Explaining Financial Statements

Following up on the introduction to finance and accounting, here's a deeper dive into the three statements of the consolidated financial statements.

Income Statement #

The income statement is usually the report that draws the most attention, and since each component of the statement shines light into different parts of the business's performance, it's worth explaining the details of the statement to understand what the different terms mean. Here's an overview of the basic structure of the income statement.

Revenue #

Revenues measure the money that is brought into a company from its business activities, often called sales. Revenues can be reported divided up into different business activities, or by different departments or regions, in the effort to provide more information and transparency into how a business operates.

The calculation of revenues often distinguishes between Gross Revenues and Net Revenues, net revenues reflected the revenues after accounting for discounts, returns, chargebacks, affiliates, or other contra-revenues.

Revenue can be recognized in different periods than the cash or payment for the revenues are received (under accural accounting), so it's important to distinguish in our forecasts when revenue is recognized and when cash or payments are received. If cash is received in advance of the revenues being recognized (for example, 12 months upfront payment for a SaaS service), then the balance goes to a balance sheet account for deferred revenue liabilities, and you decrease the revenue liability over time as you recognize the revenues. If cash is received after revenues are recognized, it's usually recorded as an accounts receivable.

For modeling purposes, if the cash is generally received within the same time period as the recognition of revenues (say 30 days for monthly forecasting), you can generally assume that revenues equals cash receipts.

The Foresight models - Standard and above - are prebuilt to handle a wide variety of revenue recognition and cash receipts scenarios, and will automatically handle the revenue recognition, cash, and balance sheet impacts of many different scenarios.

Cost of Goods Sold (COGS) #

Cost of goods sold (or cost of sales, or cost of revenues, or COGS) reflect the direct costs to produce the goods sold that earned the revenues during that period.

The rules for what costs are included into COGS can vary by business and how revenues are earned, but always true back to that basic principle. Production does not involve distribution or sales, but can include support, if the support is a function that is involved in providing the product, rather than selling the product.

For most costs it's fairly straightforward to figure out which costs are allocated to COGS and which ones to SG&A, but it can get a little complicated. GAAP and IFRS provides rules and guidance on how to handle certain costs, and for specific questions, best to consultant an accountant with experience with your types of businesses (or simply send me an email).

The Foresight Standard and Starter Models handle the allocation of costs to COGS and SG&A in a very flexible way. You can specify a COGS margin or amount - relating to revenues - and additionally type in a number of costs into the Expenses section, and allocate them to COGS simply by selecting COGS in the dropdown, and the correct accounting treatment is handled automatically. This way, you have two methods to forecast COGS that provide flexibility to change it over time, and the edits required to shift a cost between COGS and SG&A is trivial.

Gross Margin #

Gross Margin reflects the amount of revenue that the company retains after incurring the direct costs associated with providing the products and services that earned the revenues.

Or, more simply:

Gross Margin = Revenue - Cost of Goods Sold

And for gross margin %:

Gross Margin % = ( Revenue - Cost of Goods Sold ) / Revenue

Gross margin is an important concept since it is one measure of operations and profitability, and helps a company think about the costs related to produce the products and services it sells. It also helps a company think about how much money is left over to pay for the costs to operate the business.

Selling, General and Administrative (SG&A) #

Selling, general and administrative (SG&A) costs are the costs associated with operating the business, and not in producing the products or services. SG&A costs encompass many different types of costs and can be broken down into direct and indirect selling costs, fixed and variable overhead, operating expenses. Essentially, it's all the costs related to the business that are not COGS.

The Foresight models handle the allocation of costs to SG&A in a very flexible way, and allow you to assign the costs to a set of dynamic categories to help in reporting the components of SG&A. Just input the costs in each row, select SG&A in the dropdown, select the reporting category in the dropdown, and the model handles the accounting treatment automatically. The reporting is not a formal part of the income statement but provides valuable additional insight into the major cost areas.

The models use one repoting category to represent selling costs (e.g. acquisition costs, marketing costs), which is then used for calculating customer acquisition cost (CAC). It's not a formal part of the income statement but an important additional metric for business analysis that the models handle automatically.

EBITDA - Earnings before interest, taxes, depreciation, and amortization #

Fairly self-explanatory, EBITDA is a popular metric that can be used to understand the core operating earnings of a company, and it's often used for valuation ratios and evaluating the company without the impact of accounting choices.

By definition, EBITDA is:

EBITDA = Net income + interest + taxes + depreciation + amortization

I usually report EBITDA on a forecasted income statement, although it's not necessary in formal corporate accounting, as it would usually be something that is calculated as an additional information point outside of the income statement. I do it that way because it's a fairly popular metric to help understand a company's profitability and it's easy to see the flow of the revenues and expenses that way.

For the Foresight models, that means that EBITDA is calculated as:

EBITDA = Gross Margin - SG&A

By definition, that means that the SG&A does not include the "ITDA", which are reported separately below EBITDA on the income statement. The Foresight models let you input interest, depreciation, and amortization as expenses, but select the appropriate category (interest and depreciation/amortization) so that the model separates the expenses into the appropriate accounting treatment.

Depreciation and Amortization #

Depreciation is a difficult thing for most beginners to financial modeling to understand, but it need not be too hard: it is an accounting method for a company to spread the cost of purchasing an asset over it's useful life. It attempts to help correct for large one-time expenses by effectively allowing you to account for the expense over the time period where the asset will contribute to the business's operations (the useful life). It also holds with the general accounting goal of matching expenses to the time periods in which they contribute to earning revenues.

Depreciation does not impact cash, which is often the trip up for beginning financial modelers. It is one of the ways in which the income statement deviates from the statement of cash flows, and which causes net income during a period to not equal net change in cash flows during the same period.

Depreciation is recorded on the income statement, and also recorded on the balance sheet as it decreases the value of the asset on the balance sheet. When you "capitalize" an expense (recording it as a capital expenditure instead of an ordinary operating expense), you record the value of the expense on the balance sheet, and then in future periods depreciate the asset on the income statement, reduce the value of the asset on the balance sheet (typically through an accumulated depreciation account), and add it back to net income on the statement of cash flows under the cash flow from operations section.

Amortization refers broadly to the spreading of expenses over a period of time, such as a mortgage, loan, or purchase of asset, but for the context of the income statement refers strictly to the spreading of costs of purchasing intangible assets over their useful life. The rationale and concept is similar to depreciation, but applies to the purchase of intangible assets such as patents or the goodwill created by purchasing another company for a premium over it's valuation

For many companies, depreciation and amortization could be minor issues in financial models. If a company is not making significant investments in hard assets, or it not capitalizing software development costs, then depreciation may irrelevant or minor and is often ignored in very basic financial reports and analysis. Amortization will be nonexistent unless the company has purchased intangible assets.

The Foresight models handle the depreciation for all capital expenditures - all expenses categorized as CAPEX in the expenses section - using a straight-line method, and using a time period that can be input in the Get Started or Settings sheets. Straight-line is the easiest method of depreciation, and effectively spreads the cost of purchasing the asset equally over a time period, which is intended to be the asset's useful life, or time period where the asset can be used productively in the business. Depreciation and it's impact on the assets accounts are automatically handled by the model on the income statement, balance sheet, and statement of cash flows.

There are many different methods for depreciation than straight-line, and you may find yourself wanting to create depreciation schedules that depreciate different assets over different periods of time and using different depreciation methods. This is not prebuilt into the models, but can be added by expanding the depreciation schedule on the Forecast sheet.

Interest #

Interest expenses (and income) are generally recorded separately from revenues, COGS and SG&A (i.e. above EBITDA) as they generally are not associated with a company's core operations, and represent the costs (and earnings) from financing the company.

For some companies, earning income from interest may be a core part of their revenues, and should be treated appropriately as revenue.

The Foresight models (Starter, Standard, and above) have automatic schedules that calculate funding from debt instruments - loans - and their payback schedules, including interest expenses, using a set of user inputs around loan terms and interest rates. If you input new debt into one of the months under the cashflow forecast, the models will automatically handle all accounting impacts, and you can enter new debt into any month with different terms and interest rates, each month's debt is handled separately.

Other Income and Other Expenses #

Other income and expenses are earnings or expenses that are not related to a company's core business operations, and thus are recorded separately from revenues and expenses.

For most early-stage companies or users of the Foresight models, this will generally be insignificant and can be ignored and left as zeros, but the model structure allows you to input these into the income statement if they occur.

EBT - Earnings before Taxes #

EBT represents earnings before taxes, and is simply:

EBT = Net Income + Taxes

EBT may not be recorded on all income statements, but I break it out on the Foresight models so that corporate taxes may be calculated accurately. Thus, similar to EBITDA, I build down to EBT, thus EBT is calculated as:

EBT = EBITDA - depreciation - amortization - interest expenses + interest income - other income + other expenses

Taxes #

Taxes reflect corporate taxes paid on the earnings from the business (EBT). Business taxes, excise taxes, and other non-income related taxes are operating expenses and not reflected here.

In the Foresight models, the corporate tax rate is an input (for the % of EBT that is paid as tax). The calculations of tax look to model the tax situations for most companies. No tax is paid when there is a net loss (negative EBT, or more simply, expenses greater than revenues), and I track net losses over time to track the loss carryforward to apply the net losses against the net gains so that the company does not pay taxes until cumulative net profits are greater than cumulative net losses. This assumes that the losses can be carried forward in entirety over the three or five year time periods used in the models. All of this is done automatically, and the only user input required is the corporate tax rate, on the Get Started or Settings sheet. Consult a tax professional for any questions around specific tax treatment and rules around loss carryforwards applicable to your situation.

A note about value-added taxes:

I'm often asked about VAT (Value-Added Tax), for users outside of the USA. Technically, a business is collecting VAT and then disbursing it to governments, so it is not income, and the VAT you pay on expenses is recompensed by the government, so it is not an expense. Sales and expenses should be recorded net of VAT, and thus VAT does not show up on a company's income statement as revenues or expenses. VAT would be recorded on the balance sheet under VAT control accounts to track how much VAT has been collected and paid, and while this could have a balance sheet impact - and particularly an impact on cash balances - if there is a significant period between when VAT is collected and when it is paid, for the purposes of financial modeling the typical assumption is to assume that time period is within a month (or is consistent over time), and thus I generally ignore accounting for VAT in the Foresight models.

Net Income #

Typically the last item on an income statement is net income, the company's total earnings or profit.

In the Foresight models, net income is:

Net income = EBT - taxes

I typically report the net income %, which is a measure of the ability of the company to turn revenues into profit:

Net income % = Net Income / Revenues

While net income often the thing that people look at first, I hope the explanation of the income statement helps explain that in understanding a business's performance, it's just one measure of operational success.

When analayzing an income statement, often I'll look at gross margin %, EBITDA %, and net income % together to get a look at how successfully the business turns revenues into profits, to draw insights about the business model of a company, and compare it to other companies in its industry, to get a feel for whether the company is performing well or not. Different types of companies will have drastically different profitability profiles given the fundamental operations of the business and the realities of their industries.

Statement of Cash Flows #

The Statement of Cash Flows breaks down the cash flows of a business during a period into three main areas, separating out the changes in cash created from the operations of the business, investing in the business, and financing the business.

Typically, the statement of cash flows records the cash on hand at the beginning of the period, the increase or decrease in cash flow resulting from operations, investing, and financing, and the cash on hand at the end of the period.

In the Foresight models, I build a typical statement of cash flows and also generally include a fourth statement that provides an alternative look at the cashflows of a company, and is a core part of the automatic fundraising calculations. For more on that function, read about the funding round forecasting ›

Cash Flows from Operations #

The cash flow from operations details how the operations of the business creates an increase or decrease in the amount of cash held by the company. The methodology is to start with net income, and then adjust it by adding back non-cash expenses (depreciation, amortization), and then adding (or subtracting) the changes in cash flows from working capital.

Changes in working capital is the net change in many balance sheet accounts that reflect the differences in timing between then cash is received or disbursed and when the revenue or expense is recorded on the balance sheet. The impact of these timing differences are tracked on the balance sheets as assets and liabilties, and the net of the changes in these accounts during this time period is the net changes in working capital that is added or subtracted to net income to calculate cash flows from operations.

For the exact details on which balance sheet accounts are used to calculate changes in working capital, consult How to changes in working capital capital affect a company's cash flow? or review the Foresight financial model for exactly how I do it.

Cash Flows from Investing #

The cash flows from investing detail the net cash spent to invest in the business, generally through capital expenditures, investments in the financial markets, and investing in subsidiary companies not consolidated into the company's statements.

In the Foresight models, generally the only cash flow from investing are capital expenditures.

Cash Flows from Financing #

The cash flows from financing detail the aggregate changes in cash from financing the business. This will typically record equity investments, new debt, repayments of the principal on debt, dividends, changes in owner's capital, stock repurchases, and other financing-related impacts.

For the users of Foresight models, it is typically new equity investments, new debt, and any debt repayments that are important in this section. The models do allow for dividends to investors, but it is not commonly used. This section fits most usecases for private companies, but if you have specific areas that require changes to this section, feel free to add them in or contact me for any questions.

Balance Sheet #

The balance sheet reflects the financial condition of the firm at a specific date in time, usually at the end of an income statement period. The balance sheet reports the company’s assets, liabilities, and shareholder’s equity, and a correctly calculated balance sheet (and consolidated financial statements) will hold true to a basic accounting premise:

Assets = Liabilities + Sharedholder's Equity

Thus, the balance sheet is divided into three section:

Assets #

Assets are resources that the company owns or controls with the expectation that they will derive future economic benefit from them. The most obvious asset is cash, but they include a variety of current (short-term) assets, fixed assets, investments, and intangible assets, and this section on the balance sheet is typically broken out into current and long-term assets.

Assets are valued at historical cost (also called book value), and adjusted for aging, use, or improvements, through depreciation and other methods. For more about assets, Investopedia has a good summary.

In the Foresight models the default assets section consists of:

Current Assets

• Cash
• Accounts Receivable, or money due in the future for services or products already delivered
• Inventory (if applicable), the value of products currently available for sale
• Work in Progress (if appplicable, and only for the Standard models and above), the value of products currently in manufacturing process but not yet available to sell
• Prepaid Expenses

Long Term Assets

• Property, Plant and Equipment, the value of the cumulative capital expenditures over time
• Accumulated Depreciation, the cumulative of the depreciation expense to date

Other Assets

• Other assets, not calculated but left as an input to use if relevant for your company

The user inputs are on the Get Started or Settings sheets, and differ depending on the forecast method. Accounts Receivable's input is for Days Accounts Receivable, the average number of days between delivery of a product or service and when cash is received. Prepaid expenses is for the % of non-salary SG&A expenses. Inventory (and if using a Standard Model or above, Work in Progress) is calculated based on a number of assumptions around inventory purchasing behavior and desired stock levels. Depreciation is handled using the depreciation schedule and an input for # of months to depreciate an asset purchase over (using the straight-line depreciation method). All of these assumptions are 0 by default and can in many cases be left at 0.

The exact balance sheet accounts for your company may differ, for example if you hold some cash in short-term investments, or other things specific to your business, and the model can be edited to fit your exact balance sheet accounts.

Liabilities #

Liabilities are financial obligations that have resulted from the business's operations. Liabilities are typically broken out into current and noncurrent (long-term) liabilities, and include things like loans, accounts payable, credit cards payable, mortgages, accrued expenses, and deferred revenues.

In the Foresight models, the typical balance sheet consists of:

Current Liabilities

• Accounts Payable, bills that have been received but not yet paid. This input is a percentage of current period SG&A.
• Accrued Liabilties (or accrued expenses), expenses that have been incurred, not billed, and not yet paid. This input is a percentage of current period SG&A.
• Deferred Revenues Liability, a liability created when cash has been received for services not yet provided. This is explained in the context of revenues under the income statement description above.
• Inventory Accounts Payable, or payments due for inventory (and work in progress, if applicable) that have been received but not yet paid for.
• Bad Debt Allowance, an allowance for accounts receivable that may not be collected, based on the company's historical percentage of accounts receivable that is written off and not collected. This is an input as the percentage of accounts receivable expected to be bad debt.

Noncurrent Liabilties

• Long-term debt, which represents any debt that has been taken out, and is reduced over time by any debt repayments. This is calculated from the debt fundraising forecast and the debt repayment schedule.

Shareholder's Equity #

The shareholder's equity represents the financial value of the firm, measured only by the assets and liabilities on the balance sheet. The accounts here will typically consist of any equity investments, retained earnings, current period net income (or loss), and any owner's equity, if applicable.

The Foresight models use a fairly simple shareholder's equity section:

• Owner's Equity, value of cash or equity put into the company by the owner, with a default input of zero
• Equity Investment, which is calculated from the fundraising and cash forecast
• Retained earnings, the cumulative value of net income (loss) to date. Many companies reset retained earnings every year and use net income (loss) for year to date; for simplicity's sake I use current period net income and let retained earnings grow over time
• Current period net income (loss), which is calculated from the income statement

As a note, I do not use "plugs" to force balance sheets to balance (meaning, to make assets = liabilities + shareholder's equity), and there is a check at the bottom of the balance sheet to make sure that the balance sheet balances according to that equation.

If the result of that check is anything other than zero, then the user should look at their statements to see what is not being reflected appropriately. Often the balance sheet fails to balance on the initial period if there is a beginning cash balance and no other accounts are recorded for the opening balance sheet, since that means there are liabilities or shareholder's equity values not being reflected. Usually the edit is to increase the retained earnings for the value of the cash, if no other opening balance sheet information is supplied.

Why build financial statements for your financial projections? #

Financial statements are critical for running a business, but not terribly meaningful until you have a business to run. And even then, for early-stage startups, the problem with financial statements is that they surface the wrong metrics for startups.

"Large companies need financial tools to monitor how well the are executing a known business model. Startups need metrics to evaluate how well their search for a business model is going." - Steve Blank

But while you can build a basic understanding of your business without creating a set of statements, you'll need financial statements when you're raising capital or once have a business to run. Investors will often want to see your projected statements so they can understand the business deeper and make sure you know the impacts of business strategies on the financial condition of a company.

The important thing to me about financial statements is not about creating them, but about using them, and knowing what they inform about a business and what they hide. For SaaS businesses, for example, the classic income statement is a start, but a deeper look at marginal recurring revenue (MRR) and its components are critical to understand the current state and future of the business.

To me, financial statements are important because they are a standard and accepted way of presenting your projections to people, but you can't stop there. There are many metrics to use to explain how your business operates that don't show up on a set of financial statements. LTV, CAC, website traffic, average order size, churn, cohort performance, MRR, any many other metrics are important operational metrics that explain how a business is performing in way that aren't captured by financial statements.

That's why I advocate a way of presenting your financials to investors that isn't just about a summarized income statement. Read more at How to pitch your financial projections ›