Introduction
“Accounting is the language of business, and you have to be as comfortable with that as you are with your own native language to really evaluate businesses.” This quote from investor titan Warren Buffet highlights how crucial it is for a Canadian entrepreneur to have a solid understanding of financial statements. However, like Warren Buffet said, it can truly feel like another language.
You may have heard terms such as customer acquisition cost, customer lifetime value, burn rate, and runway without understanding their meaning or relevance to your business. Different ratios and terms can be complicated if you’ve never taken an accounting course. That is completely okay; this article contains the essentials on how to quickly analyze financial statements, explained simply.
Summary
After reading this article, you should have a clear understanding of the basics of the three main types of financial statements (income statement, balance sheet, and cash flow statement), compilation reports, and how to calculate and use primary metrics such as gross margin, monthly recurring revenue, working capital, and the other metrics mentioned above. Note that this is an in-depth article and we have a shorter financial statements article that summarizes how each financial statement is helpful for a startup.
Table of Content
The Purpose of Financial Statements
If you make the choice to procrastinate on learning these fundamentals of accounting, you may be missing out on a sea of valuable information that could allow you to understand your company’s financials at a deeper level. We know that it can be scary to scroll through financial statements full of terms you don’t know. It may make you want to just close off and do another task, but before you leave, let us explain to you why financial statements are so important.
Financial statements are more than just for preparing yearly tax filings -- they are a key to the success of any business. Once you have a solid understanding of how to analyze financial statements, you have a clear picture of how well your business is doing, what resources are available, and where they should be allocated. This picture is undeniably crucial for both long-term and short-term planning since financial statements allow you to easily see the flaws in your business and what steps need to be taken to succeed.
Every business also needs funding, which can’t be done if investors and bankers don’t have your financial statements to evaluate your company’s performance. All in all, financial statements are crucial to your company’s financial health and longevity.
Why Ratios Are Important for Understanding Financials
We think you get the point. Understanding financial statements is important for success, but you may be asking why they are so useful. It’s because they provide us with valuable information which can be quickly analyzed using ratios. If you use ratios properly and calculate them as we discuss in this article, they can provide insights into your company that will help optimize business performance. When you understand the ratios explained below, you can compare them with previous performance to have a deeper understanding of how your company is progressing. Some ratios tell you how likely your company will survive in the short-term or long-term, while others demonstrate to lenders how reliable you are when it comes to successfully paying back a loan. They are necessary to see how successful your operations are for a specific time period.
With that preamble out of the way, let’s dive into what you need to know about financial statements and ratios so you can get all the advantages that we’ve discussed.
Income Statement Explained
Overview
The income statement is where your company’s revenues and expenses are recorded. Some important numbers that are included in the income statement are your company’s sales, cost of goods sold, operating expense, operating income, income before taxes, income tax expense, and net income (how much is left over after subtracting expenses). With this information from the income statement, the most important ratios you can find are your customer acquisition cost (CAC), customer lifetime value (CLV), monthly recurring revenue (MRR), burn rate, and gross margin.
Customer Acquisition Cost (CAC)
Understanding customer acquisition cost (CAC) is essential for an entrepreneur’s success. Businesses that understand it use it constantly to make smart decisions; businesses that don't understand their cost for customer acquisitions are typically the ones that eventually crash and burn. Learn from the mistakes of others and take the time to fully understand customer acquisition cost.
CAC can be thought of as how much you spend to get one person to pay for your goods or services. You can calculate it by taking the total amount that your company spent on marketing and advertising (including the salaries paid for the promotion of your product or service) divided by how many new customers you have acquired. For example, if you acquired 5 customers by spending $5,000 on a Facebook marketing campaign and $6,000 on a radio ad, your CAC is $2,200. Generally speaking, the lower the number the better.
We also recommend using CAC by applying the formula separately to the different types of marketing that you use (e.g. Instagram ads, hosting events, content creation, cold calling, etc.). For example, if you find that the CAC for Instagram ads is much lower, you could consider taking money away from hosting events and double your company’s Instagram ad buy. Rather than mindlessly gathering your hard-earned money to put into mediocre marketing, imagine using all the money from wasted marketing attempts and simply putting it towards gaining more customers. You just need to spend some time understanding CAC.
Finding new customers as a startup is crucial, but it can be very daunting and difficult. Through a sound understanding of CAC, you can help alleviate that stress by finding the most inexpensive yet effective ways to market your company.
Customer Lifetime Value (CLV)
Now that you know the CAC for the marketing methods that you use, it may be tempting to stop certain marketing activities altogether if they have higher CAC.
However, if you were to focus solely on one marketing tactic and stop all of the other ones, it’d be like a new investor investing all their money into one stock. Things can go wrong. Just because one form of marketing has a higher CAC, doesn’t mean that it still isn’t a profitable form of marketing for your business. That is where customer lifetime value (CLV) comes in so you know whether or not a marketing tactic is truly worthwhile.
Customer lifetime value is how much value a single customer provides to your business. It'll help with decisions related to maintaining current customers and also gaining more customers. To calculate CLV, you take the expected number of years that a customer is expected to remain as a client with your company (this involves analyzing past customers) multiplied by the annual income that a customer brings to your company. For instance, if your company charges $2,000 per year and clients are expected to stay loyal to your company for 5 years, that would mean that your CLV is $10,000. With this number in mind, you can get a clear view of which marketing tactics are profitable by combining CLV with CAC.
By comparing the examples for CAC and CLV, it becomes clear that the marketing strategies are worthwhile since the CLV of 10,000 is significantly higher than the CAC of $2,200. This is great news but the next step would be to determine how many customers came from Facebook and how many come from radio.
Remember that your CLV should be higher than your CAC. There are certain exceptions (such as high growth companies) but this rule will apply 99.9% of the time. Furthermore, there are other costs to running a business so make sure to keep in mind that comparing CLV and CAC is just a quick calculation to know if your marketing is profitable, not your overall business. If CAC is higher than CLV, it is very likely that you will run out of cash soon.
Monthly Recurring Revenue (MRR)
As a small business owner, you need to have an idea of how much money in sales you’re making on a monthly basis. This is called