What is a Balance Sheet, P&L and Cash Flow Statement?
The following article, is part 1 of 4 in a “Finance for Founders” series, authored by Sven Huckstadt, who is a member of enki’s fractional finance community.
Sven is a Fractional CFO, who has just wrapped up his role at a VC firm where he worked closely with 3 x Series A companies, helping them scale, manage finances, and prepare for successful exits.
He brings firsthand insights from the front lines of startup finance - insights that form the backbone of this “Finance for Founders” series.
You can read more from Sven on [his Substack] or connect with him on [LinkedIn].
INTRODUCTION
As a founder, you might ask why you even need Accounting. Isn’t it enough to simply do the right thing? It’s not.
Accounting serves two functions:
It records all relevant financial transactions in your business.
It condenses these transactions into handy statements, namely Balance Sheet, P&L and Cash flow.
And whilst you’re legally obliged to go through this exercise so that tax authorities can determine your tax liability, the real excitement sets in once it becomes clear how BS, P&L and CF help you make decisions for your business.
This part of the “Finance for Founders” series takes a deep dive into exactly this - what are the three statements, what are they made of, what can we read into them and what pointed questions to ask after staring at them thoughtfully.
BALANCE SHEET - ALL YOU OWN AND OWE
The BS chronicles everything you own and everything you owe. Picture a table split in half, the left side containing all your assets, the right side how you managed to afford them; through debt or equity - like in real life.
Assets are commonly sorted by the time it takes to access them (in ascending order). The most liquid being current assets, including cash, payments you expect to receive from customers and inventory you expect to sell off for cash. Fixed assets on the other hand represent items used in the long run, think of property, buildings, manufacturing machinery or intangible assets (e.g. software licenses or acquired goodwill).
Intangible assets can include capitalised development costs. Tech companies commonly aim to capitalise developer salaries to reflect that those teams create an asset that can be used in the long run. Worth keeping two things in mind - 1) The ability to “make these costs disappear” is strictly regulated (see FRS 102 Section 18 and IAS 38) and 2) these costs will still reduce your cash balance, no matter if capitalised or not.
Liabilities follow the same logic, starting with items you expect to repay earliest. These are usually supplier payments, followed by short term debt, taxes and accrued liabilities (more on this later). Since no business runs solely on debt, the right side of the balance sheet closes off with equity - the money provided as investment by shareholders into the business. Notice that profits and losses from prior and current periods are also shown within equity. Inevitably, both sides need to balance.
The graphic below shows a simplified example of a balance sheet:
A simplified example of a balance sheet
Balance Sheet - What to look out for
Your accounting framework (e.g. IFRS or UK-GAAP) will determine in much detail how to assess and value the items on your BS. However, there are a few lines deserving universal attention:
Accounts receivable:
A deep dive into payments owed by customers is mandatory. In a best case scenario, all customers stick to their 30 day payment term and whichever value you see in AR can be assumed to hit the bank account within the next month. In reality, AR can include dubious positions, e.g. customers tight on cash or disputed services. The most transparent review of Accounts Receivable is a list of all outstanding payments categorised into 30-day intervals, showing which ones are outstanding since 30/60/90/… days.
Companies frequently add a bad debt provision to their AR line - this negative entry reflects the amount of payments that is expected to default. Picture having 10 outstanding invoices for £100 each. Assuming only 7 out of 10 will be paid, your bad debt provision will be shown as -£300 within the AR line. Understanding what payment terms customers have is equally important. Revenues are great but a business can get into trouble if it has to wait 90 days for payments.
Inventory:
Since this series focuses on tech-enabled businesses, inventory is commonly a minor concern. The opposite is true if you’re operating in the wholesale, retail or manufacturing space. The most common question to ask is: Are there any risks of not being able to sell the inventory - at all or at the price you expected. Your specific accounting framework will determine what value to assess for inventory (see FRS 102 and IAS 2).
Fixed assets:
Another one less relevant in tech. In other sectors, the key question to ask is: Are the fixed assets in a good enough shape to produce my products - or are there any investments into e.g. machinery that have been delayed, leaving you with outdated, unreliable machinery?
Prepayments:
Businesses commonly pay for services in advance - think of the annual bill for insurance or software licenses that are paid for quarterly. If you pay for the annual insurance cover in January, the insurance company owes you a service for the next 12 months. This is commonly shown as an asset on your balance sheet (which reduces by 1/12 each forgoing month).
Accounts payable:
The inverse of Accounts receivable - money you owe to suppliers. Again, an area for a deep dive into payment terms. Whilst there is less question around is it going to be paid, when those will be paid has big impacts on your cash flow. Finance teams often underestimate the opportunities to negotiate supplier payment terms.
Accruals:
Accruals provide for expenses whose specific amount or timing is not accurately known yet, or which are simply not invoiced yet by the supplier. Think of accruals for bonus payments, year end audit costs, potential legal disputes etc.
Accruals are used to ensure that all those costs are reflected on the Balance Sheet as future liabilities - and in the period they relate to. Hence bonus payments are commonly accrued for throughout the financial year even if they might be paid out in the following year.
When reviewing a BS, going through Accruals is vital. It shows you what unrealised costs the business expects in the future. The question of “Is everything sufficiently accrued for?” is a common debate during year end audits, M&A transactions or conversations with investors.
Deferred income:
Picture the following situation - In January, you just successfully closed a contract for an annual SaaS fee worth £100 per month. You immediately send the invoice once the customer agrees to pay the full amount upfront (with 30 days payment terms). Lucky you! Here is what happens on your Balance Sheet:
Here is what happens on your Balance Sheet:
Deferred income prevents you from recognising the full £1,200 as revenue/profit in January - Why?
Because you owe the customer the delivery of the service till the end of December. Since Accounting aims to allocate revenues and costs into the periods in which they occur, you don’t realise 12 months worth of revenue in month 1. Instead you recognise 1/12 of the total contract amount as revenue each month (since you successfully provided the service) and reduce the obligation (deferred income) by the same amount.
Whilst Deferred Income is a liability, it is usually considered a positive sign. It implies you managed to close a deal and have customers pay upfront. The only downside, if it can be considered as such, is that you now have to deliver on the promises you made when closing the deal.
To conclude the peak into the Balance Sheet, you will have noticed that the BS is a great starting point to calculate further ratios and KPIs that help assess the health of the business:
Cash to Deferred Income Ratio = Cash / Deferred Income
Remember deferred income being an obligation to provide a service in the future? The Cash to DI Ratio expresses how much cash the business has to honour those obligations - think of it as a delivery cushion. In an ideal scenario, where customers paid upfront and individual contracts are priced with a positive margin, this cushion should be, well, cozy. However, in fast growing businesses where investments in growth and overheads can eat up the last funding round quickly, caution is warranted.
Debt to Equity Ratio = Total Liabilities / Total Equity
Shows to what extent your business is funded through debt versus equity. Note that this metric can become quite high quickly for fast growing SaaS companies given they tend to accumulate a lot of Deferred Income. In mature profitable businesses, the ratio usually pivots back to the 1:1 range. For early stage SaaS companies it can be helpful to simply exclude Deferred Income from the Liability part of the calculation.
Current Ratio = Current Assets / Current Liabilities
Shows to what extent your current assets suffice to cover your current liabilities. In a simple scenario this represents cash and expected incoming payments from customers versus payments made to suppliers. Note how the Current Ratio is closely related to the Working Capital (WC = Current Assets - Current Liabilities).
Days Sales Outstanding = Accounts Receivable / Annual Revenue * 365
Shows how long it takes on average to collect payments from customers. Say, your outstanding AR is £100 at a revenue run rate of £1,200. In this case, your average collection time is ~30 days. Viewed from a different angle, it can become a red flag if your AR start substantially exceeding the revenues of your previous month.
P&L - ALL YOU MAKE & SPEND
If the BS highlights all that is owned and owed, the P&L shows all you make (income) and spend (expenses). The purpose of the P&L is to correctly reflect income and costs - and hence profits/losses - for any given period. Importantly, income and costs does not necessarily mean cash.
An example:
As part of a Saas contract, you agreed with your customer to charge for a 3 month implementation project with a total volume of £300.
After month 1, the implementation is on track but you agreed to wait with the invoice until the project completes. Your accounting team will recognise/accrue 1/3 of the project (£100) as revenue and add them to the Accounts Receivable line on the balance sheet, as they represent a future payment claim against customers.
Once the implementation is completed and the invoice is issued, the invoiced amount will replace the accrued revenue entries. FRS 102 Section 23 and IFRS 15 detail the rules for revenue recognition.
The same applies to costs. Say, your team hired a contractor to support the implementation project. Even if said contractor did not provide you with an invoice yet, your Accounting team will recognise the expected costs on the P&L.
This makes the link between P&L and BS quite obvious:
Step 1) Income and expenses are recognised in the period they belong to - and contribute to the current year’s earnings, increasing profits or losses.
Step 2) This income/expenses either increase/decrease cash immediately (if paid immediately) or constitute an account receivable from customers/account payable to suppliers. Again, no income/expenses without a change in cash or assets/liabilities.
Another example:
Sales employee receives £10k base salary for this month. We expect the deals they closed this month will contribute another £10k to their bonus, which is paid in April next year.
P&L: Personnel costs £20k
Balance Sheet: Cash -£10k, Liabilities +£10k, Current Year Earnings -£20k
The table below summarises the format of a standard P&L:
P&L - What to look out for
When first being presented with a P&L, there are two questions you’ll ask:
Can I trust the data in front of me?
What does this data tell me?
To trust a P&L means to believe it accurately represents income and expenses in the business in the period you’re looking at - ask:
On income:
Are revenues accurately recognised, e.g .is a 12-month split into monthly figures instead of booked when the annual invoice was sent?
Are any one-off revenues separated from recurring revenues to not create the impression that they’d be recurring?
Are there any other monthly fluctuations in revenue numbers that can’t simply be explained through adding new clients or seeing clients churn?
On expenses:
Are costs largely stable or do they wildly fluctuate - the latter can indicate that costs haven’t been accurately accrued for (e.g. in the case of annual bonus payments)?
Are prepayments accurately accounted for or are invoices just reflected in one month - think of annual insurance premiums or licensing fees which should be spread over the duration of the contract?
Are typical costs missing that most businesses have to accrue for until they actually happen (e.g. audit costs)?
Granted the data is correct, the story you look for in a typical SaaS business is: Revenues gradually increase as new customers get added, existing customers are retained, their contract volumes extended, whilst Margins remain sufficiently high (80%+ benchmark for SaaS) and Overheads, in particular staff, grow slower than revenues.
In practice, a common sense check is the rule of 40:
Add the annual revenue growth rate (Revenue this year / Revenue prior year) to your Profit Margin (Net Profit / Revenue). Many early stage start ups will grow 100% YoY whilst being loss making, say growing revenues from £1m to £2m whilst making a loss of £1m. The rule of 40: (£2m/£1m) + (-£1m/£2m) = 50%. Any value above 40 is considered a good benchmark. The metric aims to balance growth with profitability, arguing that it can be acceptable to lose money as long as it enables high growth rates.
Note of caution:
This only holds true if the business has access to sufficient funding to finance temporary losses and has a credible path to profitability, i.e. positive unit economics/a positive Customer Lifetime Value with each customer.
For simplification, some SaaS businesses calculate the rule of 40 based on EBITDA instead of Net Profit given the majority of early stage SaaS companies have negligible interest, tax, depreciation and amortisation.
As start ups scale, founders need to strike a balance between running a lean team and investing in seasoned talent who know what good looks like. A lot of business plans aim high, e.g. expanding into international markets without considering experienced senior hires to deliver those plans.
Ask yourself: If I want to 10x the size of this business:
(1) Do I believe my current team can 10x their capabilities
(2) Do I believe they’ll get it right the first time whilst someone more experienced will have made plenty of mistakes and learned from them?
Understating the investment in talent is a common mistake in start up business plans.
Rounding up the view on the P&L, the below shows an example of what an early stage SaaS plan could look like. Granted, investor appetite has changed when it comes to funding businesses who assume to be loss making for multiple years.
Note that some companies aim to isolate exceptional items (e.g. one-off costs) to exclude them from the P&L by introducing a figure for “EBITDA” and “Adjusted EBITDA”. Whilst this can help to show the “true” picture of operational performance, it should never become a way of hiding costs.
CASH FLOW - WHAT ACTUALLY HAPPENS ON YOUR BANK ACCOUNT
A common scheme amongst start ups is to review the P&L, eventually the balance sheet but struggling to reconcile what caused cash to change. Given we covered Balance Sheet and P&L, we can easily weave them together to explain changes to cash - using the indirect cash flow method (simplified):
If calculated correctly, this bridge adds up to the change in cash you see on the balance sheet between this period (e.g. this month) and the prior period (last month). It helps to uncover issues like negative operating CF being compensated by taking on new investment or strong operating CF being diluted by high investments into Capex.
The operating cash flow is an important basis to calculate cash runway. Say, your business loses £1,000 per month (your current burn rate) and you have cash reserves of £12,000. Assuming current losses continue, you’ll run out of money in a year. Early stage businesses commonly calculate cash runway this way to signal to investors how long they can sustain the current burn without accounting for the uncertain upside of higher sales.
An alternative approach to Cash flow (the direct cash flow method) does not require P&L and BS and instead sums up all cash transactions grouped into categories. Whilst both can be beneficial, the indirect method is used more commonly since it is easier to compile.
Conclusion
To recap, the BS shows what you own and owe. The P&L shows what you make and spend and the CF shows what happens on your bank account. P&L and BS are intimately linked since any revenue or cost in the business either changes the cash or obligations to suppliers/claims against customers. Given the nature of double entry bookkeeping, P&L and BS allow limited space to hide what’s happening in the business. To reduce surprises even further, ask questions about accruals of costs and deferrals of income. When reading the BS, emphasise claims against customers to ensure they are as valuable as claimed, whilst keeping an eye on the balance assets and liabilities - in particular short term assets and short term liabilities to avoid a cash crunch.
Appreciating this was a whistle stop tour, don’t hesitate to reach out for further detail and examples - or advice on how to interpret your financial statements.