You don’t need to be an accountant to start a company but you should become intimate with key accounting metrics. Lack of financial literacy is the greatest threat to a global surge in entrepreneurship. Most companies fail because their founders had little or no financial acumen.
Such was almost the case with my first company. Pockets filled with seed money, I worked hard on creating nice products and chasing down new customers only to be in deep trouble within a year. The only financial focus I took was to deposit cheques and pay bills. The only metric I looked at was my bank balance and as money ran dry. The less I had in my account the more I looked at it. The disaster was avoided only after I brought in a great CFO and took classes on accounting.
Here are the top 3 metrics that startups should pay attention to:
This is the one metric that will puzzle most founders and yet it’s one of the most important aspects of your business. Run dangerously low on cash and your entire existence will be focused on rectifying the situation. Run out of cash and the business will screech to a halt. You can lose money for years and as long as you have cash, you can still operate. Yet you can be profitable on paper and still be out of business. It’s also the toughest part of the business to plan accurately; particularly in the early stages of growth. Miss payday while accelerating and watch your talent run elsewhere.
Yet it’s relatively simple. Cash flow is cash in versus cash out. It has little to do with sales as your product or service may take time to deliver, meaning that there is a delay between customers receiving goods and your business receiving payment. It has more to do with controlling how quickly you can generate deposits versus how late you can pay suppliers.
The first step should be to create a financial model which lists every single expense and when it will be paid out. Remember that if you add people or need to move offices, capital expenditures will be necessary. The furniture provider will expect payment fully even if your accountant will amortise the cost over time so be careful to properly assess needs and put realistic payment flows. Don’t rely on an outside firm for this. Building a model allows founders to get familiar with all the income and expenses of a company.
A few tips in cash flow:
- Get paid as early as possible and pay out as late as you can, even if you have money in the bank. Pay the very important suppliers first and in a cash pinch, pay unsecured creditors as late as possible.
- Have very aggressive payments terms on collecting from your clients. Don’t think giving people more time to pay is a competitive advantage. Be firm on these terms and drop the clients that linger in payments. There is a reason they are not paying you; it’s likely because they have financial challenges. Nothing speaks of bad management like an accounts receivables list with clients over 90 days.
- If you provide a service, demand at least 50% up front and 25%-40% halfway with the balance upon delivery. Don’t wait to collect until the end. Too many things can change and you’ll be left holding all the costs.
This is the amount that you are burning in cash every month until you become ‘customer funded’. This is especially important when you start a business that will have a lengthy lag in regards to revenue. Investors will want to know what your burn rate will be and how long it will take to extinguish, as money spent is their capital.
This metric is particularly important as you seek additional funds or move into other rounds. This is a question I ask every single potential founder whose company we assess. If they even hesitate, I end our discussions there. Knowing what you are eating up in cash every month is very critical to the health of your company and shows responsibility in regards to your investors.
A few tips to control burn rate:
- Spend only what is necessary and not what is nice. Create a board or committee to help you determine how best to keep costs low.
- Keep your investors updated on the progress of the company and related burn. No one likes surprises and especially when it’s their money.
- Review your costs every week. They are like fingernails; they grow all the time and require regular trimming. Managing costs have made many companies prosper.
It’s surprising to me how few small business leaders have any sense of the margin they make on a product or service. This is the percentage of the sale that is above your cost (gross profit). As an example if you produce a widget for $10 and sell it for $15 then you margin is 33% (selling price less direct cost/selling price).
It’s important you understand your margin because it will affect virtually every part of your business. Keep in mind that the margin you create will pay for the costs of operating the business like rent, operational costs, administrative salaries and eventually be the cause of a profit. Start early to place emphasis on your company and likely success will follow.
A few tips about margin:
- Research what the standard margins are in your industry and don’t underprice unless you have figured out a way to provide a service cheaper.
- Take the time to calculate how much money you will need to pay for the running of the business and reverse engineer your pricing.