I’m stunned by the lack of financial literacy of so many people in so many contexts. The commentary by politicians, economists, and the media on the European debt crisis and the US debt ceiling dynamics is appalling. The general media and blogosphere commentary on the financials of high growth companies, especially those who have either recently gone public or filed their S-1’s, range from perplexing to just plain incorrect. And more and more entrepreneurs who I’m exposed to who are presenting their companies for financing have a complete lack of understanding of their financials – both current and projected. Of course, some of my fellow board members don’t understand how to read financial statements either, which doesn’t help matters much.
In my experience there are four specific things that people struggle with.
- An inability to read the Balance Sheet, P&L, and Cash Flow statements.
- A lack of understanding of how the Balance Sheet, P&L, and Cash Flow statements fit together.
- A lack of understanding how non-accounting metrics (e.g. bookings) impact the financial statements.
- A lack of understanding of GAAP (Generally Accepted Accounting Principles) and how to use the financial statements to help normalize out all the weird things GAAP makes you do.
I used to think it was all a GAAP problem. GAAP is complicated, continuously evolving and changing, and often creates more ambiguity that it resolves. But unless you actually understand how to read a financial statement, GAAP doesn’t even come into play. And by financial statement, I don’t just mean the income statement (or P&L) – I mean the income statement, balance sheet, and cash flow statement, along with understanding how they interact with each other.
If you understand how to read the financial statements, then you can start to solve for the GAAP challenges. You’ll be able to understand things like the implications of deferred revenue on cash flow, stock option expense on net income, and the actual equity dynamics of the balance sheet.
While there are so many things about this that I fantasize about (e.g. “the media would actually learn this stuff” and “accountants would make GAAP simpler and clearer vs. more complex”) the only thing that really matters in my world is that entrepreneurs understand how to think about this stuff. So, in the spirit of Fred’s MBA Mondays series, I’m going to write a series of posts that describe how my brain processes the financial statements of a typical high growth company with a goal of adding on to the great base that Fred has created.
I’m open for suggestions as to whether I should take on one that is newly public (e.g. the S-1 and historical financials are available), or a private company (I’m open to volunteers, although it’ll mean you are publishing your financials – at least at this moment in time.) If you’ve got suggestions or want to volunteer, just leave a comment.