5 Accounting Concepts For Startups
Updated: Oct 29, 2020
To be a successful startup founder, we don’t need to be an accounting expert; we can outsource that. But we do need a solid grasp of basic accounting concepts. As a small business owner, we need more than an intuitive feel for the performance of the business. Understanding a few basic Accounting 101 concepts goes a long way towards keeping the goals for a company in alignment with performance. Here are 5 accounting concepts to get started.
The Balance Sheet
A great place to start, when evaluating the performance of an organization is how to decipher a balance sheet. At a minimum, we should understand assets and liabilities, and how they relate to one another. Assets are what we own, which includes contracts we haven’t taken payment on. Liabilities are debts, as well as goods and services that we have taken payment for that we must contractually deliver.
A basic equation to calculate the worth of the company is to take the assets and subtract the liabilities, with what’s left being the equity. Putting this on paper results in a balance sheet. This provides us a quick overview of your organization. Lots of cash on hand and little debt means a strong balance sheet. High debt and low cash means a weak balance sheet. The balance sheet drives long term decisions on where to invest resources.
A Profit and Loss statement (or P&L for short) provides a good idea of how the organization is doing at any given point in time. The P&L indicates the cost of sales, margins on each product, and costs that impact margins. Those costs include inventory, shipping, manufacturing, etc. The more granular these become, the more data-driven we can get with establishing the cost of products. Every P&L includes net income. The net income is a statement about the profit made; you know, the reward for the time and blood and sweat and tears we invested!
The Cash Flow Statement
In startups, cash is king. Cash is a cushion for when, not if, the business suffers a setback. Cash should cover the operational costs of running a business for a period of time (each organization has a different outlook on how long that might be). The key to understanding cash flow is the statement of cash flows.
Consider the statement of cash flows as the connection between a balance sheet and income statement. The statement of cash flows explains how our net income transformed into net cash over a given amount of time. The statement of cash flows divides activities into three categories: operations, investment, and financing. Initially organizations have cash from ongoing operations, but as we grow, we’ll also manage cash from investments and operations. We usually pay taxes on at least some of that cash and take deductions from those investments and operations.
As a founder and so business owner, we need to understand taxes. Most organizations need to minimize their tax burden as much as possible and that’s where our knowledge of accounting can really pay off – we'll understand the tax advantages of different legal structures (e.g. a corporation vs. a sole proprietorship), and about the potential tax savings that are available to small business owners. This isn't something we should do on our own though - hire a great tax advisor.
Pro Forma Projections
Accounting is a story of the past and the present. The pro forma is a projection of future performance based on past performance. Pro forma projections enable us to project how the business will do in the future. Projections are critical, as they allow us to make informed decisions about staffing, delivery, and the value of each line of business.
At the end of the day, most small businesses will outsource accounting, so don’t get too hung up on all the accounting jargon or the finer points of different depreciation methods. A basic understanding of the three core financial statements and a good idea of what they tell us about future performance will set you on your way to becoming a solid founder!