ES-IV: Managing Finances of a Startup

Profit & Loss and Balance Sheet

While cash-flow management is a priority for startups and mature companies, an important question one needs to ask is how much money a company will generate from each unit of product or service that it sells (or plans to sell). A good understanding of this will help the entrepreneur arrive at the number of products / service offerings to be sold, for the company to break-even and become profitable. We will start this blog by understanding Product / Service Margin. This will play an important role when we take up Profit and Loss (P&L) computation later.

Though a startup may have some distance to go before actually selling products/services, these estimates should be computed even during the product development stage. Let us term this Product margin estimation. When the product/service is being sold, this straightaway gets plugged into the P&L. The margins multiplied by the number of units sold and delivered will be cash-inflows in the cash-flow computation, but it must be noted that sales do not imply an immediate cash-inflow. In fact, payments against sales may take time to materialize, especially in B2B (Business to Business) transactions. Furthermore, cash-outflow (for materials, manpower and utilities) typically occur much before product sales/delivery. Normally, the interim gap between cash outflow and inflow is captured as finance cost on working capital, and considered part of product cost. The actual timeline of cash outflow and inflow directly impacts cash-flow computation.

Product-margin estimation excludes cost of marketing and sales: a company will usually incur expenses for marketing and sales team,  including that for travel, advertisements, are all reflected only in the P&L. However, direct cost of sales like dealer commissions is captured and subtracted from product selling price while computing the product-margins.

Margin from a unit of good/service sold: How much will the company make from each unit of product / service sold?

The margin-estimation involves the following:

1. Expected Average Sale price of a unit of goods / services (taxes on sale of goods / services can be treated as extra and all taxes on materials purchased, utilities can be offset against it and should not come in sale price).
2. Cost of goods (materials required) and any material wastage for each unit.
3. Manpower costs for manufacturing each unit of goods and service.
4. Utilities, rentals and infrastructure costs required to deliver each product (for example, rentals and electricity bills of manufacturing place).
5. Finance cost of the money required to purchase raw materials for each unit of goods (from the time material has to be sourced till cash is expected to be received in full for the goods sold). This often becomes the key problem in India as payment for goods / services delivered is delayed beyond what the contracts allow (the delay will imply higher finance costs that is not captured in the margins).
6. Research and Development costs amortised against each unit of goods/services.
7. Direct cost of selling goods (commission paid to dealers, etc); marketing and sales costs are not included here. Likely cost of free warranty given for a period should also be factored in while calculating the cost.
8. This will help compute margins that the company will make per unit of goods / services sold, which will be equal to (1 - 2 - 3 - 4 - 5 - 6 - 7 - 8).

As mentioned, a startup may be far from delivery. In that case this may somewhat be postponed. But in forward-going plan, this will play a major role. For those in production, this is critical. The margins will indicate the flexibility available to a company in varying the selling-price and returns associated with it. Of course, material cost could reduce significantly with volume and in time. Normally one should estimate margins assuming certain volume of production (and take loss in margins during early production as a startup cost). However, it is important to remember that every Rupee lost has to be recovered later [1]. The product margin computation needs to be periodically refreshed taking into account  changes in costs and selling price. Once production starts it may be worthwhile to carry out this exercise every three months, with corrections reflecting actuals.

Profit and Loss (P&L)

We are now ready to build the P&L statement for a company. First the revenue side followed by expense. A startup should prepare a P&L plan for the next month, quarter and year ahead based on the following:

1. Expected Order value for goods/services (called Revenue, shown as A in the Table 1) month by month for a year and half at its delivery time (when the revenue will normally be recognised [2]).
2. Take into account all the Cost of Goods Sold (as discussed in the previous section on product / service Margin computation) and shown as B in Table 1. Also referred to as Direct Costs, which are directly attributable to production including direct material, direct labour and other direct expenses.
3. The margins and therefore Gross Profit (or loss) A-B for the company, shown as C in Table 1.
4. A company’s monthly burn [3] (total amount of money company must spend irrespective of any inflow, which covers employee salary, rent, utilities, insurance, etc.), also termed as Operational Expenses (item D in the table), includes projections and needs to be computed on a monthly basis for at least a year and a half (e.g. one may wish to increase employee size in the future and related expenses must be captured in projection).
5. Gross Revenue minus Operational Expenses will indicate Net Profit (or Loss), also commonly referred to as earnings before interest, depreciation, tax & amortisation (EBIDTA) (Table 1: E = C-D). This can be computed every month for the next 18 months.
6. Next, account for Depreciation & Amortisation (F in Table 1) on investments (for all capital costs including the costs involved in setting up production plant & machinery, and also any other capital investments) made in the company. 
7. Finance cost or Interest expenses [4] for any borrowings including that for plant & machinery are accounted as H (Table 1).
8. Net profit minus Depreciation/Amortisation indicates the Operating Income or EBIT (G in Table 1).
9. This gives us Net Profit (I = G-H in Table 1). This should be computed monthly for next 18 months. A key financial parameter, commonly referred to a Profit before Tax (PBT).
10. P&L is almost complete. The next entry is Income Tax [5] to be paid by the company based on PBT. Note that startups may benefit from tax breaks, which diminishes with significant scale.
11. Profit after Tax (PAT) is K = I -J (Table 1). This can be estimated for next 18 months. 

Table 1: P&L statement

Visibility into the likely P&L for next few months and a year and half gives the CEO the leeway to operate. Note that R&D costs have not been accounted here. There are two ways to do this:

• One is to capitalise, amortise and recover R&D costs when company sells goods, as mentioned in the 'Product margin computations' section (item 6).
• Alternatively, one can take R&D expenses directly in P&L and club it with depreciation, as shown in the P&L Table 1 as item F [6].

Note that even if there are no sales (net revenue is zero), the rest of the items from P&L (D to J in Table 1) are still valid and contribute to losses for the company. Therefore, this computation should be done for every company from month 1 onwards.

P&L of a company feeds into the Balance Sheet, another important financial statement that reflects the current state of the company. It can be computed month after month and gives the state of the company from the very beginning to the current date. In contrast, P&L is for current month / quarter / year. Balance Sheet, P&L (for the month / quarter / year) and current Cashflow together forms three most important documents of the company. It reflects financial health of a company and indicates problems that it faces. All these three documents are audited by an auditor and must be presented every quarter to the Board. For listed companies, the Board needs to approve these statements and the results must to be declared, published and filed with Ministry of Corporate Affairs (MCA) and stock-exchanges every quarter. For non-listed companies, it is mandatory for the Board to approve these financial statements and the company to file these documents with MCA at the end of each financial year [7].

Let us now discuss the Balance sheet.

Balance Sheet

Balance sheet is the next important document that should be tracked month by month by company management, and every quarter by the Board. It reflects the state of the company from its very beginning (from when the company started) to the current date (the date the balance sheet is prepared). It captures all sources of funds for the company and any accumulated profit and losses, which is referred to as Current Liabilities [8] and Equity. Similarly, it captures Assets of a company, where the company has applied its funds. The two numbers must balance all the time.

Let us start with liabilities and equity.

Current Liabilities and Equity (source of funds) includes the following:

1) Shareholder’s funds: includes Share Capital, Reserves and Surplus as well as surplus in income statement

• Share Capital (amount of investment): This is the sum total of all the funds that have been invested into the company at any point of time. This is the actual amount of money that came in, irrespective of the valuation at which money was invested.
• Reserves and Surplus (accumulated profit): This is the sum total of all profits (or losses) year after year till the end of last financial year. A negative amount implies that the company has accumulated losses. If the losses are higher than the share capital, then the company has wiped out all its investments, thus implying that net-worth has eroded completely. This is a precarious state of the company.
• Surplus in income statement (current profit): This amount is the profit (or loss) in the current year, taken from P&L. At the end of the year, it will get added to reserves and surplus. 

2) Non-current Liabilities

• Long-term borrowings: These are long-term funds borrowed by the company from banks, financial institutions or promoters. They need to be returned with finance charges.
• Other long-term liabilities: Any liability other than loans (from banks and financial institutions) and not payable within 12 months; any long-term advances, security deposits from any clients.
• Deferred tax [9] liabilities [10]
• Long-term provisions: long-term employee benefits like gratuity and provision for warranty.

3) Current liabilities [11]

• Trade Payables: Amount a company owes to vendors against the purchase of goods or services. In some sense it is the amount borrowed from vendors. Such late payment (contracted or otherwise) may carry interest and penalties, which also needs to be captured here. 
• Short-term borrowings: Loans which are payable on demand.
• Other current liabilities (payables in short run in the current year): Statutory Remittances, current portion of long-term debt, current portion of long-term liability and interest accrued but not due on loans, interest accrued and due on loans, advances from customers, retention of money payables, etc.
• Short-term provisions: Current portion of provisions like provision for employee benefits, taxation, warranty etc., and any salaries, rent or other outstanding in short-run.

The sum total of all these will be the current equity and liabilities of the company. This is the amount that must tally when we look at assets, where these funds have been used: Assets must match Equity and Liabilities. Some of it may be cash and cash equivalents (cash in bank). Let us discuss each item.

Assets (application of funds)

Assets can be grouped into three categories: non-current assets, non-current investments and current assets.

1. Non-current Assets 

    a) Fixed Assets

• Tangible: Building, land, machinery, office equitable.
• Non-tangible: Software license, business license (amount paid minus depreciation / amortisation)
• Capital Work in Progress.

    b) Long term Loans and Advances (electricity deposit, capital advance for purchase of capital assets rental advances paid)

2. Non-current Investments: A long-term investment is an investment other than a current investment. Investments made by the company in Equity shares, Preference Shares, Debentures, Mutual Funds and property, which are unrelated to investing company, and which the company plans to hold for more than a year. 

3. Current assets: An investment that is realisable and is intended to be held for not more than one year from the date on which such investment is made. 

    a) Current Inventories and stock of consumables (e.g. diesel or items for production)

    b) Trade Receivables: Amount to be received from those who owe money to the company (sundry debtors)

    c) Short-term loans and advances: Travel advance, staff-advance, advances given to suppliers for goods/services.

    d) Cash and cash equivalents (in bank)

    e) Other current assets: Include items which cannot be grouped under any of the current asset item.  

As mentioned above, these are the total assets in the balance sheet and must match liabilities to the last paisa all the time. If the company is doing well currently, its P&L will reflect that. But the company’s accumulated losses, reflected in the balance sheet, may be so large that the company may never be able to pay back its liabilities (unless its current and future profits multiply significantly). In that case, the value of a company may be negligible, even though it is profitable. Alternatively, it may have huge surplus from the past and the current negative amount in P&L may be a temporary phenomenon that can possibly be reversed. Value of the company is then still intact. There could also be a situation where cash-flow is a serious challenge, even though P&L and Balance Sheet look okay. This shows that company urgently needs to raise some equity. If it fails to do so, value of the company may be wiped out.

It is critical that startup founders and management are always on top of Cash-flow, P&L and Balance sheet. It may take time to understand these, but failure to do so may harm a company.

Summary

* Cashflow, P&L and Balance Sheet together reflects the financial state of a company at any point of time. These must be given utmost importance by the company / founders.
* Product Margin will indicate the flexibility available to a company in varying the selling-price and returns associated with it. Margin computation needs to be periodically refreshed taking into account  changes in costs and selling price. Once production starts it may be worthwhile to carry out this exercise every three months, with corrections reflecting actuals.
* It is important to have visibility into the likely Profit & Loss (P&L - estimated revenue and expenses) for the next few to 18 months. This gives the CEO adequate leeway to operate the company.
* A Balance Sheet shows what a company owns and owes and how much shareholders have invested. Assets (cash, inventory, property/long term investments) = Liabilities (rent, wages, utilities, taxes, loans ) + Shareholders' Equity (retained equity).
* If the company is doing well currently, its P&L will reflect that and it could result into a good valuation. But the company’s accumulated losses, receivables and borrowings (reflected in balance sheet) may be so large that the company may never be able to pay back its liabilities. Valuation will then be severely eroded.

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[1] A company may choose to incur certain cost and not worry about losses, as they believe that they are market-making in nature (for example, Ola chose to give away all that it collected in the beginning to drivers as commission and recover losses from its investment).
[2] Company board should setup a revenue recognition policy, indicating when should the revenue be recognised. For a startup, revenue could be recognised on the date the product / service is delivered and accepted by the customer. But others may have some earlier revenue-recognition, especially in long service contracts.
[3] P&L statement is prepared on an accrual basis and not cash basis; therefore all expected costs for that month, irrespective of actual payments, need to be reflected in P&L.
[4] Finance costs for working capital here has been taken into account in margin computation to better understand what one earns from a unit of production. There is a view that instead, it can be included in P&L.
[5] Every company is liable to pay tax. Current Tax is determined based on the taxable income of the Company. The numbers reported on the face of the Profit and Loss account is Accounting Income. There are certain allowances and dis-allowance to the Accounting Income and the taxable income is determined. More on it later.
[6] Whether to capitalise the R&D expenses and amortise it when product is sold, or to directly write it into expenses in the month it is made, is a matter that board needs to decide. Generally in a startup, one capitalises the R&D expenses so as to avoid building up losses in startup phase and amortise it over future sales of product. But in a mature company, the R&D expense (especially product development expense) is written as current expenses.

[7] In India a financial year is between 1st April of a year and 31st March of the following year.
[8] It is referred to as liabilities as company owes these funds to someone.
[9] Taxation are broken down under two heads: Current Tax and Deferred Tax. Current tax was discussed in P&L section and applies some allowances (for tax break) or disallowances (no break). Deferred Tax is timing difference between taxable income and accounting income that originate in one period and are capable of reversal in one or more subsequent periods.  For example, Provision for gratuity are disallowed for tax purpose, and hence the company pays tax in the year of provision.  However, this can be claimed as a tax expense in the year in which gratuity is paid.
[10] Deferred tax can also be an asset in certain cases instead of a liability. For example, income tax treats depreciation differently from the way income tax treats it. For income tax computations, depreciation can be claimed only at income tax rates. If company depreciation is larger, it can result into deferred case later.
[11] A liability is classified as current if a company does not have an unconditional right as on the Balance Sheet date to defer its settlement for 12 months after the reporting date. All other liabilities are Non-current.