ve said: 1- what delays do their suppliers give them? and upon hearing that they pay their suppliers right away, I would’ve said “death spiral.” Working capital can kill you. It can also be magic when you have a low working capital, or even better negative working capital, business (Amazon, Wal-Mart). Either way it’s just crucial to understand it, especially as you try to manage growth in a fast-growing business.
good point about working capital. i might tackle that next week.
In businesses w/ a discrete product revenue and a billing/collection discipline — businesses which make and sell stuff — the turnover ratios and working capital are things which can be and should be managed.You can extract a significant amount of free cash from your business by reducing the working capital requirement which usually entails simply a clear payment policy at the time of sale, timely billing, a firm payment policy as it relates to aging, a definitive collection policy of aged accounts (not ancient accounts but ones which are still collectible) and a scorekeeping mechanism.I once literally freed up or removed $1MM in working capital in a business with only $5MM in annual revenue by simply demanding compliance with the payment terms of the contracts. It took less than 60 days.I simultaneously dramatically decreased “doubtful accounts” because we were beginning our collection efforts before the accounts had aged so long that they became “doubtful”.It was incredibly easy and only required enforcement of the contract terms, a twice monthly aging report and the assignment of the folks who had sold the contracts to make the original collection efforts. I never took anybody to Court though I did threaten a few.
You’re absolutely right that billing/collection discipline is crucial tomanaging working capital, is often lacking in smaller businesses and thatenforcing “obvious” processes can make a huge difference.In some sectors however, it isn’t always as easy as you make it sound,however. Working capital is a huge problem here in France, where vendorfinancing > bank financing.
It is easy if you make your mind up to do it. I find that with most things. Where there is a will, there is a way.I have no absolutely no experience in France and bow to your superior experience in your home markets. I love France and its nuclear power industry amongst all the other things to love.
Don’t get me wrong: by and large I agree with you.The situation in France however is serious and complex. One problem is thatthe court system is pretty slow and has few protections for lenders sothreatening legal action isn’t always credible, because it’s (justifiably ornot) thought more costly.Another is extremely risk-averse banks who fear supplying liquidity tocash-crunched businesses, creating a self-fulfilling prophecy. French banksare in my view astonishingly derelict in their duty to, uh, providefinancing for the economy, but as a former (baby) corporate lawyer I knowthe legal system doesn’t make it easy. In bankruptcy proceedings, theirclaims can be voided if they provided too much financing to a business whichwas “intrinsically not viable.” Of course, by the time you’re in bankruptcycourt, with hindsight you can always find some way to argue the business wasnot viable to start with, whether that was true at the time or not. So theydon’t take that chance — again, creating a self-fulfilling prophecy.Another thing is that in many markets you are dealing with a small number ofactors and so you can’t credibly threaten to take your business elsewhereand so you will prefer to grant delays rather than poison the relationshipby going to court. In these markets you have chains of suppliers andcustomers where everyone owes everyone money and if one goes down it mighttake everyone with them so you’re walking on eggshells. These fears canoften be overblown but it certainly makes that behavior understandable.I could go on and on… This is a very serious problem, one of the keyreasons why French SMEs generally underperform their British/German/etc.counterparts.
Are there factoring or merchant cash advance businesses in France?
Absolutely. But the sector is not very competitive so they’re veryexpensive. It’s one of the few banking/finance activities GE didn’t divestfrom in France because it’s such a cash cow.
Bill early and often, that’s what I always say.
Thanks for putting a focus on what is a top down banking system in which the thousands of businesses that formerly acted as their own “banks” with longer cycle traditional businesses (such as manufacturing, trade, even agriculture) are not being funded.Instead, there is concentrated funding of mega businesses that would not exist if not for their dependence upon the US banking system now that Wall Street is not separated from banking. Thanks for helping me to understand the nature of the problem we face in financing “the banks” of our businesses. Our competitors are borrowing at zero per cent.
very interesting that working capital is defined here as “non-cash” current asset – current liabilities.from an accounting perspective it is always seen as current asset – current liability. and that a positive working capital is good whereas a negative working capital means you are not liquid enough to pay off your st debts in time which can mean trouble.
Zero’d in on -current cash balance-current burn rate-months of runwaymerging that with self funded work with my cofounder. As long as we don’t starve, are learning by building, and making progress towards a great first tool my figures of merit are checked off. We have reinvented the service 3 times since beginning, I suspect a dozen more refinements until it’s easy/fun to use, understand and build onI didn’t fall asleep (too gorgeous outside, aka break out your bike Fred). The analyses of business health through the 3 data forms is actually more than understanding the definitions of each line item. I guess it’s like comparing vocabulary to conversation :), communicating is always more fun.
While Cash is King, Working Capital is the Kingmaker, and single best predictor for future near-term cash flows. Another working capital topic you might want to highlight is the Deferred Revenue liability which is created when a company gets cash today for services that need to be delivered in the future. While getting 12 months (or more) of cash upfront from a customer is a good thing, it can lead to incorrect planning assumptions and lead to real cash emergencies if cash flow implications of all working capital accounts aren’t fully understood. This is why “burn rate” is only 1 of the tools you should use to project future cash needs.
yup, i left out deferred revenue. an oversight for sure
I think one thing you haven’t addressed is the temptation for the entrepreneur to engineer the numbers. Pascal correctly points out there are accounting *choices*. When you’re a start-up there really isn’t much of a need to deal with these choices, but as you grow the temptation is always there, and on that note I say:Engineering the number sucks!I used to subscribe to the theory that a good CFO or Controller “smoothes” the numbers…they ask you what you want the number to be and deliver.Wrong! What a good CFO needs to do is have perfect numbers, ready as fast as possible, with key metrics developed, evaluated and articulated. The entire company can focus on what needs to be improved to improve the numbers. People can see what works and just as importantly what doesn’t.Smoothing the numbers means one thing and that’s manipulating sales higher and expenses lower. Almost nobody “holds back” and the most anybody does really amounts to being conservative. But to smooth numbers you have to “avoid a miss”. The irony is that manipulating these numbers actually causes them to get worse and worse.When you try and goose sales by stuffing the channel, getting customers to buy early, or giving away a ton of extra future value you hurt sales. Not only in the long run, but in the short run. Buyers know when a company is desperate and demand and get better and better terms. Salespeople are spineless when they know in their hearts you will give. All those forward commitments add up. The biggest problem is that huge amounts of time are wasted trying to: “get to the number today” instead of working on how to improve the number going forward.Decreasing expenses by capitalizing them, pushing into the next quarter, or coming up with a special charge has the same effect. Those capitalized expenses get depreciated, not spending if you truly need to is more expensive in the long run (think of maintenance on a car), and if you are a late payer vendors give you a much worse deal.You now have a company that from top to bottom won’t care about the actual numbers they’ll look to engineer the number. It’s the way it works: if management yells and swears, employees will yell and swear. When you don’t care about the actual numbers you can’t improve them.You’ve “crossed the line”. What starts as “just this once” explodes over time. Once you cross the line it becomes easier and easier to get farther and farther away.
All this talk of smoothing the numbers and accounting gimmickry is all the more reason to look at cash first.Cash and cash burn are the absolute most important things to understand if you’re running a start-up. And I’m not saying that burning cash is bad – there are quite compelling reasons to invest in R&D, product development, initials sales and marketing efforts – but understanding the implications of cash burn and runway are paramount.As someone commented on the cash flow post of a few weeks ago – cash doesn’t lie. Sometimes (as you and others have pointed out) the P&L does.
Everything you have discussed is able to be discerned by reviewing the accounting principles utilized and looking at the cash flow statement.While I do not know your industry, most of what you say is also in variance from GAAP. Too many folks think that GAAP pertains only to public companies. GAAP is gaap and should be adhered to like religion.Sales people can only disciplined by tying their compensation to quotas of sales at given levels of pricing over determinant periods of time.
Respectfully, I completely disagree.You can look up Brad Feld and my discussion about capitalizing software development costs. The accountants will fight for it tooth and nail. Its bullshit.Same for taking a three year subscription agreement and marking it to market.
The ultimate obligation of any business professional or accountant is to “fairly” represent the financial condition of the company. To do less is wrong and for a CPA is unethical.Under SOx, CEOs and CFOs are signing financial statements under the pain of perjury. Which in my personal view is not a new development as I always thought that was what I was doing anyway.As I said, “I do not know your industry”, so I bow to your personal knowledge and wisdom as it pertains to software development costs.I have however been involved in a number of industries (real estate, cable TV, multi-unit/multi-state unitary operating businesses) in which the issue of capitalizing the acquisition and start up expenses has bubbled to the surface time and again.The only real risk is that you may have to append an “accouting note” disclosing your failure to adhere to the advice of your auditors or you may risk a “qualified” audit limited to the auditor’s notation again that you have failed to adhere to their advice.My approach always seems to “understate” earnings rather than overstating earnings.When SOx first came out, I immediately expressed my reluctance to adhere to the section 404 requirements to document critical systems. I thought it a bunch of baloney. In addition, it immediately became a cottage industry with every accounting firm offering this service to the tune of $100K +.I simply told our auditors that I refused to comply and that they could annotate away.The implementation deadlines were ultimately relaxed, the big push turned into nothing and a few years later we did our own analysis using Visio. Interestingly enough, our auditors asked us if they could use our work as an exemplar for other clients.Whenever you are fussing w/ accountants or auditors, simply say — I think my approach “fairly” represents the financial condition of the Company. At last resort, present it two ways and let the reader take their pick. In some ways, this is the benefit of being able to do everything on a computer.
We agree with each other.”My approach always seems to “understate” earnings rather than overstating earnings.”My point is that there is a HUGE temptation not to do this sometimes and it comes back to bite you.Its no different than setting the clock ahead so you’re on time…..my wife and I used to fight about this all of the time. The clock is either right or wrong.As for SOX…..they could have done something ten times easier…….if you make over $500k (or some arbitrary big number set at 10 times the average workers wage, where you should have to admit you know much more than anybody what is going on and that’s why you get paid so much money) you sign a document saying if there is a restatement of the period where you made the money, you give up the excess in pro-rata share back to the stockholders…….
I have always been an equity guy who has never been focused on current income so I don’t normally focus much on compensation but I have also been in businesses which generate huge amounts of cash and I feel compelled to get my fair share.I live off my assets and am constantly leveraging and de-leveraging them to create cash flow (which by the way is the only way I intend to generate cash while Mr Obama is in office).I do not want the government in any way in the business of setting wages in the private sector. That fact alone was enough for me to be skeptical about the healthcare bill.
I don’t want to set wages in anyway.I also don’t care about salary.For publicly traded companies and that is what SOX applies to, there has been a disconnect on shareholders controlling salary/getting screwed.There are CEO’s that make 100’s of times than their salary because they started and own a huge amount of shares in their companies…..examples would be Gates, Jobs, Buffet.But if I’m a trader for AIG or an executive for Enron, or Worldcom and I say I made the company $250M and deserve $100M to that I say……first if you could pull that out of your ass in the middle of a field I agree, but fact is nobody would even talk to you unless you had the assets (and shareholders of AIG) behind you, and second if the trade blows up give me back the money.
Incentive compensation is a different animal. I take a bit of a modified EVA approach. I deal with this all the time.The big variable is the value of the “house” account and support. The company may have very high expectations as to its ROI and therefore EVA expectations are very high also.Also, you have to take a bit of a longer view of things. Just because somebody has had a banner year, does that not mean you should not go back and look at a 5 year continuum in which he may have underachieved the EVA expectations of the enterprise as well as his peer group?The toughest element of incentive comp is designing the system.In the end, the incentive comp must apply a golden handcuff for some period of time otherwise your folks will just go out and start their own businesses. In my instance that is exactly what motivated me to go out on my own. An employer took advantage of me when the numbers got very, very big and I said — King’s X, I can do this for my own account. Thanks a lot.If that had not happened, I would probably still be working for them because otherwise they treated me like a champ.
i tried to address all of this in my first post on accounting
I really enjoyed this post, and if you feel up for it I would be very interested in reading more about financial statement analysis.I’ve been trying to teach myself some of these concepts but many of the other articles I’ve found on the Internet have been too simplistic or far too advanced. This was a very clearly written article and taught me a lot and I would love to learn more.
Thought you might find this interesting. The power of Twitter and social media in general during the aftermath of Haiti’s earthquake is pretty astounding.http://www.boston.com/news/…
Are you going to talk about forecasting Fred? I’ve always found the cashflow forecast, plotting actual along with forecast, both in table and graphical format the most useful tool in getting start up management to focus on the length of the runway.
Couldn’t agree more that forecasting is an important topic to cover from the startup management perspective.
Agree! Would love to see forecasting.
Budgeting and forecasting. Two different things.
Indeed different.What I meant there was pro forma revenue forecasting, particularly early on.But now that you mentioned it would love to see what sets off Fred’s bullshit meter vis-a-vis budgeting as well.
just like an accountant is to an analyst
looks like a good topic based on the number of likes and replies you got. i’ll see if i can tackle that one
That sounds interesting to learn about.
my favorite part of the MBA mondays is the subjective ‘this is how i/we look at the numbers’. the basics and details can be found from many sources….but its difficult to find insights into how a VC may look at the numbers, what is most important, etc. i especially appreciate the perspectives on pre-revenue consumer internet as it is a unique beast that few have the expertise or courage to tackle. thanks.
Great post!”So if monthly income and monthly cash flow aren’t in the same ballpark, look at the changes in working capital month over month. We went over this a bit last week in preparing the cash flow statement. If working capital is the culprit soaking up the cash, you need to look at two things.”There are many of us (myself included) who prefer to (more or less) ignore the income statement, and look only at “free” cash flow. It’s hard to get a uniform definition of this, but it’s always some version of net cash-flow less recurring capital expenditures.For the engineers and scientists out there — if you think of a company like an engine, the ration of free cash flow to regular cash flow is like the efficiency. Those capital expenditures are entropy, that your company has to pay to play. Can’t avoid them anymore than the Second Law. But some companies produce a lot less noise and heat than others.One other point worth adding to the discussion — time-averages. It’s very important to look at all of these measures over multiple periods. Anything can happen in a period or two. Sometimes basic order of magnitude estimates can tell you that the rate of change in a given account is not sustainable.If Edward Tufte were to redesign financial statements, I like to imagine that he would do away with the income statement and cash-flow statement, and simply report a time-series of balance sheet accounts, updated daily or weekly throughout the period. Wouldn’t that be a much simpler and more informative way to understand the company?
I agree with what you say but what you say doesn’t have any magic in it. And magic does exist in business whether you call it luck, fate, good work, or good weather. (unlike science)So when it does, it is important to have the vision and that changed things financially.
i love the comparisons between financial analysis and engineering concepts. i started with an engineering education and then learned finance. it was pretty easy to grok finance after getting a solid math and engineering education
A resource I found useful back in my SBDC days was the book, Managing by the Numbers (published 2000). A good discussion of how the different statements work together to give a full picture of the health of the businesshttp://www.amazon.com/Manag…
thanks for the suggestion. i had not heard of that book before
Fred, what I think would be useful as a summary to this great post is a list of commonly used financial ratios and what these indicators tells us from a directional perspective. There are dozens of ratios that management and analysts use, but perhaps focusing on the ones most relevant to startup businesses (e.g. cash flow specific ones) may help.Should you think anyone thats interested to enroll a free online training program on financial statement analysis, let me know and I’ll pass on a link.
ratios is not a strong suit of mineguest post??
A few financial ratios:Acid Test Ratio = (Cash + Market Sec + Receivables) / Current LiabilitiesCurrent ratio = Current Assets / Current LiabilitiesAsset Management:Day’s Receivable = 365/ (Sales / Ending Receivables)Day’s Inventory = 365/ (Cost of Sales / Ending Inventory)Day’s Payable = 365 / (Purchases / Ending Accounts Payable) =365 / (Cost of Sales + End Inventory-Beg. Inventory) / Ending Accounts PayableAsset Turnover = Sales / Total AssetsFinancial Leverage:Long-term Debt to Total Assets = (Current LT Debt + LT Debt) / Total AssetsLong-term Debt to Stockholders’ Equity = (Current LT Debt + LT Debt) / Stockholders’ EquityInterest Coverage Ratio = (Income Before Taxes + Interest Expense) / Interest ExpenseProfitability:Gross Margin Ratio = Gross Profit / SalesReturn on Sales (ROS) = Net Income / SalesReturn on Assets (1) (ROA) = Net Income / Total AssetsReturn on Assets (2) (ROA) = (Net Income + Interest Expense) / Total AssetsReturn on (ending) Equity (ROE) = Net Income / Stockholders’ EquityDupont Analysis:Return on (beginning) Equity (ROE) = Return on Sales * Asset Turnover * Leverage = (Net Income / Sales) * (Sales / Assets) * (Assets / Beginning Stockholders’ Equity)
Sure, would love to – will send you an email to follow up.
Financial statements are kind of like a data dump. You can use them to answer questions about the company. The questions vary at different stages. For an early stage, a question might be, how much capital is the company going to burn before it gets to positive cash flow.For later stage, the question might be, how well does the company perform relative to others, and how much is the company worth in the stock market to a passive minority shareholder.Ratios are summary answers to those questions but depend on a lot of assumptions.Dupont type analysis is not that relevant for startups, I think. Since ROE on GAAP basis is negative and uncertainty clouds the distant time it will turn positive, you have to fall back on non-GAAP ratios like unique visitors / growth of ; lifetime value of customer / customer acquisition cost.Valuation is a topic in its own right and worth its own post… one approach is to look at comparables for various types of investors would pay: income, growth, value, active, strategic, and say a strong holder won’t sell unless they get close to the highest any one of those would pay, or at least some probabilistic blend.
Fred,Suggestion…put ‘social’ in front of it you will SRO (just kidding). Moreover, catch the wave of the strategic, right-brain CFOs…transmute to predictive analytics, ROI, scenario planning, etc. is my $0.02 on this important topic to bring the functional areas into silos of collaboration.Cheers…Steve
You are providing great service to your audience. Thank you. Appreciate how easy it is to read your stuff, especially when you are tackling complex concepts. Like the anecdotes.Certainly wouldn’t ask for more, but if you choose go deeper on FSA, I’m all eyeballs.
Excellent post, thank you.
Great post and discussion starter. I suggest the following bit of context may be useful.1. Understand the accounting principles utilized in making the financial statements as much as what they say. Read the principles and have your financial guy explain them to you.There may be a huge difference between booking “revenue net of doubtful accounts” v “revenue” and an expense for “doubtful accounts”.2. Test for seasonality when looking at the “trends” of the income statements and ratios. Most businesses have a bit of seasonality and the ability to remove that seasonality is important to divining the true trend.This is also where forecasting ties in as you should be looking at the past, present and future all at the same time to ensure your forecasts are based upon reality.3. From the beginning use ratios to establish trend line base lines for your business. Graph them. Liquidity, asset turnover, financial leverage and profitability ratios are like a blood test for a business. When a ratio peaks or drops, it can be a very important leading indicator.It can be an early warning giving you plenty of time to act.4. Use the financial statements, ratios and a smidgen of operating info to create a “dashboard”. Don’t overdo it but just a weekly dashboard can give you a keen insight into how things are going.5. Perhaps the most important thing is to have a conversation w/ your financial guy — ask him if there is anything “going on”. Financial types have a tendency to be a bit introverted and they think you know what they know, so ask and make sure there is nothing cooking you don’t know about.6. Engage in a “brief back” wherein you tell the financial guys what you think the financial statements have revealed to you.7. Make this a formal exercise with a deadline for the receipt of financial statements and a deadline to analyze them.Once you are up and going, have the monthly numbers delivered w/ the analysis prepared by your financial guy. It will become second nature to manage using this approach.Damn, I love seeing a plan come together!
Where Fred’s post is “Analyzing Financial Statements”, yours (which is post-worthy — and you have many more like this) are the adjunct “Effective Management w Financial Statements”.Completes the picture very well — thanks.
It’s funny that almost everything I think about business is from an operating perspective. I guess I have been an operator too long to stop thinking like that. I also have experience on my side or as my mill stone, take your pick.I have seen a whole lot of bright young MBAs w/ mousse in their hair. I have eaten quite a few meals from their chili bowls.I only wish I knew what I know when I was 30.I find one of the weaknesses amongst the VC world is very limited knowledge of operations and a sense that many tools — such as financial statements — are both deal making tools as well as operating tools.I also find myself focusing on “turnarounds”, a class of investment that scares the crap out of the typical VC. Turnarounds are a nice niche — almost no competition, an arcane skill set and low entry pricing. The critical skill is leadership and planning. You are changing the outcome while often using the same ingredients and people. It is also fun.You buy them, you fix them, you sell them.
I completely agree with this…..I also have spent quite a bit of time on turnarounds…..Its tough mentally though…..no matter how I try its impossible to separate the human emotion from it….and I’ve come to think that is a good thing. I can do it for a period of time and then need to get refreshed.
I completely agree w/ you as to the level of emotion involved. Evaporating the emotion is the key to success. I have always preached the mantra of — you can have “jobs” or you can work w/ me and have “secure jobs”. BTW, I have never missed a payroll in 33 years. Gets them every time.I know exactly where you are coming from as it relates to the necessity of re-charging your batteries. Been there, done that. 12 handicap >>> scratch
The point-of-view of a fluent, seasoned operator is necessary to round out these discussions. You, Phil Sugar and a few others on AVC tend to add very richly to this perspective. I pay attention to your collective comments on the topic.The successful business operator is a thoroughbred. The full suite of business skills comes together. So much more than just financial dealmaking (which is important, but still just a blip in time)The typical VC viewpoint (and there are important exceptions to this, including Fred, Brad, Mark S.) is generally limited to Yes/No (overwhelmingly No). Not How. The fact that many NY VCs are ex-bankers exacerbates this operations/finance divide. But this does seem to be shaking out somewhat. They’re not well equipped to assess early-stage opportunities in web services, yet given the low cost of starting up, that’s the part of the investment funnel where the opportunity is.Part of the rub is that you have to show an unaddressed gap in the market, but by definition, if it’s a big gap, they don’t have experience in it. If your market is one they don’t have very direct personal experience in, your pitch is DOA. Why bother asking. It’s a guaranteed No.Better to create a business that feeds itself, with money from people that know you well and trust you.Turnarounds are great. Especially because when they’re sucking wind, they cannot resist change.JLM I’m curious — how do you find them? (Or, do they find you?) Do you underwrite them yourself? How does that all come together?
Finding deals is an art but a very easy art.Check w/ the commercial banks (troubled asset or workout department if they have one) and let them know you are interested in acquiring bad assets and companies as a result of failures in their loan portfolio.You will drink a lot of lattes and you will kiss a lot of frogs and then they will call you. Banks are always the best sellers as they cannot value their losses and they have completely lost the art of the “workout”. They just want to dump them.Second, hang out a shingle as a turnaround specialist. Once you have a couple of heads on the wall, the troubled deals will come to you. When they ask for advice, sometimes the right answer is to sell the company. To you.Third, network like crazy amongst business brokers and see what they have for sale. Pick a price point, minimum revenue, etc. which gets you up out of the weeds and screen for the number. Screen for number of days available as that always indicates a stinker.Learn to say — “When order is made from chaos, value appears.”Look for deals that are small to start with and which can be scaled up. Look for deals for which the biggest problem is money and then raise a boatload of money. Look for family succession issues. Demand and get huge amounts of seller financing.You have to be able to make a financial plan which is comprehensive. Everybody has to become a numbers wizard these days. It is a basic skill. Go to an IB intensive numbers boot camp program even if only half of it is of any interest to you. Even the best MBA schools have to send their grads to these kind of courses. It’s like going to Airborne and Ranger schools.The deals you are looking for used to be called “bootstrap” deals and then LBOs. You want an LBO with blood in the streets, with seller financing and for which your skill set is available at wholesale to solve a retail problem (e.g. they could not raise money, you are a money hoover).
That’s great stuff.At the moment I’m very focused on getting my current startup up and running, as I see a big market gap there which no one’s executing on in the right way.But I always wondered about the turnaround segment at the small-mid-sized business segment. There must be some great assets for the picking right now which if new technology and discipline were injected could throw off really nice cash.A finance refresher is always useful, especially one that is comprehensive from end to end. Many of my b-school friends went through thoughts IB courses….12 years ago when I graduated. <sigh. i=”” am=”” old!=””>I just brought in a great COO who can double-hat on finance and tech. I’m extremely externally focused and decided I need a partner who force feeds me the structure. He is terrific. We are spending many many hours teasing through all previous assumptions. It’s nothing new, on a technical basis, but the fact that it’s my own raises my attention level by leaps and bounds, versus when it’s arm’s length for someone else.It’s greatly enjoyable when you believe it’s a really good market. When it’s a stinker, it’s painful.
The biggest money making opportunities in the world will be to inject capital coupled with modern operational management, better financial leverage, modern marketing expertise and technology in general. Do this w/ old line businesses which have demonstrated a bit of longevity and staying power.Why? Cause you CAN teach an old dog new tricks, but only if you know the tricks that the old dog needs to learn.Look for businesses which are family owned (typically poor operational management), strapped for cash or otherwise not adequately capitalized, are not using the web or social media to market and which can improve with technology (silly example, cameras on the POS).Only buy businesses which do NOT have a written strategic plan.
Attempt 1: Cash is king/queen.Attempt 2: Cash is royal.
Cash is king. I go to business school in Manhattan and I made sure I had my business plan’s financials checked-out by my teachers and my friends who are Finance majors like myself.
Those of you who find financial statement analysis interesting may be interested in the Altman Z-Score model (and its variations), which are tools for predicting whether a company will default within the next year or two, based on a handful of key ratios that include balance sheet and income statement items.
These Monday posts rock. Thank you very much.
Fred,I am loving the MBA Mondays series. Despite the fact that these are many straight up MBA topics, it isn’t too dry, and I appreciate your perspective.Thanks!
Cash is an extremely key metric but is not a stand alone metric. I think you need to look at cash and cash flow relative to revenue growth and unit economics.The key is can you drive revenue that is incremental to Cash Flow and the cash balance.The most important model in the P&L is the revenue model. It is extremely important to understand the drivers and the assumptions. For a retailer/restaurant it is same store sales growth while for a twitter or a Facebook it will differ (I do not know these drivers). The key is how does a company drive y/y revenue growth and then what is the subsequent cash flow from that revenue growth (unit economics). So the question for Four Wall and Twitter is what are the unit economics of their business – is revenue consumer driven (paid subscriptions) or business driven (advertising, special placement, etc). If consumer driven, how many will pay versus leave or will all pay $10 a year (that could be huge by the way) and stay active and then what is the monthly rate and what is the cost to carry a consumer from cap ex in equipment to op ex. If business driven, what is the average cost per ad/placement/etc to how many placements a tweet/etc and what is the cost to carry that. Then how many potential customers X the revenue per customer X the contribution margin = operating margin increase. After tax cash flow is different and can be manipulated by a lot of factors. Still important to cash balance but less relevant if your business generates meaningful revenue.Cash flow, cash balances, revenue and cost to run the business are all integrated. The key question becomes ARE YOU RELEVANT to the consumer, can you monetize relevance and at what % and what rate, at what unit level economics and how much cash and runway do you need. For start-ups, start with the cash burn and runway and work backwards because cash and cash burn are extremely important.Sorry for the long post, I really love this stuff.
Would love to get your thoughts on hiring and managing a bookkeeper. How do you know if they’re doing a good job? At what point to do think an entrepreneur should hire one as opposed to doing the books themselves? What questions should a CEO ask when interviewing potential bookkeepers?
The only problem is that no on has ever seen a bad forecast.Pilots are taught: Never run out of altitude before you run out of ideas. Startups can substitute capital for altitude.
I’m sure you have a post planned on business models, which would tie in all the groundwork you’ve laid down.I always have trouble explaining to people why all growth is not the same. Whilst receivables are important, it’s the variable costs which can really kill you. This is why (for a given level of revs) I would much rather own a search engine than, say, YouTube.
Please keep up the great knowledge share! Sure reading through all the accounting stuff is a bit of labor, but it’s really great information. Thanks so much for share your knowledge and time, I have really started to look forward to these posts.
I know writing MBA Monday’s must be boring but I love reading it every week and get a lot out of it so hopefully you will keep it up. Also Fred small spelling mistake, second last par ‘The fiancial markets like’ should be ‘financial’.Cheers,Andrew
thanks for the copy editi could use more of that unfortunately
Great post, thank you for the continued insight!
A good overview of a very big topic. I also think it is important to compare how other companies that are in the same business sector are performing, because these financial indicators change look very different depending on industry.
Fred,Have fallen behind on my blog reading, as you can see. If you haven’t made up your mind yet about continuing the MBA thread, this post was the best of the MBA Mondays, IMHO and I would like to see them continue. I’m going to “borrow” some of your ideas into our daily financial dashboard. One suggestion would be to include the “assumptions” in a single easy-to-find location – there’s been a lot of discussion here regarding revenue recognition, write-downs, etc. These things are all ok to be different (based on your business), and if defined someplace up front makes the analysis of the numbers easier to digest.Going back to a daily dashboard, I’ve done this over the past several years and continue to tweak/improve over time – given how you describe your quick scan of a business, do you have a sample dashboard you could “open source” for the crowd here to review and add to? I would be happy to do same – the feedback/iterations on something like this would be invaluable.
Great post and very informative summary. The issue I see a lot of as a business coach is companies don’t have timely and accurate financial information to analyze. I saw a post below where someone said look at trends, I couldn’t agree more.Some good real world information here.