Essentials of Finance and Accounting for Financial Modeling

I build Foresight's templates so that they can be used with a minimal amount of knowledge about finance or accounting, and ideally, no need to edit the template other than using the inputs and paying attention to the instructions on how to use the model. I have an MBA in Finance and Accounting and 20 years experience in corporate finance and spreadsheet modeling, and I've worked to embed as much of that knowledge into building model templates that are accessible to beginners and powerful for experienced finance practitioners.

If you have experience in finance and accounting, the templates should make sense to you immediately. If you're a beginner, some basic knowledge of spreadsheets ^[1] and finance allows you to unlock a lot of the functionality and power of the templates. With that in mind, here's the basic concepts about finance and accounting you need to know to be able to use the Foresight templates. ^[2]

The "Accounting Equation" and Double-Entry Accounting #

The double-entry accounting system is based on the idea that every financial transaction has an equal and opposite impact on at least two financial accounts, and is recorded as a debit to at least one account and a credit to at least one other account.

The equation underlying this is:

Assets = Liabilities + Shareholder's Equity

In using the templates, you should never have to worry about this, as the process of forecasting doesn't involve making entries into an accounting system. That said, understanding the basic principle underlying accounting is still a good thing to understand. Everything that's forecasted - revenues, expenses, investments, etc. - impact the financial accounts in multiple ways, and the resulting financial reports - the consolidated financial statements - are tightly interlinked because of how double-entry accounting records financial transactions.

Generally Acceptable Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) #

What is GAAP? GAAP, or generally acceptable accounting principles, is a set of rules that set how accounting works. GAAP is the foundation for how the Financial Accounting Standard Board (FASB) sets the accounting standards for companies in the USA.

There are no set of accounting rules throughout the world, however. The International Accounting Standards Board (IASB) sets the international financial reporting standards (IFRS) that are used in the UK and widely across Europe, as well as other countries.

The basic difference between GAAP and IFRS is that GAAP is rules-based and IFRS is principles-based, and have a number of technical differences around inventory costing, revenue recognition, and other accounting methods. If you want to read about GAAP, start here, and more about the differences between GAAP and IFRS, start here, but for the purposes of general forecasting at the level of detail for most companies using these templates it isn't important. The templates are built to handle a wide variety of companies and the concepts applied are fairly universal. ^[3]

Cash and Accrual Accounting #

Fool.com explains this well:

Companies can track their income and expenses on either a cash basis or an accrual basis. Under the cash method, revenue is recorded when it is actually received from customers, and expenses are recorded when cash is actually paid out. Under the accrual method, revenue is recorded when it is earned and expenses are recorded when they are incurred, regardless of when the cash is actually received or paid out.

The Foresight templates are built to handle either cash or accrual accounting, it's up to you in terms of how you input your revenues and expenses and use the inputs around accounts receivable, inventory, and other accounts that are used to help handle the timing differences between revenues, expenses, and cash receipts and disbursements. The Standard Model has a lot more prebuilt functionality for accrual accounting, but any of the models can be used for cash or accrual-based accounting.

Which should you use? C Corporations, companies that gross more than $5 mm in revenue, or companies that sell products to consumers and gross more than $1 mm in revenues must use accrual accounting. GAAP requires the use of accrual accounting, and public companies will have to use accrual accounting. If you are looking to raise investment capital will want to use accrual accounting.

Cash accounting, however, is pretty straightforward and easier to maintain, and is used by many small companies. More on cash accounting here.

The Matching Principle #

The matching principle is a fundamental concept in accounting that ensures expenses are recognized in the same period as the revenues they generate. This principle is integral to accrual accounting, where transactions are recorded when they occur, rather than when cash changes hands. The core idea behind the matching principle is to provide a more accurate picture of a company's financial performance and profitability within a specific period.

By aligning expenses with associated revenues, the matching principle ensures that financial statements reflect the true costs of generating income. This approach helps in avoiding significant fluctuations in profitability from one period to the next due to timing differences in recognizing revenues and expenses. For example, if a company incurs costs to produce goods in one period, but sells those goods in a later period, the costs associated with producing those goods are not recognized until the sales occur. This creates a clearer way of understanding the performance of a business.

Consolidated Financial Statements #

The financial report of a company usually consists of three different reports, that combined, are called the consolidated financial statements. Each of the three reports provides a different view of the company's performance, but they tie together to provide a "consolidated" view of the company's financial results and current position.

• Income Statement: Often called a profit and loss, or P&L, report, the income statement is the most commonly known and used financial report. The income statement summarizes revenues and income and expenses and losses for the period, and ends with net income or net earnings, the bottom-line profit for the period. Typically we build income statements to look at different periods, commonly for months, quarters, and years. More at Investopedia
• Balance Sheet: A summary of the financial condition at a date in time (usually at the end of an income statement period). As opposed to the income statement and statement of cash flows, which report results over a period of time, the balance sheet reports results at a specific date, and thus it can be thought of a snapshot of the company on a particular date. The balance sheet reports the company's assets, liabilities, and shareholder's equity. A proper balance sheet will result in assets = liabilties + shareholder's equity. More on the balance sheet, assets, liabilities and equity at Investopedia
• Statement of Cash Flows: A summary of the net cash increase or decrease during a financial reporting period (the same period as the income statement). The statement of cash flows typically consists of three sections to report the cash inflows and outflows from operating the business (cash flows from operations), from investing in property, plant and equipment, or capital expenditures (cash flows from investing), and from financing the business, including external investments, loans, dividends, and more (cash flows from financing). More at Investopedia

When we're building projections for an early-stage company, sometimes we will only build the income statement and a simple statement of cash flows, because our first focus is on the company's revenues, costs, and cash position. So it's not uncommon to start there and build a balance sheet later, especially if the business is relatively simple, doesn't have significant timing gaps between when revenues are earned and cash is received, and doesn't have significant physical assets or capital expenditures. Not to say the balance sheet is not necessary, just that it's often something we'll add later. ^[4]

So, why do we build financial statements? The key questions will vary based on the kind of business and its maturity, but the reports are designed to answer a few questions:

• Does the business earn a profit or incur a loss during a period?
• How did revenues change over time, and is the growth or declines in the business reasonable?
• Are the profit margins of the business reasonable?
• What is the cash flow resulting from the profit or loss during the period?
• What does the company own or owe (assets and liabilities)?
• Where does the business get the capital needed to operate the business, and is it being used appropriately?
• Does the business need more capital in the future?

To help understand those questions and the financial statements deeper, read the article about Financial Statements ›

OpenVC's post on Accounting 101 for Founders is a great explainer of the tactics to managing accounting at a growing company, detailing the tools, roles, and responsibilities involved in building a company's capabilities in accounting.