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Financial Literacy

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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.

Fred Wilson took on some of this with his awesome MBA Mondays series, including several great posts around financial statements that every entrepreneur should go read right now:

In my experience there are four specific things that people struggle with.

  1. An inability to read the Balance Sheet, P&L, and Cash Flow statements.
  2. A lack of understanding of how the Balance Sheet, P&L, and Cash Flow statements fit together.
  3. A lack of understanding how non-accounting metrics (e.g. bookings) impact the financial statements.
  4. 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.

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July 13th, 2011     Categories: Financial Statements     Tags: , , , , ,
  • http://www.coreedges.com Julien

    And now I know what I’m gonna read on my ipad during stretches :-)

    Seriously, awesome idea and looking forward to reading it!

  • http://www.coreedges.com Julien

    And now I know what I’m gonna read on my ipad during stretches :-)

    Seriously, awesome idea and looking forward to reading it!

  • http://reecepacheco.com reecepacheco

    awesome. looking forward to it.

  • http://reecepacheco.com reecepacheco

    awesome. looking forward to it.

  • Kyle S

    I think this is a great idea. I doubt you’ll have too many private takers, but as there are so many S-1s and 10-Qs from going public or already public companies, you should have a lot of targets to work with. Off the top of my head: AWAY, P, LNKD, Groupon, Zynga, plus the foreign IPOs (RenRen, Qihoo, Yandex).

    One topic I would be interested in is how VCs value high growth, revenue generating companies in later rounds. I understand that in early rounds, this is more black art than science, as there is no “there” there, i.e. no business to apply valuation metrics to. But in later rounds, there are plenty of numbers to look at. One possible example would be to look at Zynga’s or Groupon’s S-1, go “back in time” to their last private financing, then use the numbers VCs would have seen at the time to explain how those rounds were valued and/or sized.

    Also, you should probably mention some non-blog resources that readers could use to brush up on this stuff. Graham & Dodd, for instance, but even a basic Accounting textbook; if you don’t understand the basics of accrual accounting, you can’t understand how working capital changes impact cash flow, or the difference between bookings and GAAP revenue. Perhaps you’ll cover such topics as these in your series :)

    • Kyle S

      To explain my last comment better: while you could write a series of one-off posts explaining why, for instance, an increase in AP is actually a source of cash, your readers would be better served if they understood the principles behind such things. Teach a man to fish, and all that.

  • http://twitter.com/peteskalla Peter Skalla

    Brad,  this is a good idea and important.  As an entrepreneur I work hard to understand technology.  But as a finance guy, I see how much entrepreneurs miss not making the modest effort it takes to understand financials.  In fact I’ve spent the last year working on a solution.  Seth was kind enough to review briefly and didn’t see an investment fit, but it may be interesting relative to this post for you.  Take a look at our MVP product video for automating and making financial statement analysis social at http://www.youtube.com/user/QbillionInc#p/a/u/1/sL_G_BtItok .  I’d love to hear your reaction or suggestions.  Let me know if I can be helpful on this upcoming financial series.

  • http://www.justanentrrepreneur.com Philip Sugar

    Totally agree and it amazes me that super smart people abdicate this part of their business.  After all it is addition and subtraction and can be kept track of on ones hands.  I wrote about it too http://www.justanentrepreneur.com/?p=84, after being frustrated when talking to somebody, but am going to love to see your analysis.

    Bookings must be near and dear to your heart with Zynga.

  • SM

    I think these topics work well visually, and would recommend the Khan Academy videos
    http://www.khanacademy.org/#finance

    • http://www.feld.com bfeld

      Agree – they are excellent for the basics.

  • Walter

    Sounds like the start of a new book!

    • http://www.feld.com bfeld

      Nah – I’ve got enough books on my plate right now between Venture Deals coming out and work with Amy on Startup Marriage. It’ll have to be blog posts for now.

  • Mac W

    Fantastic idea!  Fred’s series was excellent.  I suspect long time readers have been waiting to know “how your brain processes the financial statements….”.  I would agree with Kyle S regarding S-1s and the targets you can work with.  Thanks. 

  • http://globalsitesecrets.com Russell Lundstrom

    The 800 lb gorilla.
    I always recommend the following book (and CO authors) to anyone needing help in this area.

    http://www.amazon.com/Managing-Numbers-Complete-Understanding-Financials/dp/0738202568/ref=sr_1_1?s=books&ie=UTF8&qid=1310566451&sr=1-1

    Thanks Brad.

  • Rich

    It’s always good to have knowledge and I think financials are important. But, one thing your post makes me wonder about… Are you losing sight of the fact that entrepreneur and businessman are two different things?

    Entrepreneurs focus on innovation and opportunity. They typically have knowledge of the technology or other area where a business operates. Businessmen focus on financials, day-to-day operations, etc. Entrepreneurs hire businessmen to “manage” a business opportunity the entrepreneur identifies.

    Thomas Edison is a good example. He was a knowledgable inventor and business planner. But, he could not “run” a business. Only after businessmen where hired did Edison’s businesses take off.

    I’ve seen other indications that people in the business community don’t understand the difference between entrepreneur and businessman.

    • http://www.feld.com bfeld

      Rich – I strongly disagree. I think all entrepreneurs should have good financial literacy and a solid understanding of their business financials all along the way. The best entrepreneurs I’ve funded and worked with were strong product innovators that understood the economics of their business. Sure – they either had parters / co-founders that took care of finance / operations or hired people as the business grew, but they never abdicated responsibility for the financials of their business.

      • Rich

        You’ve missed my point. I know that entrepreneurs should *understand* financials. That’s why I said “It’s always good to have knowledge and I think financials are important.” You’re right partners or employees should handle financial operations. But, entrepreneurs always abdicate from responsibility of the financials, they need to. Visionary thinking is only clouded by $ thinking. Visionaries that focus on $ are not visionaries, they are bean counters.

        I really think you’re getting mixed up between businessman and entrepreneur. A businessman buys a McBurger franchise, because he’s focused on numbers and eliminating risk. He does nothing new or different, he just follows the proven franchise method. While an entrepreneur doesn’t care about money or anything else smelling of “safe” and “risk averse”. An entrepreneur sees the future and works to make it a reality. An entrepreneur is a leader. You can’t codify or qantify what an entrepreneur does. Because by definition once something is codified, quantified, and stardardized it is no longer entrepreneurial.

        Only 1 out of every 1M people who call themselves an entrepreneur, is *truely* an entrepreneur. The rest are business people trying to find a pattern to follow. The is *never* a pattern in entrepreneurism.

        This is way so many big deals are passed on and why so many investors kick themselves for returns they could have had. And why so many entrepreneurs struggle to find seed money. Business people come in and try to quantify and standardized entrepreneurial “vision”.

        Financials, regulations, standards, etc. are all for followers not leaders, not entrepreneurs!

        • http://www.feld.com bfeld

          Rich – I respectfully disagree.

          • anon

            No, bfeld, Rich is right.  I agree you need to understand how the financials work and what they mean, but you can’t be a bean counter.  And Rich is speaking from a visionary viewpoint while you are speaking strickly from an ROI point of view. 

            My own opinion is that there is a tech bubble and a lot of finance deals have been made on tech so a “style” or even culture in the VC world has been created surrounding this that isn’t germane to the rest of the world.  The context is different but you wouldn’t know because its about the language of tech vs other business models.

            I suspect the interpretations of the financial statements are also tech related.  How people are hired today are based on looking through the technology lens.

            The filter tech has created has skewed so much thinking that we no longer have real innovation even happening.  You think Groupon who is highly overrated is a good business model?  It’s a good idea….marketing well, but doesn’t do a real service for it’s customers:  the ones creating the deal through them.  So this isn’t a sustainable model.  Then you’ve got “Color” with all that money being thrown at it and there is no customer period for the product…..

            VC’s speak out of both sides of their mouths.  They are looking at executive summaries that are one or two pages or on the back of a napkin and on the reverse they are telling the new venture to understand the financials, how they work, and to become an accountant.  Any entrepreneur worth his salt is going to have an understanding of what he is offering in terms of innovation and what the deal is and how to strike a deal.  Meantime, he needs good financial advisement to put the whole picture together. 

            What I find is that the VC world is too focused on the financials.  If you scan the executive summary and run to the financials within seconds, what are you really looking at.

            From the inventor/innovators/entrepreneurs side of the table it’s the VC world that needs some education.

            Just saying. 

            But I still appreciate you taking the time to spell all this out.

  • http://patrickfoley.com/about Patrick Foley

    Looking forward to the new posts.

    Carl Erickson from Atomic Object has also begun to write about his approach to financials: http://greatnotbig.com/2011/04/arranging-your-income-statement-pl-organization/. If you are growing a consulting business, read Carl’s blog.

  • http://twitter.com/peteskalla Peter Skalla

    I’d take the ‘newly public company’ route to begin.  One like LinkedIn that is well known and straight forward in its business model would be perfect. 

    Later in the series when you cover private company reporting, I hope we’ll see something on driver-based financial reporting.  Present a P&L with compensation expense as a function of headcount and salary+benefits, etc, and it becomes intuitively strategic for board discussions and engaging for engineers.  Entrepreneurs will benefit from understanding that financials don’t have to be abstract. 

  • http://twitter.com/tungshan Roger

    I would like for you to dissect a business that is a subscription based business based on recurring revenues. A majority of the new SaaS, freemium and web-based businesses charge a monthly subscription for a service. In my experience with subscription based businesses, they are more complex to run than say a consulting business. 

    Some issues to talk about would be:

    1. Do all subscription based businesses have at least two sets of financial statements? GAAP vs Long-Term
    2. I have found that GAAP financial statements are always lagging the Long-Term financial statements. (i.e. the GAAP financial statements can look great while the fundamental operating metrics of the company are deteriorating)3. Dealing with the cashflow challenges of paying for marketing & fulfillment costs upfront while having to wait multiple months for the customer to keep paying the monthly subscription to breakeven.4. Whether to maximize lifetime revenue of a customer or retention rate of a customer (i.e. I can charge more for a customer and make more profit over the long term but the customer will cancel his subscription sooner)5. How do financial investors typically value a subscription based business? EBITDA or discounted cash flow or something else?

  • http://twitter.com/wcadkins Bill Adkins
    • http://www.feld.com bfeld

      Wow. Great example.

  • http://twitter.com/Fail_Harder Matt Carroll

    Wholeheartedly agree ->  With the blasphemy of an MBA there is a certain dearth of understanding/appreciation of how systemically important finance is to running your business has emerged within the SF startup culture.  The tippy-top players like Square “get it” with TVs and dashboards that clearly communicate & bring alignment to 

    Even though I think it’s BM and kinda douchey to self-promote, there was a really in-depth Quora piece about financial modeling that pretty unique

    After getting numerous requests on Quora, I ended up doing a deep dive into one of my models - http://www.quora.com/Financial-Modeling/Where-can-web-startups-learn-about-financial-modeling-that-accounts-for-the-important-metrics-and-costs/answer/Matthew-Carroll

    The outline is a full e-commerce direct men’s luggage startup that forecasts rev growth through:
     - Organic growth
     - Blog/Promotional build
     - Social (I haven’t really seen a “good” social financial model methodology)
     - Paid
     - Costing & Production Expense builds

    The Goal was push startups to quantitatively “tell the story” and dig into the #s about what actions mea.  Hopefully, the model will teach young startups about margin tolerance and where to invest engergies.
    It’s about 12 pages (when you pdf it), but it’s pretty much the only deep dive investigation on the interwebs that breaks down and explains methodology & offers comparables to help a young startup.

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  • Jim Leonard

    Brad, why are you surprised?  For more that a generation we have been raising/educating science-, economics-, business-, and independent-thinking-illiterate high school grads and citizens. We are now reaping what we sowed.

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  • Roman Levandovsky

    Brad, mostly listener, first time caller.

    Financial literacy is like anything else if you do not have exposure to it and practice with it you do not understand it and can not read the financial statements.

    When I was doing my CompSci degree I also took some accounting classes – it never really connected with me until I started my own company and had to worry about the money that was coming in and coming out. I had to get my sleeves rolled up and delve into the actual accounting process and the books.

    You do that for a while you understand how every check you write and every one you take affect your financial picture, then all these little details are put together into a big picture and how each financial statement shows how well or poorly you are doing.

    At school cash flow was an abstract concept, when you start running out of it you quickly realize that it is the only thing that matters at that point and that it is key to survival.

    There are two preconditions that are required for financial literacy to improve in the world

    A. Someone has to want to learn this stuff and be aware that it is very important
    B. The best way to learn it is to experience it and spend some time in the accounting department either by doing the books for a bit and becoming an accountant for a day or ask lots of questions while you observe the accountants at work.

    Roman.

    • http://www.feld.com bfeld

      Strongly agree with you on A and B below! The best CEO’s I know have spent
      real time understanding this.

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  • http://www.jaysonlynch.com Jayson

    Financial literacy is such a needed tool, that in 2003 the Financial Literacy and Education Act created a commission comprised of 20 Federal Agencies for the purposes of promoting financial literacy. If you are looking for a financial literacy program…I represent a 501C3 non-profit that provides a financial literacy course to Nasa, The Federal Reserve and many others. The course is endorsed by a consortium of college’s and universities across the country. To learn more: marketing@jaysonlynch.com

  • Carol Fabbri

    I founded a Denver based financial literacy nonprofit over a year ago- Fair Advisors Institute. Despite the overlap in subject title, FAI’s courses focus on personal finance. We’ve received great feedback so far, including several requests for a course that explains financial statements. I’ll be glad to have a resource to direct people toward since it’s not an area we’re likely to move into.

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Brad Feld

Hi, I'm Brad Feld, a managing director at Foundry Group who lives in Boulder, Colorado. I invest in software and Internet companies around the US, run marathons and read a lot.