Finance best practices for startups

taking care of business means taking care of moneyI believe every person has at least once considered the option of opening their own business. It may be for a variety of reasons, such as having a great idea, a desire to leave the employment market with its vicious job-seeking procedures, the desire for more control over one's life and time, or the simple wish to improve one's own financial well-being.

Eventually, only a handful of people actually bring their idea forward to the stage of beginning to set up their own enterprise.

Once the startup is set-up and running, in the first year it has a 90% chance of going bankrupt and failing, as nine out of ten startups fail during this critical period. According to CB, the most common reason for startups' failure is that there is no market for the product. The second most common reason, common to 29% of failures, is the lack of cash. In other words, most enterprises with a good and solid idea and a real market need for it, fail because entrepreneurs are not aware of financial management. You may disagree with me and say that this means that companies are underfunded, but let's consider the following example.

Let's say, that John and Sarah, a married couple, decide to open up a family-owned shop, which sells toys in their neighborhood. They can see that in their neighborhood most families have kids and the nearest toy shop is 20 km's away from them. At the same time, they have kids of their own, meaning that they know the market, they know what kids and their parents want from the toy shops. In other words, the situation is set up and there is a clear opportunity for John and Sarah for opening a toy shop in their neighborhood, paired up with their understanding of what the customers want.

The first step they can take towards opening up their business may be going to investors in search for funds for their startup and this is the wrong approach. Investors, especially professional investors, have a strong preference for understanding the financials of their investments, what their money will be spent on, and they want to see some financial figures. At the end of the day doing a little homework and actually calculating exactly how much money they need for opening the business is not that much of trouble and at the same time gives an image of people who know what they are doing.

Let's say that John and Sarah have managed to raise their initial money and started their toy shop in March. The company was running well, until in September they figure out that they have to pay electricity bills, rent and interest on the bank loan they have borrowed, but they have eaten up all of their cash. What will they do now? Most likely they will start hastily searching for money from investors, bank or family, and friends and if they don't find any, they will become part of the 29% of people who fail because of lack of cash. Could this problem be avoided? In most cases it would be easily avoidable. You ask me how? I say financial planning and controlling.

For the time their shop was running, John and Sarah would have enough information to estimate the costs of their business and have a basic idea of their profits. In June, they would have at least two months of data on those matters. In this way, they would be able to make certain forecasts of the future performance of their business based on its past performance. In the majority of cases, if they would put enough effort to crunch the numbers together, they would be able to see the upcoming problem in advance, unless they ran out of cash due to some unpredictable reasons, such as the shop burned down, new legislation banning small family-owned toy shops came out, or any other reason.

Again, if they would have crunched the numbers and prepared the forecast, they would have been able to foresee the future problem. What is the benefit of this approach? There are two benefits: time and information. They will have three more months to raise extra finances and would have the information before the actual problem arises to take necessary actions for preventing the issues.

From the information side, they will be able to figure out the exact problem of their cash burn-out, be it the problem with costs that are higher than revenues, the business's profits are not matching their lifestyle, or any other reasons. Based on this information, it is possible to take action necessary for preventing the problem from appearing in the first place and thus avoiding the problem.

This series of articles is intended for people who are planning to start up their business or have already done so and are willing to learn the basics of finance and financial management. The ideas and concepts presented are helpful both for the creation of a business plan and also the financial management of the running company and will help you to avoid common pitfallsc and bring your brilliant business idea to success, avoiding some basic mistakes in controlling and business finance management.

Cash, not profit, is King
"Cash, not profit, is King". This saying sounds counterintuitive when talking about the financial management of a firm, but it lies at the core of financial management of a firm. If you ask any student who has had their first lecture in university on this topic, most likely they will be already familiar with this concept. The big question is: why is this concept so important? Again, let's consider Sarah and John and their toy shop.

Let's assume that they own the store and all the furniture and equipment they have in it. The only monthly payments they have to make are electricity and water bills, which sum up to 100$ per month. At the same time, they have no cash left in their bank account. In this month, let's say it's June, they have bought 1,000$ worth of toys to sell in their shop on credit, which should be repaid at the end of the month. In June, they had only one customer, who bought all the toys for the price of 1,200$. What does the situation look like at the end of the month?

At first glance, everything is perfect. They have made a profit of 100$ (The calculation is: 1,200$ - 1,000$ - 100$). When we start looking at the details, they are actually in huge trouble. At the end of the month, they have to pay 1,100$, for the credit and the electricity bills, but they have not received the money from the customers. If they do not have enough cash reserves or are unable to borrow this money, they will go bankrupt, even though their business is actually profitable. In other words, they have made a profit, but did not have enough cash to make the outstanding payments and thus went bankrupt.

This is the most simple example, explaining why cash, not profit, is the key aspect of financial management, and is it is the exact reason why some profitable businesses run out of cash and join the 29% statistic of startup failures.

On the other hand, it is often seen in the news that some companies are not making a profit for a long period of time and they are not going bankrupt. The only reason for this situation is that those companies are able to meet their obligations due to sufficient cash reserves and, thus, they are gaining an opportunity to rethink their strategy and organization to make the shift in their business and become profitable again.

The Cash Flow Calculation
The basic way of keeping an eye on the cash balance, will be organizing a Cash Flow account. Depending on the country where you are planning to open or already have an operational business, it may turn out that the Cash Flow statement will have to be produced by your company or you will apply for simplified accounting regulations for SMEs and your accounting statements are be heavily based on the cash flow concept.

Please pay attention, that this article does not provide an explanation on how to prepare those accounts for the purposes of reporting to local tax authorities, but rather explains the principles of gathering the required data for your personal use and analysis of your enterprise's financial situation. There are two reasons for this. Firstly, in each country, accounting standards are different. Secondly, there are many options for making this process easy, be it accounting software or outsourcing the bookkeeping process to specialist firms.

How should the cash flow data be collected? There is one answer: look at the moments when cash flows into the firm or leaves the company. When I say cash, I mean the physical cash or money coming in or out of the company's bank account. To make this explanation clearer, let's use the following example Sarah and John's toy shop.

Let's say, that during the last week the following events have occurred:

  • There were 20 customers who bought something and altogether paid 500$ in cash
  • A direct debit of 80$ was actioned for paying the 80$ electricity bill
  • The water bill invoice of 20$ was received, but not paid yet
  • To replace the sold stock, an order for 1,000$ worth of toys was made, with a prepayment of 400$ already made

Before we run into the calculations, I would like to point to one key aspect of cash flow calculations. Those are always performed for a given period of time, which can be a week, month, quarter, year or any other period. In this case, the calculation is done for the transactions which occurred during the last week.

First it is important to understand which transactions should go into the cash flow and which category those should fall into. In this example, there is a cash inflow of 500$ from customers. On the cash outflow side, the situation is a little bit trickier. First there was an 80$ outflow in the form of an electricity bill payment. The water bill invoice does not enter the cash flow calculation, as it was not paid yet. The similar logic applies for the 100$ worth of toys bought. The only payment already made is 400$ prepayment and it should go into the cash flow account. The cash flow should look as follows:

Cash inflows  
Sales  +500$ 
Cash outflows   
Electricity bill  -80$ 
Prepayment  -400$ 
Net cash change for the week    +20$ 

To make it more relevant for real-life use, it is important to notice that businesses operate before and after the period, for which the cash flow is calculated. Let's assume that after the previous operations before the last week, the company had 2,000$ of cash reserves in its bank account. In this case, the cash flow statement will look in the following manner.

Cash at the beginning of the week    2,000$ 
Cash inflows  
Sales  +500$ 
Cash outflows   
Electricity bill  -80$ 
Prepayment  -400$ 
Net cash change for the week +20$ 
Cash carried for the next week +2020$ 

After understanding the logic of recording the company's cash position, the next article will explain how to produce and calculate the cash budget and cash flow forecast for a company.

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