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As first-time tech services founders, we struggled to wrap our heads around finances. We were dumbfounded by how the numbers weren't aligning for something as simple as adding up and getting money. And at that point, we got a glimmer of how complex finances can be in a business - especially in a fast-growing business.
We have been talking about monitoring your finances, but many early-stage tech services founders don't have the basic knowledge to monitor finances properly. This article defines ten key financial and accounting terms to build a foundation and give you direction to continue your learning.
1. Accrual Accounting
Accrual accounting is a fundamental concept in finance that tracks revenue and expenses when they are incurred, regardless of when cash transactions occur. Unlike cash accounting, which records transactions only when money changes hands, accrual accounting recognizes revenue when earned and expenses when incurred, regardless of the timing of cash receipts or payments. So, employees' salaries are counted when they work, not when payroll is run. Similarly, the revenue is counted when invoiced regardless of the net terms.
This method is critical for any fast-growth tech services company. There is a lag between the work you do and receiving the money. Accrual accounting showcases the money that is promised. Without it, growth would show as losses.
2. GAAP
GAAP or Generally Acceptable Accounting Principles is a set of accounting rules to make financial statements consistent, understandable, and transparent. GAAP is on accrual accounting and has detailed rules that public companies must comply with.
If you are an early-stage tech services company, you'll find GAAP is still useful in helping you understand the financial state of your company. But it may become too onerous and require more advanced systems than your team is ready to handle to be fully GAAP compliant. You can fill these as you mature. Beware, larger acquirers will be suspicious of your books if they find deviations in GAAP and redo your accounting before arriving at the final sales price.
3. Cash Accounting
Cash accounting records transactions when the money is transferred: when payroll is run, checks from customers are received, vendor payments are made, and so on. Cash accounting is just as critical to the company, even if you do everything by GAAP. It determines the money in your bank account at any time. Just like your household finances, if you are not on top of cash in the bank, you won't be able to meet your obligations to your vendors and employees even if you have a large amount of money in accounts receivables.
4. Balance Sheet
A balance sheet is a financial statement that provides a snapshot of a company's financial position at a specific point in time, typically the end of the quarter. It gives an understanding of the overall financial health of the company.
5. Revenue
Revenue is your company's total income from its primary stream of operations. This is why you're in business, and this is the bedrock of your profitability and growth. Higher revenue signals greater business viability to investors.
For tech services companies, it's worth keeping in mind that revenue is not counted when the work is done and ready to invoice but when the work payment is actually made.
6. CAGR
CAGR is Compound Annual Growth Rate, which measures the average annual growth rate over a specified time. It helps mitigate the effects of any temporary fluctuations and provides a consistent measure of growth. A high CAGR means your business has had strong & sustained growth.
7. Gross Margin/Profit
Gross Margin is the percentage of your company’s revenue left after subtracting the cost of goods sold (COGS). It tells investors how strong your company's business model is and your company's potential for steady growth in the future.
A tech services company mainly sells engineer hours. The bulk of its COGS is the payroll for the delivery team. The gross margin shows how premium your services are considered.
8. Net Margin/Income
Net Margin is the ratio of net profit to revenue earned. It’s how much income is left after expenses have been deducted from it. it shows how much profit you can make out of your sales and how efficiently your company operates. An early-stage tech services founder may also find this number affecting their day-to-day personal life.
9. EBITDA
EBITDA is Earnings Before Interest, Taxes, Depreciation & Amortization. It helps investors assess the fundamental profitability of your company. It is a measure that ignores items on the income statement that may not relate to operational performance. Since amortization is frequently used in the software industry, it also helps highlight cash profits that might otherwise be obscured by it. See also: Operating Margin
10. Working Capital
Working capital is the difference between your company's assets and liabilities. In other words, it's the difference between how much you own and how much you owe. It helps you understand your company's financial health in the near future and the efficiency with which it operates. Having more working capital means you can invest it into growth or save it for the future, but be wary of having excess working capital at the expense of investment opportunities.
These metrics are commonly used in financial analysis to assess a company's performance, financial health, and resource efficiency. Remember that financial metrics may vary between industries. You should consider industry-specific benchmarks and norms for a comprehensive analysis.
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