“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.
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
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 monthly recurring revenue (MRR) which is defined as an estimate of how much revenue your company will typically make every month. This is especially important to keep track of if you own a company that requires customers to pay a subscription. It provides investors a picture of your company’s performance over time and allows you to identify trends. Plus, it’s not a lot of work to calculate while providing a lot of valuable information. You can calculate MRR by adding together how much revenue you received from all customers in the last month. You can also average the calculation using 3 or 6 month periods.
There are four types of MRR and each represents a different source of revenue.
Churned MRR Firstly, there is Churned MRR which is lost MRR from customers opting out of their subscriptions with your service.
Existing MRR The second type of MRR is Existing MRR, which is ongoing revenue from existing customers.
Expansion MRR The third type of MRR is Expansion MRR, which is additional revenue from existing customers.
New MRR The fourth type of MRR is new MRR, which is revenue from recently acquired customers.
Using the four types of MRR will help you find Net New MRR, which helps indicate swings in revenues in the past.
For a company that offers a monthly subscription service for $10 per month, if 10 customers opted out of your service, 100 customers continued their subscription, 5 existing customers opted for the more premium $20 subscription, and 30 customers were recently acquired, we can calculate the four types of MRR quite simply.
Churned MRR would be $100 (10 customers opted out x $10 price of product), Existing MRR would be $1,000 (100 recurring customers x $10 price of subscription), Expansion MRR would be $100 (5 customers upgraded X $20 price of subscription) and new MRR would be $300 (30 new customers x $10 price of subscription). The result would be a Net New MRR of $1,300.
A company’s burn rate is a term used mostly for newer companies or startups that need to initially spend more money than they make to get off the ground. More specifically, burn rate is how much cash your company uses (or burns) on a monthly basis when it is not yet profitable. When people talk about burn rate, there’s two types that they generally talk about - gross burn and net burn. Gross burn relates to only the cash outflow (mostly expenses and loan payback), while net burn also considers any cash flow inflow (mostly revenue), resulting in a lower amount of money “burned” since you also consider money coming in. This is important to note because even if a company has a higher gross burn than before, if they have generated more revenue, this may result in a lower net burn. If your company has $10,000 of operating expenses each month, $10,000 would be your gross burn. However, net burn, on the other hand, takes into consideration any revenue that was made during the month, so if your company brings in a revenue of $8,000 in a month, that makes the net burn equal to $2,000. Startups need to pay particular attention to burn rate since it can help make wise decisions while deciding how much funding to allocate to different aspects of the business.
An important consideration while making decisions such as increasing marketing efforts or hiring new staff is if your burn rate is higher than anticipated or your company is not making enough revenue. If that’s the case, you may need to cut certain operating costs and consider another metric, runway, which we will also detail below.
Gross Profit Margin
You may have been confused about what gross profit margin is in the past because this term can be used interchangeably with a different term called gross profit. Gross profit margin is a ratio while gross profit is simply a dollar amount. We will detail gross profit first and then discuss gross margin afterward.
The amount of money your company keeps after considering the costs related to getting your goods or service ready for sale is called gross profit. It is found near the top of the income statement. Gross profit is your company’s revenue - cost of goods sold.
Gross profit margin or simply gross margin, on the other hand, is a ratio that you can take to compare with other companies in your industry. It tells you how well your business operations are performing and can be calculated in two steps. First, you take your gross margin and divide it by your company’s total revenue. Second, multiply that by 100 and you now have a gross profit margin.
For example, if a company has a revenue of $200,000 and a cost of goods sold of $50,000, then their gross profit would be $150,000. To get the gross margin, You would take $150,000 divided by $200,000. Then you multiply that new figure by 100 to get a gross margin of 75%.
The Business Development Bank of Canada outlines what an ideal gross profit margin is, stating that anywhere from 50-70% is generally good for many businesses. However, gross profit and gross margin vary tremendously between industries, so it is important to do your own research regarding what ideal values would be for your individual business.
Balance Sheet Explained
The balance sheet is a financial statement that has two main parts - one part will describe all the different assets that your company has, while the other describes your company’s liabilities and shareholders’ equity. The balance sheet is given this name because the two parts of the balance sheet must equal each other - the value of your assets is the same as the sum of your liabilities and shareholders’ equity. The two parts must balance.
Most Canadian small businesses will have both current and long-term assets as well as current and long-term liabilities. The shareholders’ equity section will contain your company’s retained earnings from another financial statement called the statement of equity, but we won’t go through the details of that in this article. Essentially, what you need to know is that your shareholders’ equity section will mainly contain your retained earnings (previous profits that are going back into the business). The Shareholder Equity section will also include common shares, which just refers to money received from stakeholders who invested in your company.
Now that we have an understanding of the main aspects of a balance sheet, we can calculate values and ratios that benefit Canadian small businesses. Knowledge is power. The information from your balance sheet will allow you to calculate working capital, runway, and debt to equity.
Think of working capital as the engine of your company. All your company’s cash and other helpful resources are used to power this engine. All your equipment, supplies, cash, and many other assets are powering your company. Working capital is what you have in current assets after subtracting your current liabilities. It is a collection of everything that is helpful to your company after considering any debt and other payables that would lessen the value of your company’s resources. Evidently, you want a higher working capital, as it demonstrates to investors and lenders that you are able to pay off short-term debt. Although it may depend on the industry, a loose guideline for working capital would be between $1.50-$1.75 per dollar of current liabilities ($1.5 current assets for every $1 of current liabilities).
The amount of time you have before running out of money in the early days when your business or startup is spending more than it’s making is referred to as runway. This was the term that we mentioned earlier when explaining burn rate. We can see how important understanding runway and burn rate can be by taking for example how much e-commerce stores spend on advertising. Consider a company with a current cash balance of $50,000 and through vast efforts to gain more customers has been spending $3,000 in advertising each month. They also have $2,000 worth of other costs on a monthly basis. As a result, their gross burn rate is $5,000 per month. If the company is not generating revenues, their runway is 10 months ($50,000 cash divided by $5,000 burn)
Burn rate and runway work together to provide a startup with a better understanding of the funds they have and how long the company will stay alive before reaching profitability.
Debt to Equity
Debt to equity will show you how much debt you have compared to the sum of your retained earnings and any money that has been invested into the company. It’s calculated as total liabilities divided by shareholders’ equity.
This ratio is used by banks when you apply for a loan, so a good debt to equity ratio is important if you need more funding for your company. At face value of what you’ve read so far, you may be thinking the lower the better for debt to equity, right?. Well... not necessarily. A lower debt to equity ratio isn’t always ideal because it could demonstrate that the company isn’t willing to take risks. At the same time, having a higher ratio isn’t always bad either.
Imagine if you’ve been looking relentlessly for how to further invest into your business. You’re committed to taking that next step. You scour through many ideas, talk to many people, and look at many different investments you could make. Maybe you find one that can be profitable, but it requires a big investment. You can’t let it go, but you’re afraid it will bring on too much debt. If you find yourself in a similar position, you shouldn’t be worried right away and completely give up on the investment. Banks will take into consideration the potential revenues from the investment when looking at your debt to equity ratio. With that being said, even though there are exceptions where a higher debt to equity ratio isn’t the end of the world, a loose rule you could use is to aim for a ratio of around 2, meaning $2 of debt for every $1 of investment. However, it also depends on other factors such as the industry your company operates in.
Cash Flow Statement Explained
The cash flow statement explains what happened to a company’s cash during a period of time. It’s a record of both cash receipts and cash payments. Through this detailed statement, it’s easy to see exactly why your company is experiencing a positive or negative cash flow, painting a picture of how well a company is doing currently, and in the future. There are three parts of the cash flow statement - operating cash flows, financing cash flows, and investing cash flows. The three parts are extremely useful tools for entrepreneurs as it gives a clear view of how cash changes due to each activity. At ReInvestWealth, we can automate these three parts of the cash flow statement so you can have an up-to-date and clear view of your cash flow, something that is vital for a business owner.
Operating Cash Flows
This part of the cash flow statement details the cash increases and decreases from day-to-day operations (providing goods or services). It contains revenues and expenses and how both play a role in your net operating cash flow. This may sound similar to the income statement, but there are differences. Operating cash flow differs from the income statement – the operating cash flow statement is like a mirror, while the income statement is like a camera with a filter on it. The cash flow statement cannot be artificially pumped with payables and receivables. It shows the real cash movement and can quickly tell an investor or business owner if the business is doing a good job collecting money from customers and paying expenses on time.
Financing Cash Flows
Financing cash flows refers to money that comes from debt and equity financing. Explained simply, this section of the cash flow statement relates to things such as what happens with your company’s shares, dividends, and from funding or repaying debt. For instance, if your company issues shares, pays dividends and gets funding from issuing long-term debt like receiving a bank loan, these are all activities that would fall under financing cash flows.
In the case of an online IT consulting business, let’s say that they had the following financing activities:
-Took out a bank loan +$100,000
-Paid off previous debt -$10,000
-Issued shares of +$6,000
-Paid dividends -$30,000
In the end, their financing cash flow would be $66,000, as you simply sum up all of the above. The overall financing cash flow plus a look into the different financing activities tells us how the company received funding and gives money it owes to investors.
Investing Cash Flows
The last section of the cash flow statement is investing cash flows, which usually includes transactions where a company buys or sells assets. Examples of cash inflows within this section of the cash flow statement would be if you sold company equipment or other bigger assets like buildings. Cash outflows can arise from buying property such as company cars or investments such as stocks.
For the IT consulting business mentioned above, perhaps they had the following investing activities:
-bought the land for their new office -$100,000
-bought new company equipment -$10,000
-sold previous equipment +$5,000
This would leave the company with a negative investing cash flow of $105,000 after summing up the above. As an investor looking into this company or if you were the owner of a company with the cash flow above, it may be scary to see a negative cash flow of $105,000. However, this section of the cash flow statement will illustrate what caused the negative cash flow. In this case, seeing that most of the negative cash flow came from the big investment of buying land, this will bring some ease to a potential investor.
Difference Between Profitability vs. Positive Cash Flow
Through your time and effort to learn about the cash flow statement and monitor it, your company is now experiencing a positive cash flow. Yay! That’s good right? It may be a fair assumption to make that if your company has a positive cash flow, that also means that it is profitable. This is an honest mistake that most who are new to accounting and finance make, but it’s important to know the differences between profitability and positive cash flow or else you’ll run into some problems when you face expenses or loans you have to pay off.
When we talk about cash flow, we are referring to the movement of cash. On the other hand, profitability is determined on an accrual basis which is different from the movement of cash. This becomes an issue when we mistake profitability for positive cash flow. A simple way to understand this is to remember that in accounting, we must record things as they happen. If we were to take on the job of painting a building and finish painting it at the end of the year of 2022, the job is considered finished and revenue is to be recorded in the year of 2022. However, even though it looks like we made a profit this year, we may not actually receive the cash until the next year. If the client is unable to pay after the job is completed, we may find ourselves short of cash and unable to pay bills or loans when they are due. In this example, the company is profitable but may experience negative cash flow.
What Is a Compilation Report and When Is It Needed?
If you want to avoid the hassle and expense of hiring an accountant who creates these financial statements for you, you may want to consider accounting software that can automate the process for you at a lower cost. This is a great option for many startups, but you may be confused about what a compilation report is or when you need it.