Kauffman Founders School, Bill Reichert, The Art of Startup Finance, Financial Processes:
Your Income Statement
So in this module we're going to talk about the financial processes of your business.
That encompasses the income statement and the cash flow statement. The income statement
and the cash flow statement sit right on top of your balance sheet, on top of the financial
foundations of your company. So the balance sheet is a static snapshot of your company's
health at any given point in time. Your income statement and your cash flow statement show
your financial processes. And that's like a video of your business over a period of
time. And so while your balance sheet is as of a certain date your income statement is
over a period of time. First, of course, at the top of your income
statement are sales or revenues. One thing we get from some first‑time entrepreneurs,
they start calling sales the same is income. And that's not right. Don't call it income.
Income is at the bottom of your statement, not at the top. Now below your revenues are
your costs of goods sold. The costs that you incur to make the product that you're going
to sell. It's the material you use. It's the labor you put into a building it. Those are
the costs of goods sold. So you've got your revenues. You've got your costs of good sold
underneath. You subtract cost of sales from revenues and that gives you your gross profit.
Your gross profit is the profit that you make, the difference between the cost and the revenues.
Your gross profit margin is the percentage of that profit measured against the sales
number. If you make something for $50 and you sell it for $100, your gross profit is
$50. Your gross profit margin is 50 percent. So sometimes entrepreneurs make the mistake
of saying hey, if I sold it for $100 and I made it for only $50, that $50 profit is 100 percent
profit. That's wrong. The gross profit number is calculated on the sale number, not on the
cost number. Get that right. Investors love it when you have a big gross profit margin.
So you'll hear investors ask what's your margin. Because they want to know, is the fundamental
structure of your business really profitable. So we as investors, we like to see companies
with a gross profit margin of 70 or 80 percent. We hate it when a company has a gross profit
margin of only like 10 or 20 percent. That gives you very little wiggle room to grow
your company if your margin is that small. The next thing on your income statement are
your operating expenses. So that includes things like your R/D and your engineering.
It includes your marketing and sales. It includes some of your operation and administrative
activities. Traditionally accountants will say, okay, you have this expense item which
is called S.G.A. S.G.A. means selling, general and administrative expenses. They lump all
of these different expenses into that one category. That's not very useful to you as
an entrepreneur. As an entrepreneur you want to be able to take apart the processes of
your business into the important components. I want you to manage your income statement
the way you run your business, not the way a bookkeeper wants you to run your income
statement. Think about what are the critical activities of your business and then organize
your income statement, operational expenses according to critical activities of your business.
Such as key activity is, building the product. So put the R/D and the engineering together
into one expense category. How much do we have to spend each month to build and maintain
and support and continue to develop this product. Administration also may be a separate activity.
What do you have to pay for the infrastructure of your business? You know, the rent on your
building, the cost of your data lines and phones, things like that. So you put together
all of those operating expenses, you deduct those from your gross profit and that becomes
your operating profit. Your operating profit shows the profitability of your company's
operations. You know, a lot of what I've been saying about
the income statement and the details of the income statement sounds like a lot of work,
right? So I really encourage you, don't take it on yourself. There's all these details
of running a business that can overwhelm you as the entrepreneur. I strongly encourage
you, get a great office manager who can take care of all of these details, can make sure
that your books are in order and can keep you focused on the most important parts of
your business. Well I mentioned before investors are really
interested in your margins. Particularly focus on your gross margin, obviously at some point
they're going to be really interested in your operating profit margin. And finally your
net margin, which is the net income margin. So they're going to look at those numbers
as indicators of how profitable you are and how efficiently you're running your business.
But there are some other deeper dives that investors are going to do into your income
statement. They are going to be looking for what we call operational efficiencies. How
efficient are you at running these processes compared to our other companies? So they are
going to do ratios on, you know, how much are you spending on marketing compared to
your revenues, how much do you spend on sales compared to your revenues, and how do those
ratios compare to other companies in your business and other companies in their portfolio.
So you're going to want to learn to look at these ratios. And you're going to want to
focus on figuring outer how to get those ratios in line with the expectations of investors.
And even better for your own sake, how can you squeeze more profit out of your company
by being even more efficient than you are.