Medical Tech in Germany

Industry Overview

The medical technology (medtech) sector is a market which is growing dynamically worldwide. An aging population combined with the need for new and innovative medical technology sustain the sector’s strength and constant growth, despite the current economic situation. Today, Germany is Europe’s leading location for medical technology and 3rd biggest medical technology producer and medical services provider worldwide. In terms of new patent registrations German manufacturers rank second behind teh USA, making Germany Europe’s strongest location for innovation in this industry.

The broad spectrum of technologies available in this area ranges from electrical engineering/electronics to precision mechanics and optics. Furthermore, technologies from the textile industry, the plastics processing, pharmaceutical and, most recently, from the biotechnology industries are also utilized in German medical products.

Industry in Numbers

  • Total industry turnover of EUR 18.3 billion in 2009
  • Around 9% of the total turnover was reinvested in R&D
  • In 2010 exports increased by 6% in the EU member states, 19% in rest of Europe, almost 13% in North America, more than 26% in Asia and over 28% in Middle and South America
  • With 87,000 employees the number of workers remained constant; 15% of all employees in this industry work in R&D
  • The industry is characterized by small and medium-sized enterprises. 95% of all companies employ less than 500 people.

Market Potential

Germany is the largest market for medical devices in Europe and the third-largest in the world. Nowadays, the medtech industry is considered to have the highest growth potential. According to a recent survey from the Medical Technology Association, (BVMed), 46 percent of the surveyed medtech companies expect a rise in revenues in 2010. In comparison to last year, businesses in the field are being more careful about their expectations, but have confidence in the sector’s stability.

Market Access

Foreign exporters must be aware that, in order to place medical devices on the market for the first time, the products must be registered with the appropriate competent authorities. In general, the manufacturer or authorized representative is responsible for the introduction of new medical devices on the market. The medical device’s importer is responsible in cases where the manufacturer’s location is outside the European Union and an authorized representative in the EU has not been designated. The Federal Institute for Drugs and Medical Devices (BfArM) offers detailed information on the EU directives on medical devices as well as guidance in accessing the German medical device market and the prerequisites to be fulfilled. Furthermore, a list of notified bodies can be found on the German Institute of Medical Documentation and Information’s website (DIMDI). This site offers access to about 60 databases with approximately 100 million documents.

Manufacturers and importers of medical products must also make sure that their products comply with the REACH regulations (Registration, Evaluation and Authorization of Chemicals). According to REACH, companies are required to prepare information on the chemical substances used in their products and register the data with the European Chemicals Agency (ECHA). Registration is required for most hazardous substances above 1 ton per year, for substances toxic to the aquatic environment above 100 tons per year, or substances manufactured or imported above 1.000 tons per year. For many medical products compliance with REACH is a prerequisite for affixing the CE marking.

All medical devices intended for the German market must bear a CE marking before they can be sold or installed. The CE marking is a mandatory conformity mark attached to certain products intended for sale within the European Union which indicates conformity with the essential health and safety requirements set out in the applicable European directives. Depending on the type of product, conformity can be assessed either by the manufacturer himself or by an authorized office.

Distribution Channels

Foreign manufacturers of medical devices tend to enter the German market by setting up subsidiaries. It is also possible to enter the market by contracting with a specialized importer in the medical device field or by participating in the tender procedures of hospitals or clinics. Another way of finding business partners in Germany is by participating in specialized trade fairs. The Association of the German Trade Fair Industry, (AUMA), offers a search engine on its website where interested companies can find trade fairs in their business sector.

Institutions in the German medical devices industry can be of great help in finding ways of effectively introducing products to the market.  The German Medical Technology Association, (BVMed), for example, represents about 230 manufacturers and service providers of medical devices. As a trade association, BVMed promotes and represents the combined interests of the medical technology industry and trade companies. Users can download several documents, e.g. the BVMed Annual Report which expands on the medtech market in Germany.

The Trade Association Medical Technology, (SPECTARIS), represents the interests of around 400 mostly small and medium-sized companies in the medical technology goods and appliances sector. The Trade Association Medical Technology provides its members support with and information on different industry-related areas and topics.

The German Association of Biomedical Engineering, (DGBMT), works to promote the development and application of innovative medical technologies. In the DGBMT, Physicians, scientists and engineers combine their efforts to facilitate the use of advanced technologies for diagnostics and therapy. The DGBMT organizes initiatives, projects and events to support promising activities like micro- and nanotechnologies in medicine and life sciences.

Hospimed publishes information databases on manufacturers and suppliers in the German health service sector in print, on CD-ROM and online.

Eucomed is the voice of the medical technology industry in Europe. The alliance represents around 22,500 European designers, manufacturers and suppliers of medical technology used in the diagnosis, prevention, treatment and amelioration of disease and disability. Small and medium-sized companies account for more than 80% of the businesses in this sector. Eucomed is active in market data collection, research and innovation projects as well as in international trade issues.

German Food and Beverage Business

Industry Overview

Germany’s 82 million inhabitants make the food and beverage market the largest in Europe. The sector ranks fifth among the local industries and has a workforce of over 544,000 in the 5,900 predominantly small and medium sized enterprises.
Germany’s main trading partners in the food and beverage industry are other EU countries followed by Russia, the United States and Switzerland. Even though part of the local demand is satisfied with domestically produced goods, the country is a net importer in major groups of food and drink products. In the past ten years, food imports have steadily increased, thus underlying the rising demand for foreign as well as exotic foods.

Industry in Numbers

  • Second largest food producer in Europe with a total turnover of around EUR 150 billion in 2010
  • Exports amounted to EUR 51.8 billion in 2010 making up 34.5% of total sales
  • Imports of processed foods and agricultural commodities to the value of EUR 60.7 billion in 2010, making Germany a net importer of food & beverage products.
  • Largest sector sub-segments in 2009: meat (22.7%), dairy (15.4%), alcoholic beverages (8.7%), and confectionery food (9.4%)
  • Industry analysts forecast growth of 2.5% in 2011, with growing demand for convenience, health and wellness food products.

Market Potential

Given the large size of the German market, the existing opportunities in the food and beverage sector are very attractive to exporters worldwide. Especially the increasing demand for wellness, convenience food and organic products in the past years, represents a large potential for foreign companies active in these market segments.

German consumers are generally well informed. They expect high quality and low prices for their food and beverage products. The domestic food and beverage sector has profited from the fast economic recovery in Germany and the growing demand for food products made in Germany brought the export quota to an all-time high. Moderate growth was recorded in the meat and sausage products, confectionery, baked goods, and non-alcoholic beverage segments. The German food service market is also expected to grow significantly in 2011.

Market Access

The German food & beverage industry is highly fragmented and competitive. Food imports from other countries within the European Union fall under the “free movement of goods” principle. This means that products that are imported by other EU-countries may be brought into Germany even if they violate German food laws. If this is the case, importers must obtain a permit from the Federal Office for Consumer Protection and Food Safety (BVL) in order to sell the product in Germany. The duties to be paid for food brought from outside the European Union are subject to European legislation as well. The tariffs for different food products are published in TARIC, the Online Customs Tariff Database.

FOOD SAFETY – The legal framework on food safety was established by the European Union. The European Food Safety Authority plays a key role in the risk assessment of food. Many developments of the previous years were aimed to increase transparency and consumer confidence, by providing better information on food ingredients. Traceability of food products is also of utmost importance. For example, the country of origin must always be listed on food labels and all intermediaries (suppliers, distributors, etc.) that joined the food chain must be included as well. Companies trading food of animal origin from one country of the European Union to another need a special permit that is issued by the Federal Agency for Agriculture and Food (BLE).

NOVEL FOODS – Novel food imports in Germany must undergo a safety assessment before being brought into circulation. Importers of novel foods must apply for a license to sell these products at the Federal Office for Consumer Protection and Food Safety (BVL). As the responsible federal authority, the BVL will perform the necessary testing and send the results to the European Commission and the Member States for final approval. Detailed guidelines for the import of novel foods can be found at the Federal Institute for Risk Assessment (BfR).

PRODUCT PACKAGING – Exporting companies should be aware that product packaging is very important to German consumers since they are highly environmentally conscious. Manufacturers, importers, distributors and retailers must make sure that their packaging materials for their food products comply with the EU’s and Germany’s domestic regulations in terms of recycling and disposal. There are several dual system companies licensed in Germany offering various waste disposal schemes. Foreign exporters are free to choose which dual system they join. It is not mandatory to display any dual system membership seal on sales packaging.

Distribution Channels

Few German retailers import products directly from other countries. Most food retailers rather buy from central buyers/distributors specialized in the import of food & beverages. In general, these wholesalers have specialized in products or product groups; some are even experts in food products from a specific country of origin. These specialized importers have in-depth knowledge of all importing requirements such as the necessary product certificates, labeling and packaging and also take care of the shipping, customs clearance, warehousing and distribution of the products within the country. It is advisable that foreign exporters find a local representation in order to place and promote their products successfully within Germany.

The German retail food sector is dominated by five large retailers that claim more than 74 percent of the market. In 2010, the overall market share of discounters offering a limited selection of mainly private label goods at low prices remained stable at 41.6 percent. As mentioned above, all these retailers rely on specialized distributors/wholesalers for their products. However, some supermarkets will sometimes contract directly with a foreign supplier and appoint an importing company of their choice to bring the products into Germany accordingly.

Especially for foreign food and beverages companies, another useful way of finding the right distribution for their products is to participate in the various food trade fairs taking place in Germany. Trade shows like ANUGA, the Green Week or BioFach in Germany enjoy an exceptional reputation among industry experts worldwide. Participating in any of these events facilitates the direct contact with German food brokers, importers and wholesalers.

Supporting Institutions

Foreign companies looking for German food importers, wholesalers or distributors can find further information at the Federation of German Food and Drink Industries (BVE), theFederal Association of the German Retail Grocery Trade (BVL) as well as at the different food market segments industry associations.

The BVE represents the interests of 21 branch associations and 49 food and beverage companies in Germany. It is one of the first stops for foreign companies looking for information and contacts in the German food and drink industry. The BVE’s main responsibility is to represent the interests of its members at both national and international levels. The BVL serves as the federal organization for the food retail trade in Germany and represents all sales channels and companies in the field. The association’s role is to safeguard the sector’s interests with regard to legislation, the public authorities and the general public in Germany and Europe.

Information about the different industry-related trade fairs being held in Germany can be found in the database of the Association of the German Trade Fair Industry (AUMA).

Income Statement

A profit and loss statement is a report of the changes in the income and expense accounts over a set period of time. The most common periods of time are months, quarters, and years, although you can produce a P&L report for any period.

Here is a profit and loss statement for the past four years for Google. I got it from their annual report (10k). I know it is too small on this page to read, but if you click on the image, it will load much larger in a new tab.

Google p&l

The top line of profit and loss statements is revenue (that’s why you’ll often hear revenue referred to as “the top line”). Revenue is the total amount of money you’ve earned coming into your business over a set period of time. It is NOT the total amount of cash coming into your business. Cash can come into your business for a variety of reasons, like financings, advance payments for services to be rendered in the future, payments of invoices sent months ago.

There is a very important, but highly technical, concept called revenue recognition. Revenue recognition determines how much revenue you will put on your accounting statements in a specific time period. For a startup company, revenue recognition is not normally difficult. If you sell something, your revenue is the price at which you sold the item and it is recognized in the period in which the item was sold. If you sell advertising, revenue is the price at which you sold the advertising and it is recognized in the period in which the advertising actually ran on your media property. If you provide a subscription service, your revenue in any period will be the amount of the subscription that was provided in that period.

This leads to another important concept called “accrual accounting.” When many people start keeping books, they simply record cash received for services rendered as revenue. And they record the bills they pay as expenses. This is called “cash accounting” and is the way most of us keep our personal books and records. But a business is not supposed to keep books this way. It is supposed to use the concept of accrual accounting.

Let’s say you hire a contract developer to build your iPhone app. And your deal with him is you’ll pay him $30,000 to deliver it to you. And let’s say it takes him three months to build it. At the end of the three months you pay him the $30,000. In cash accounting, in month three you would record an expense of $30,000. But in accrual accounting, each month you’d record an expense of $10,000 and because you aren’t actually paying the developer the cash yet, you charge the $10,000 each month to a balance sheet account called Accrued Expenses. Then when you pay the bill, you don’t touch the P&L, its simply a balance sheet entry that reduces Cash and reduces Accrued Expenses by $30,000.

The point of accrual accounting is to perfectly match the revenues and expenses to the time period in which they actually happen, not when the payments are made or received.

With that in mind, let’s look at the second part of the P&L, the expense section. In the Google P&L above, expenses are broken out into several categories; cost of revenues, R&D, sales and marketing, and general and administration. You’ll note that in 2005, there was also a contribution to the Google Foundation, but that only happened once, in 2005.

The presentation Google uses is quite common. One difference you will often see is the cost of revenues applied directly against the revenues and a calculation of a net amount of revenues minus cost of revenues, which is called gross margin. I prefer that gross margin be broken out as it is a really important number. Some businesses have very high costs of revenue and very low gross margins. And example would be a retailer, particularly a low price retailer. The gross margins of a discount retailer could be as low as 25%.

Google’s gross margin in 2009 was roughly $14.9bn (revenue of $23.7bn minus cost of revenues of $8.8bn). The way gross margin is most often shown is as a percent of revenues so in 2009 Google’s gross margin was 63% (14.9bn divided by 23.7). I prefer to invest in high gross margin businesses because they have a lot of money left after making a sale to pay for the other costs of the business, thereby providing resources to grow the business without needing more financing. It is also much easier to get a high gross margin business profitable.

The other reason to break out “cost of revenues” is that it will most likely increase with revenues whereas the other expenses may not. The non cost of revenues expenses are sometimes referred to as “overhead”. They are the costs of operating the business even if you have no revenue. They are also sometimes referred to as the “fixed costs” of the business. But in a startup, they are hardly fixed. These expenses, in Google’s categorization scheme, are R&D, sales and marketing, and general/admin. In layman’s terms, they are the costs of making the product, the costs of selling the product, and the cost of running the business.

The most interesting line in the P&L to me is the next one, “Income From Operations” also known as “Operating Income.” Income From Operations is equal to revenue minus expenses. If “Income From Operations” is a positive number, then your base business is profitable. If it is a negative number, you are losing money. This is a critical number because if you are making money, you can grow your business without needing help from anyone else. Your business is sustainable. If you are not making money, you will need to finance your business in some way to keep it going. Your business is unsustainable on its own.

The line items after “Income From Operations” are the additional expenses that aren’t directly related to your core business. They include interest income (from your cash balances), interest expense (from any debt the business has), and taxes owed (federal, state, local, and possibly international). These expenses are important because they are real costs of the business. But I don’t pay as much attention to them because interest income and expense can be changed by making changes to the balance sheet and taxes are generally only paid when a business is profitable. When you deduct the interest and taxes from Income From Operations, you get to the final number on the P&L, called Net Income.

I started this post off by saying that the P&L is “one of the most important things in business.” I am serious about that. Every business needs to look at its P&L regularly and I am a big fan of sharing the P&L with the entire company. It is a simple snapshot of the health of a business.

I like to look at a “trended P&L” most of all. The Google P&L that I showed above is a “trended P&L” in that it shows the trends in revenues, expenses, and profits over five years. For startup companies, I prefer to look at a trended P&L of monthly statements, usually over a twelve month period. That presentation shows how revenues are increasing (hopefully) and how expenses are increasing (hopefully less than revenues). The trended monthly P&L is a great way to look at a business and see what is going on financially.

I’ll end this post with a nod to everyone who commented last week that numbers don’t tell you everything about a business. That is very true. A P&L can only tell you so much about a business. It won’t tell you if the product is good and getting better. It won’t tell you how the morale of the company is. It won’t tell you if the management team is executing well. And it won’t tell you if the company has the right long term strategy. Actually it will tell you all of that but after it is too late to do anything about it. So as important as the P&L is, it is only one data point you can use in analyzing a business. It’s a good place to start. But you have to get beyond the numbers if you really want to know what is going on.

The Important Financial Statement Analysis

Financial Statement Analysis

This topic could be and is a full semester course at some business schools. It is a deep and rich topic that I can t cover in one single blog post. But it is also a relatively narrow skill set at its most developed levels. If you are going to be a public equity analyst, you need to understand this stuff cold and this post will not get you there.

But if you are an entrepreneur being handed financial statements from your bookkeeper or accountant or controller, then you need to be able to understand them and I d like this post to help you do that. I d also like this post help those of you who want to be more confident buying, holding, and selling public stocks. So that’s the perspective I will bring to this topic.

In the past three weeks, we talked about the three main financial statements, the Income Statement, the Balance Sheet, and the Cash Flow Statement. This post is going to attempt to help you figure out how to analyze them, at least at a cursory level.

In general, I like to start with cash. It s the first line item on the Balance Sheet (it could be the first several lines if you want to combine it with short term investments). Note how much cash you have or how much cash the company you are analyzing has. Remember that number. If someone asks you how much cash you have in your business, or a business you are analyzing, and you can t answer that to the last accounting period (at least), then you failed. There is no middle ground. Cash is that important.

Then look at how much cash the business had in a prior period. Last month is a good place to start but don t end there. Look at how much cash went up or down in the past month. Then look much farther back, at least a quarter, and ideally six months and/or a year. Calculate how much cash went up or down over the period and then divide by the number of months in the period. That s the average cash flow (or cash burn) per month. Remember that number.

But that number can be misleading, particularly if you did any debt or equity financings during that period (or if you paid off any debt facilities during that period). Back out the debt and equity financings and do the same calculations of average cash flow per month. Hopefully the monthly number, the quarterly average, the six-month average, and the annual average are in the same ballpark. If they are not, something is changing in the business, either for the good or the bad and you need to dig deeper to find out what. We ll get to that.

If cash flow is positive for all periods, then you are done with cash. If it is negative, do one more thing. Divide your cash balance by the average monthly burn rate and figure out how many months of cash you have left. If you are burning cash, you need to know this number by heart as well. It is the length of your runway. For all you entrepreneurs out there, the three cash related numbers you need to be on top of are current cash balance, cash burn rate, and months of runway.

I generally like to go to the income statement next. And I like to lay out a few periods next to each other, ideally chronologically from oldest on the left to the newest on the right. For startups and early stage companies, a 12 month trended monthly presentation of the income statement is ideal. For more mature companies, including public companies, the current quarter and the four previous quarters are best.

Some people like to graph the key line items in the income statement (revenue, gross margin, operating costs, operating income) over time. That s good if you are a visual person. I find looking at the hard numbers works better for me. Note how things are moving in the business. In a perfect world, revenues and gross margins are growing faster than operating costs, and operating income (or losses) are increasing (or decreasing) faster than both of them. That is a demonstration of the operating leverage in the business.

But some early stage companies either have no revenue or are investing in the business faster than they are growing revenue. That is a sound strategy if the investments they are making are solid ones and if they have a timeline laid out during which they ll do this. You can t do that forever. You ll run out of cash and go out of business.

From this analysis, you may see why the business is burning cash or burning cash more quickly or less quickly. You may see why the business is growing its cash flow rapidly. I am most comfortable when the monthly operating income (or losses) of a business are roughly equal to its cash flow (or cash burn). This does not have to be the case for the business to be healthy but it means the business has a relatively simple economic architecture, which is always comforting. From Enron to Lehman Brothers, we ve learned that complex business architectures are hard to analyze and easy to manipulate.

One thing that bears mentioning here are one time items on the Income Statement. They make your life harder. You need to back that one time charge out for a consistent presentation, but you also need to be somewhat suspicious of one-time charges. Companies can try to bury ongoing expenses in one-time charges and inflate their earnings. You don t see that much in startups but you do in public companies and it s a red flag if a company does it too often.

If the monthly operating income (after backing out one-time charges) doesn t come close to the monthly cash burn rates, then something is going on with the balance sheet of the business. Many of these differences are normal for certain businesses.

A type of business income is working capital.  Working capital is the non cash current assets and liabilities of the business. When they grow rapidly in relation to revenues, it means you are financing other parts of the food chain in your industry and that s a great way to run out of cash.

So if monthly income and monthly cash flow aren’t in the same ballpark, look at the changes in working capital month over month. We went over this a bit last week in preparing the cash flow statement. If working capital is the culprit soaking up the cash, you need to look at two things.

The first is if the revenues are real. A great way to inflate revenues is to ship product to people who aren t going to pay you. A company that is doing that is operating fraudently so you don t see it very often. But if someone is doing this, cash will be going down while profits are steady and accounts receivable are growing rapidly. I always look for that in a company that is supposed to be profitable but is sucking cash.

The second is the availability of working capital financing. If a business can finance its working capital needs inexpensively, then it can operate successfully with this business model. In times when debt is flowing freely, these can be good businesses to operate. When cash is tight, they are not.

The final thing to look for on the balance sheet is capex. If a business is operating profitably, and growing profits, but its capex line is growing faster than profits, it s got the potential for problems. Hosting companies are an example of a set of companies that might be in this situation. Again, the availability of financing is the key. Local cable operators operated profitably for years with big negative cash flows because of capex. The financial markets like the monopolies these busineses were granted and consistently provided them with financing to buy more capex. But if that party ends, it can be painful.

This post is three pages long in my editor so it s time to stop. There is more to discuss on this topic so I d like to know if I did this topic justice for most of you or if you d like another post that digs a little deeper.

Balance Sheet

The Balance Sheet is a report of the asset and liability accounts. Assets are things you own in your business, like cash, capital equipment, and money that is owed to you for products and services you have delivered to customers. Liabilities are obligations of the business, like bills you have yet to pay, money you have borrowed from a bank or investors.

The top line, cash, is the single most important item on the balance sheet. Cash is the fuel of a business. If you run out of cash, you are in big trouble unless there is a filling station nearby that is willing to fund your business. Alan Shugart, founder of Seagate and a few other  companies, famously said “cash is more important than your mother.” That’s how important cash is and you never want to get into a situation where you run out of it.

The second line, short term investments, is basically additional cash. Most startups won’t have this line item on their balance sheet.

The next line is accounts receivable and it is the total amount of money owed to the business for products and services that have been delivered but have not been collected. It’s the money your customers owe your business. If this number gets really big relative to revenues (for example if it represents more than three months of revenues) then you know something is wrong with the business. We’ll talk more about that in an upcoming post about financial statement analysis.

I’m only going to cover the big line items in this balance sheet. So the next line item to look at is called Total Current Assets. That’s the amount of assets that you can turn into cash fairly quickly. It is often considered a measure of the liquidity of the business.

The next set of assets are long term assets that cannot be turned into cash easily. I’ll mention three of them. The most important long term asset is Property Plant and Equipment which is the cost of your capital equipment. For the companies we typically invest in, this number is not large unless they rack their own servers. Depreciation is the annual cost of writing down the value of your property plant and equipment. It appears as a line in the profit and loss statement. The final long term asset I’ll mention is Goodwill. This is a hard one to explain. But I’ll try. When you purchase a business, like YouTube, for more than it’s book value you must record the difference as Goodwill.  If you think that the value of any of the businesses you have acquired has gone down, you can write off some or all of that Goodwill. That will create a large one time expense on your profit and loss statement.

After cash, I believe the liability section of the balance sheet is the most important section. It shows the businesses’ debts. And the other thing that can put you out of business aside from running out of cash is inability to pay your debts. That is called bankruptcy. Of course, running out of cash is one reason you may not be able to pay your debts. But many companies go bankrupt with huge amounts of cash on their books. So it is critical to understand a company’s debts.

The main current liabilities are accounts payable and accrued expenses. A good example of an accounts payable is a legal bill you have not paid. A good example of an accrued expense is employee benefits that you have not yet been billed for that you accrue for each month.

If you compare Current Liabilities to Current Assets, you’ll get a sense of how tight a company is operating. Company A’s current assets are $29bn and its current liabilities are $2.7bn. It’s good to be Company A, they are not sweating it. Many of our portfolio companies operate with these numbers close to equal. They are sweating it.

Non current liabilities are mostly long term debt of the business. The amount of debt is interesting for sure. If it is very large compared to the total assets of the business its a reason to be concerned. But its even more important to dig into the term of the long term debt and find out when it is coming due and other important factors. You won’t find that on the balance sheet. You’ll need to get the footnotes of the financial statements to do that. Again, we’ll talk more about that in a future post on financial statement analysis.

The next section of the balance sheet is called Stockholders Equity. This includes two categories of equity . The first is the amount that equity investors, from VCs to public shareholders, have invested in the business. The second is the amount of earnings that have been retained in the business over the years.That is also called the book value of the business.

The important thing about a balance sheet is it has to balance out. Total Assets must equal Total Liabilities plus Stockholders Equity. In Company A’s case, total assets are $40.5bn. Total Liabilities are $4.5bn. If you subtract the liabilities from the assets, you get $36bn, which is the amount of stockholders equity.

balance sheet has to balance can be very helpful in analyzing and projecting out the cash flow of a business.

In summary, the Balance Sheet shows the value of all the capital that a business has built up over the years. The most important numbers in it are cash and liabilities. Always pay attention to those numbers. I almost never look at a profit and loss statement without also looking at a balance sheet. They really should be considered together as they are two sides of the same coin.

Cash Flow


Cash flow is the amount of cash your business either produces or consumes in a given period, typically a month, quarter, or year. You might think that is the same as the profit of the business, but that is not correct for a bunch of reasons.

The profit of a business is the difference between revenues and expenses. If revenues are greater than expenses, your business is producing a profit. If expenses are greater than revenues, your business is producing a loss.

But there are many examples of profitable businesses that consume cash. And there are also examples of unprofitable businesses that produce cash, at least for a period of time.

Here’s why.

revenues are recognized as they are earned, not necessarily when they are collected. And expenses are recognized as they are incurred, not necessarily when they are paid for. Also, some things you might think of as expenses of a business, like buying servers, are actually posted to the Balance Sheet as property of the business and then depreciated (ie expensed) over time.

So if you have a business with significant hardware requirements, like a hosting business for example, you might be generating a profit on paper but the cash outlays you are making to buy servers may mean your business is cash flow negative.

Another example in the opposite direction would be a software as a service business where your company gets paid a year in advance for your software subscription revenues. You collect the revenue upfront but recognize it over the course of the year. So in the month you collect the revenue from a big customer, you might be cash flow positive, but your Income Statement would show the business operating at a loss.

Cash flow is really easy to calculate. It’s the difference between your cash balance at the start of whatever period you are measuring and the end of that period. Let’s say you start the year with $1mm in cash and end the year with $2mm in cash. Your cash flow for the year is positive by $1mm. If you start the year with $1mm in cash and end the year with no cash, your cash flow for the year is negative by $1mm.

But as you might imagine the accounting version of the cash flow statement is not that simple. Instead of getting into the standard form, which as I said I don’t really like, let’s talk about a simpler form that gets you to mostly the same place.

Let’s say you want to do a cash flow statement for the past year. You start with your Net Income number from your Income Statement for the year. Let’s say that number is $1mm of positive net income.

Then you look at your Balance Sheet from the prior year and the current year. Look at the Current Assets (less cash) at the start of the year and the Current Assets (less cash) at the end of the year. If they have gone up, let’s say by $500,000, then you subtract that number from your Net Income. The reason you subtract the number is your business used some of your cash to increase its current assets. One typical reason for that is your Accounts Receivable went up because your customers are taking longer to pay you.

Then look at your Non-Current Assets at the start of the year and the end of the year. If they have gone up, let’s say by $500k, then you also subtract that number from your Net Income. The reason is your business used some of your cash to increase its Non-Current Assets, most likely Property, Plant, and Equipment (like servers).

At this point, halfway through this simplified cash flow statement, your business that had a Net Income of $1mm produced no cash because $500k of it went to current assets and $500k of it went to non-current assets.

Liabilities work the other way. If they go up, you add the number to Net Income. Let’s start with Current Liabilities such as Accounts Payable (money you owe your suppliers, etc). If that number goes up by $250k over the course of the year, you are effectively using your suppliers to finance your business. Another reason current liabilities could go up is Deferred Revenue went up. That would mean you are effectively using your customers to finance your business (like that software as a service example earlier on in this post).

Then look at Long Term Liabilities. Let’s say they went up by $500k because you borrowed $500k from the bank to purchase the servers that caused your Non-Current Assets to go up by $500k. So add that $500k to Net Income as well.

Now, the simplified cash flow statement is showing $750k of positive cash flow. But we have one more section of the Balance Sheet to deal with, Stockholders Equity. For Stockholders Equity, you need to back out the current year’s net income because we started with that. Once you do that, the main reason Stockholders Equity would go up would be an equity raise. Let’s say you raised $1mm of venture capital during the year and so Stockholder’s Equity went up by $1mm. You’d add that $1mm to Net Income as well.

So, that’s basically it. You start with $1mm of Net Income, subtract $500k of increased current assets, subtract $500k of increased non-current assets, add $250k of increased current liabilities, add $500k of increased long-term liabilities, and add $1mm of increased stockholders equity, and you get positive cash flow of $1.75mm.

Of course, you’ll want to check this against the cash balance at the start of the year and the end of the year to make sure that in fact cash did go up by $1.75mm. If it didn’t, then you have to go back and check your math.

So why would anyone want to do the cash flow statement the long way if you can simply compare cash at the start of the year and the end of the year? The answer is that doing a full-blown cash flow statement tells you a lot about where you are consuming or producing cash. And you can use that information to do something about it.

Let’s say that your cash flow is weak because your accounts receivable are way too high. You can hire a dedicated collections person. You can start cutting off customers who are paying you too late. Or you can do a combination of both. Bringing down accounts receivable is a great way to improve a business’ cash flow.

Let’s say you are spending a boatload on hardware to ramp up your web service’s capacity. And it is bringing your cash flow down. If you are profitable or have good financial backers, you can go to a bank and borrow against those servers. You can match non-current assets to long-term liabilities so that together they don’t impact the cash flow of your business.

Let’s say your current liabilities went down over the past year by $500k. That’s a $500k reduction in your cash flow. Maybe you are paying your bills much more quickly than you did when you started the business and had no cash. You might instruct your accounting team to slow down bill payment a bit and bring it back in line with prior practices. That could help produce better cash flow.

These are but a few examples of the kinds of things you can learn by doing a cash flow statement. It’s simply not enough to look at the Income Statement and the Balance Sheet. You need to understand the third piece of the puzzle to see the business in its entirety.

One last point, when you are doing projections for future years, I encourage management teams to project the income statement first, then the cash flow statement, and then end up with the balance sheet. You can make assumptions about how the line items in the Income Statement will cause the various Balance Sheet items to change (like Accounts Receivable should be equal to the past three months of revenue) and then lay all that out as a cash flow statement and then take the changes in the various items in the cash flow statement to build the Balance Sheet. I like to do that in monthly form. We’ll talk more about projections next week because I think this is a very important subject for startups and entrepreneurial management teams to wrap their heads around.

Start Up Financing

Friends and family financing is popular because it is easy to get a hearing from the people who know you best and they are positively inclined to say yes. But there are some negatives as well. It’s tough to know how to price and structure an investment where the investors are close friends or family. You don’t want to take advantage of them and they may not be sophisticated enough to know what is a good deal and what is a bad deal.

And friends and family often cannot come up with a lot of capital so unless your business doesn’t need much funding, this will not be the only round you do. But friends and family can get you into business and give you some time to create value that other investors will recognize and value.

Probably the most tricky part of friends and family financing is that you really don’t want to lose money that friends and family have invested with you. And most startups fail so the chances that will happen are high. I would encourage entrepreneurs who take funding from friends and family to be very clear about the risks and downside. I would also suggest only taking capital from friends and family members who can afford to lose the investment. That way, if the investment does turn out to be bad, at least you won’t lose valuable relationships. Even so, it is easier on the mind to be doing a startup when your capital comes from professional investors than your loved ones.

I would recommend doing friends and family financings as convertible notes with a discount and a cap on the valuation. That way you don’t have to worry about how to price the investment. A 20-25% discount from the next round is appropriate. The valuation cap is going to vary depending on the size of the raise and the size of the opportunity. I’d suggest a cap that gives the friends and family around 10% of the business if things work out. But that is just a suggestion. A 10% interest will not be appropriate for every friends and family investment.

Friends and family funding is the most common form of startup financing but also the most tricky in many ways. Be careful to do it right because there’s a reason why these people will back you when nobody else will.