Accounting is the language of business.Warren Buffet
One of the biggest challenges of running a business is the need to understand and leverage accounting as a practice to be able to both run and understand your business. As conveyed by the quote above, it’s indeed a language for businesses and a means to convey the health and aspects of the business through it.
While as an individual, we typically deal only in cash. A business can have revenue, bookings and obligations/costs associated with it which can occur over a long period of time (a few years). Which basically means, the typical means of cash-based accounting of things does not quite reflect the story completely and you need to rely on accrual-based accounting.
Accounting like code(programming) has certain standards like GAAP and FRS but plenty of aspects are open to interpretation and this is where the creative aspect comes in. Due to this, companies often try and present the best picture possible without completely letting in on the risks and assumptions made.
Typically, most startups by nature in early days, are losing money or are still trying to figure out a viable business model, thereby simplifying the accounting side of things. For such a business, there are fewer things to worry earlier on, compared to a Fortune 500, for whom the financial statements are no different than quarterly and annual mark-sheets.
Because, certain aspects(revenue, expenses) of the business can be interpreted differently and thereby reflected differently, accounting is an art, not a scientific process. There are a set of 3 main financial statements reported by a business. Each one of them tries to capture certain aspect of the business performance and state of affairs.
- Income Statement (aka Profit/Loss Statement): This is your performance over the recent quarter or the year in case of an annual statement.
- In brief terms, the goal here is to capture, the incremental performance of the business. Think of this as the change in the state of affairs.
- One analogy with personal financials could be the combination of your salary and credit card statements.
- Balance Sheet: Basically reflects the current state of affairs for the company, it’s basically the assets and the liabilities of a company.
- The analogy of personal finance would be wealth. This is basically a reflection of all assets you own and any debts you owe.
- Your equity is basically the difference between Assets and Debts (Liabilities). A balance sheet tries to balance the equation Assets = Liabilities + Shareholder’s Equity
- Cashflow Statement: This is further divided into operating, financial and investing parts.
- Operational reflects cash generated by the business, financial reflects cash from shares issuance or raising of debt.
- Investing in cash generated from any investment activities, think interest or bond payments etc.
I need an income statement because it tells me how the company performed in recent times and how well their strategy or execution recently was. Balance Sheet is a reflection of the company’s strength long term state of affairs. Cash flow how well liquidated the company is. Without cash and ability to service obligations like rent, salaries, a company will die and thereby lose on its ability to maximise share holder’s equity.
From a startup’s standpoint, especially software firms, two of the key metrics are EBITDA and gross margins. EBITDA or Earnings before income tax, depreciation and amortisation reflect operational earnings/income generated by a firm minus the expenses. When we mean before the 3 parts, we mean, we don’t include numbers from those to understand the operational performance of the business.
- Income Tax: Most startups likely are not profitable earlier on and thereby income tax component is likely to be nothing.
- It gets important in situations when say, a company gets tax credits as incentives by the government. e.g. Tesla. To evaluate Tesla’s performance in that quarter/annual period, we can need to remove the tax credit’s components.
- In the case of Amazon, they carry forward their losses from earlier years and can set them off incomes from the current year to reduce the net income or profit.
- Depreciation: All tangible assets owned by a company, in our context office furniture, laptops, devices and office buildings if owned by the firm etc can be depreciated over a period of time.
- Unlike individuals, assets are used by companies over a period of time and thereby the drop in the value over a period of time, can be attributed as an expense. e.g.
- If my office furniture is worth 1000$ and I plan to use for 5 years. I can depreciate the assets over 5 years period as 200$ expense every year. This allows me to lower my net income and taxes but then I need to reduce my asset value by a similar amount every year as well.
- Amortisation: Very similar to depreciation but for intangible assets. Let’s say, a company has a certain license/patent and company has attributed certain goodwill to the same.
- The company would like to amortise the value of patent over its entire period until expiry. e.g. A pharmaceutical company amortising its patent value over the remaining patent time.
- This can also include any kind of debt payments, instead of expensing entire interest payments in chunks, the company will spread the amount similar to an EMI over the repayment period.
Given the accounting complications behind the income tax, depreciation and amortisation. EBITDA is the most relevant and accurate measure of a company’s operational performance and one widely used for startups. EBITDA reflects if the company made more money than the cost of goods, which in case of software is very small. The Software can be replicated almost for free of cost. Costs associated are things like recurring server costs etc.
EBITDA = Revenue – Cost of Goods
Just to be clear, EBITDA expenses does not include fixed costs like salaries of developers, office rents but rather operational expenses needed, like any other software subscriptions, support salaries etc. Because aspects like salaries, rents etc are not measured. An EBITDA positive firm can still be losing cash due to fixed expenses.
Gross Margin is basically taking EBITDA and dividing it over the revenue. This gives a sense of the pricing power or how strong the business moat is. An increasing margin over a period of time is great and the other way around is not good. A light touch sales process would result in high gross margins and with sufficient volume of sales, the entire business might become profitable as well.
Besides the above, as the business scales and especially for firms with operational aspects like Amazon, Flipkart etc. The accounting gets more complicated and aspects like operational expenses vs capital expenditure have an impact on how these numbers treat the EBITDA calculation. Operational expenses are one time and CAPEX is spread across a period. This might help understand Flipkart/Amazon vs Income Tax Department