Author Archives: TheMill

How to Read an Income Statement

The below post is from @OnlyCFO who are a great source of financial information and you can follow them on Twitter at (@OnlyCFO) / Twitter

The income statement is one of three primary financial statements:

All three of these statements are prepared in accordance with GAAP (Generally Accepted Accounting Principles) for US companies or the international version for foreign-based companies. These are the accounting rules for how everything should be accounted for, but they are frequently updated and changed.

Below is CrowdStrike’s 2022 income statement.

Income Statement Cheat Sheet

Below is the quick cheat sheet on the main income statement lines. If you want the detail and explanations then keep reading…

Revenue

SaaS companies usually have two categories of revenue:

  1. Subscription revenue – the “good” revenue
  2. Professional services & other – considered either bad or neutral revenue

If the professional services revenue is immaterial, then a lot of companies will just show one line called “revenue” on their financials. For internal management reporting all major revenue categories should be broken out so each revenue type can be reviewed separately.

SaaS Revenue

Depending on who you are talking with, the word “revenue” can mean a dozen different things at SaaS companies. Check out the below tweet storm on the differences in a lot of these acronyms.

On the income statement when we say “revenue” we are referring to GAAP revenue. All other commonly used acronyms about “revenue” such as ARR, CARR, and ACV are annualized amounts. For GAAP revenue these amounts must be spread across the period that the service is delivered (subscription or usage period).

There are two main types of SaaS revenue recognition models (and there are various degrees of hybrid models in between):

  1. Consumption-based pricing models
  2. Term-based subscription model

Below are the typical revenue recognition rules, but each company’s specific facts may impact how revenue is recognized. Many thousands of pages have been written on this topic because it’s complex!

Consumption-Based Pricing (aka usage-based)

For companies with a pure consumption-based pricing model, GAAP revenue will be recognized as consumed.

Example: Company ABC signed a $120K deal for 10 GB of data usage on January 1st, 2023.

Solution: Revenue is only recognized as it is consumed so usage-based pricing revenue may be lumpier that the traditional SaaS model.

 

Consumption-based pricing revenue is seasonally impacted

“And also Q4, as I said, is one that has seasonally higher number of holidays with people taking — and remember, about 70% of our revenue is tied to human interaction with our system, 30% is really driven by scheduled jobs. So, that has an impact.” Mike Scarpelli (Snowflake CFO)

Consumption-based pricing revenue is more impacted by the macro environment

“We recognize revenue based on customer consumption of our platform, and that consumption is closely related to end-user activity of the application, which can be impacted by macroeconomic factors.” – Michael Gordon (MongoDB CFO)

Subscription Pricing (term based)

This is referring to the traditional SaaS pricing model. This can be a number of seats or licenses that you have access to for the term of the contract – doesn’t matter how much you use the software.

Example: Company ABC signed a $120K deal on January 1st, 2023 for 5 seats for a subscription term over the next 12 months.

Solution: Revenue is recognized ratably over the subscription term. This is true regardless of the usage level because it is continually available to be used throughout the subscription term.

Professional Services & Other

This revenue is almost always broken out from subscription revenue unless it is so immaterial that it doesn’t really impact gross margins. Most investors look at professional services revenue as either bad or neutral to a company’s valuations because of the following:

  • Professional service gross margins are usually very low (or even negative) for SaaS businesses.
  • The scalability and distribution of SaaS are why it can grow so fast. Service businesses just can’t do that because of the reliance on people.
  • High professional services may mean people are making up for a bad SaaS product.
  • If implementation services are high due to product complexity, then the distribution of the SaaS solution might be significantly slower.

When is professional services revenue recognized?

Depends. Typically professional services are recognized as they are performed.

But the revenue might need to be recognized over the term of the software subscription if:

  1. The services significantly customizes the SaaS solution
  2. The services from the company are required in order for any value to be obtained from the SaaS solution

Most SaaS companies are able to recognize professional service revenue as it is performed.

Cost of Revenue (COGS)

A lot of people just say “COGS”, which stands for cost of goods sold, but there aren’t any “goods” in pure SaaS so when it is reported on financial statements this line just says “cost of revenue”.

Cost of revenue is broken out the same way that revenue is broken out:

  1. Cost of revenue – subscription
  2. Cost of revenue – professional services and other

Cost of Revenue – Subscription

The major categories that are included here include the following:

  1. Customer hosting costs – AWS, GCP, Azure
  2. Support team – responding to customer support tickets
  3. Dev Ops – people ensuring uptime and reliability of accounts
  4. Software and other costs for the teams above
  5. MAYBE customer success – see below

Most SaaS companies are fairly consistent with these groupings with a few exceptions:

  • Early-stage companies aren’t great at properly breaking things out and allocating the right things to COGS. I almost never trust COGS for companies less than $15M ARR and a built-out accounting team.
  • Customer Success: Even in public companies there is diversity on whether this team lives in COGS or S&M (or how they are allocated between the two). Companies have to determine what their customer success team is actually doing to determine where it should be recorded on the income statement, but there will always be an element of judgment. Accounting rules aren’t black and white for this. My thoughts on how to categorize customer success below.

Investors need to make sure they understand what is being included/excluded in COGS so they can make informed decisions when comparing it to other companies.

Cost of Revenue – Professional Services & Other

Professional services COGS is pretty straightforward:

  • People costs for delivering the services
  • Software and other people-related costs to deliver the services
  • Costs for any other revenue generated

Gross Margins

Gross margins tell you how much (either as a $ or % of revenue) profit you have after subtracting COGS from revenue. In the formula below, we can see gross margin expressed as a percentage of revenue. Viewing gross margin as a percentage of revenue is generally more useful because then it is comparable across benchmarks and other companies.

Gross Margin = (Revenue – COGS) / Revenue

COGS is a very protected financial expense group because SaaS company valuations are (or at least should be) highly correlated with gross margins.

SaaS vs Professional Services Gross Margins

As noted earlier, there is a reason investors typically view professional services revenue as either bad or neutral in their investment decisions. Professional services’ gross margins are very low when compared to SaaS gross margins.

Having said that, Crowdstrike’s professional services gross margins are phenomenal at 33%….Most SaaS companies either lose money or break even on professional services for a long time and may only be slightly profitable at scale.

But the ability to have subscription gross margins of 76% with essentially limitless distribution is what makes SaaS so special.

Below is a table from Clouded Judgement for the highest valuation multiple companies and it shows the average gross margin is 74%.

Operating Expenses (aka “OpEx”)

The operating expense section of a SaaS company’s income statement almost always has the following categories:

  1. Sales and marketing (S&M)
  2. Research and development (R&D)
  3. General & administrative (G&A)

What is included in each category?

Sales and marketing (S&M)

  • Sales team payroll (AE, SDR, SEs, sales management, etc)
  • Marketing payroll (demand gen, PR, events, comms, etc)
  • Customer success payroll (see COGS section on debate between COGS and S&M)
  • Rev ops and sales enablement
  • Software and other non-headcount costs for these teams
  • Trial hosting costs (such as AWS)

Research and development (R&D)

  • Engineering, product, and design team payroll-related costs
  • Software and other non-headcount costs for these teams
  • Dev infrastructure costs (such as AWS)
  • Note – a lot of earlier-stage companies don’t properly break these costs out properly between COGS, R&D, and S&M
  • Quality assurance (QA)

General & administrative (G&A)

  • Finance, legal, HR, and other executive payroll-related costs
  • Corporate insurance
  • Financial audits
  • Charitable contributions

Specific Callouts in OpEX

In addition to these core expense groups that show up on the income statement, there are a couple of key expense callouts that you should also understand so you know how to compare the income statements of different companies.

Allocated Departments

There are certain expenses and teams that are frequently allocated across all of the above expense groups based on relative headcount (or some other reasonable allocation methodology). These are judgemental and there is sometimes diversity in how they are treated.

  • IT – people and software the entire company uses
  • Recruiting – internal recruiting resources
  • General – Facilities, company offsites, etc

Understand how they are coded versus other companies so proper comparisons can be made.

Stock-Based Compensation (SBC)

SBC has recently been a hotly discussed topic amongst tech companies as a result of the implied shareholder dilution that results from sky-high equity awards given out in Silicon Valley.

Here are the basics that you should know about SBC:

  • SBC includes all equity-based awards that are given to employees, consultants, advisors, etc.
  • Equity awards may include: stock options, RSUs, RSAs, PSA, SARs, etc
  • SBC expense is based on
  • The fair value of the award on the date of the grant. This is important because if the stock price subsequently shoots up or crashes, then that is not reflected in SBC expense.
  • SBC expense is recognized over the vesting term (i.e. the period of time the equity award is earned). For tech companies, somewhere around 95% of companies have equity awards that vest over 4 years.

Based on the above, you need to understand that SBC expense does not equal the amount of dilution. Especially during times of high stock price volatility, the SBC expense and shareholder dilution can diverge significantly.

Below is an interesting chart from Guggenheim on SBC % based on growth rates.

Sales Commissions

This is an area that the accounting rules has changed in the last few years. Prior to the accounting overlords changing the rules, most SaaS companies expensed sales commissions in the period they were earned by the sales folks.

Under the new accounting rules, most sales commissions for SaaS companies get capitalized on the balance sheet (i.e. not expensed immediately) and then expensed over a period of time determined through some judgment. Almost all SaaS companies expense sales commissions over 3 – 5 years.

Not all sales commissions are expensed over time though. Some are expensed immediately. Only sales commissions that are solely dependent on the contract getting signed are deferred and expensed over time. All other sales commissions are expensed immediately.

So AEs and their managers would almost always be capitalized and expensed over time since they only get paid if the deal is signed, but SDRs whose commission is based on setting up meetings are expensed immediately.

Other income (expense)

  • Interest expense and income
  • foreign exchange gains and losses
  • Investment gains and losses

Income Tax Expense

As crazy as it might sound to some SaaS companies, eventually the goal is to be profitable and make money. Once this crazy phenomenon happens a company will owe income taxes.

But income taxes might be owed before a company is profitable.

  1. Foreign entities: If a company has set up foreign entities, then based on the tax laws there will usually be income taxes owed in these foreign jurisdictions.
  2. Financial net income doesn’t equal taxable income: Not going to explain all of this, but there are lots of differences so a company might have taxable income before financial statement income.
  3. Change in tax laws for research and development expenses. This may actually be a pretty big deal if it doesn’t get repealed. See the Twitter thread below

Concluding Thoughts

All investors and business operators should understand the basics of an income statement. If you don’t understand an income statement then mistakes will be made in allocating capital and making investment decisions. Source: @OnlyCFO

10 Step Guide to Starting Your Business with LEO (Local Enterprise Office)

The following material is provided by the Local Enterprise Office (LEO). For more information on supports available to your business from Louth LEO please click here.

If you’re thinking of starting a business, LEO’s Start Your Own Business programme will help you, from developing and researching your ideas, learning basic business start-up skills and expanding your potential with marketing and financial planning advice. LEO’s Start Your Own Business programme introduces you to thinking about running your business and testing out
your business ideas and plans along with like-minded people.

Step 1: Test Your Business Idea

– LEO’s Start Your Own Business programme provides you with an opportunity to assess the potential of your business idea.
– Have I got the right business skills?
– Think about who will buy your product or service.
– What is the benefit to them and how much will they pay?
> Use our experience to realise your business idea.

Step 2: What About Market Research?

– From the outset market research is essential in helping you to identify your target market
and customers.
– It will also help you to identify your competitors and how to compete effectively.
– Research is also effective in assessing demand for a new product or service.
> Market research will establish the real potential for your product or service.

Step 3: What are Your Business Requirements?

– Have you considered the best location for the business?
– Identify your basic equipment requirements and costs.
– How many staff will you need to employ?
– Identify your overhead costs e.g. insurance.
– Can your business idea benefit from new technologies? e.g. by online selling.
> We give you access to information and specialist expertise.

Step 4: What are your Investment Requirements?

– Identify all start-up and running costs associated with the business.
– Identify ways of financing your business venture.
– Seek financial support and benefit from direct referral to Government agencies.
– Seek advice on other sources of support e.g. Banks, Credit Unions, Microfinance Ireland,
family support, other non-bank finance.
> LEO can give you advice on all financial sources that benefit you or your businesses.
Advising…
Supporting…
Developing…

Step 5: Developing your Marketing Strategy

– Marketing your business idea is a fundamental aspect of starting up.
– Research the most cost effective methods of marketing your business.
– Write your Marketing Plan.
> Learn from us how marketing works for you.

Step 6: Developing your Sales Plan

– How will you promote your product or service?
– Who and where is your target market (local, national, international)?
– What channels of distribution will be used?
– Determine your selling price and break-even point.
> Learn from us about how to plan, promote and grow your sales.

Step 7: What is the Best Legal Structure for you?

– What type of company will allow you to make the best decisions for your business?
You could be a:
– Sole Trader
– Partnership
– Limited Company
> We can help you decide on the right structure from the beginning.

Step 8: Managing the Risks

– Starting a business is a big step to take.
– A new business can be exciting. However, it can also be risky.
– For some it means risking personal savings and secure employment.
> We help you to best manage the risks.

Step 9: Avoiding Unnecessary Risks.

– Register your business with the Companies Registration Office (CRO). Visit www.cro.ie
– Be aware of your tax obligations and register with your local Revenue office. Visit www.revenue.ie
– Be aware of other statutory obligations such as trading licenses, planning permission, insurance, health and safety, patents, etc.
– Be aware of your responsibilities under employment rights legislation.
> We can steer you to make sure your business is fully compliant.

Step 10: And Finally . . . Write your Business Plan

– Business Planning is fundamental to success in business – managing the company, generating
sales and growing jobs.
– It is the key to getting things done and making things happen.
– The finished business plan can be used as an operating tool that will help you to make important decisions and manage your business effectively.
> Using all the tools above LEO can train you to plan and deliver on all aspects of your business.

For more information on startup supports we recommend that you speak with Louth LEO

Accounting Terms 101

Accounting Terms Glossary

Accounts Payable (Creditors, Payables)
Accounts payable are those accounts where the business has an obligation to pay for receiving goods or services. They are classified as a current liability.

Accounts Receivable (Debtors, Receivables)
Accounts receivable are those accounts where the business is owed money for providing goods or services. It is an asset.

 

Accrual Concept
Accrual concept is one of the core accounting concepts. Accrual concept states that an economic event should be recorded in the period in which it is incurred rather than when it is paid for or when cash is received in return. It also includes the Matching concept which says that the revenues and related costs should be matched in the income statement

 

Accrued Expenses (Accruals)
Accrued expenses are those expenses which have been incurred but not yet invoiced or paid. They are usually  treated as a Current Liability

Accrued Income
Accrued income is income that is earned but not yet invoiced or received. It is treated as a Current Asset.

 

Asset
Asset is something that is owned by a business that has commercial value or exchange value. Assets are subdivided into Fixed Assets ie those that will be there for more than one year and Current Assets ie those that will convert to cash within one year

 

Balance Sheet
A balance sheet is the list of all the assets and liabilities of the business.

 

Capital Employed
Capital Employed reflects the Balance Sheet  value of the assets used by the business to generate revenue. It is calculated as follows:

Capital Employed = Fixed Assets + Current Assets – Current Liabilities. 

It can also be calculated by looking at the financing side of the balance sheet when it will be:                           .                            Capital Employed = Shareholders Funds + Term Liabilities

 

Cash

Cash includes all notes and coins held by the business together with all credit balances in bank accounts and sometimes includes short term investments in other liquid assets eg Government Bonds

 

Cash Flow Statement
Cash flow statement is a financial statement that provides details of the inflow and outflow of cash for the business. It is divided into three parts:

  1. cash flows from operations
  2. cash flows from financing,
  3. cash flows from investing

 

Collection Period (Days Sales Outstanding, Debtor Days)
Collection period defines the amount of time it takes to convert  average sales into cash. In other words, it reflects the average number of days credit taken by customers. It is calculated as follows

Collection Period = (Debtors X 365) / Sales

 

Consistency Principle
Consistency principle of accounting says that the same accounting policies and procedures should be followed in every accounting period. If policy is changed the relevant change should be disclosed in the notes to the accounts

 

Cost of Sales (Cost of Goods Sold)
Cost of Sales is the cost of procuring and processing goods. In a manufacturing business it includes direct material, labour and factory overheads. In a trading business it is usually just the cost of the goods traded. In a service business it is usually just the direct labour used in delivering the service.

 

Creditors
Creditors reflect the total amount of money owed to suppliers but not yet paid. It is usually divided into Trade Creditors and Other Creditors

 

Creditor Days (Payments Period)
This reflects the average number of days taken to pay creditors. It is calculated as follows:

    .                          Creditor Days  = (Creditors X 365) / Cost of Sales

This is usually calculated on Trade Creditors

 

Current Assets
Current Assets are those assets that are usually sold or converted into cash within the normal trade cycle of the business which is usually taken to be one  year.

 

Current Liabilities
Current liabilities are the liability obligations of the business which it is expected to pay off within one year.

 

Current Ratio
Current ratio is the ratio that compares the current assets to the current liabilities in the business. It is calculated by the formula: Current Ratio = Current Assets / Current Liabilities.

 

Days Inventory
Day’s inventory shows the average amount of time that the items are held in the inventory. It is calculated as follows:

Days Inventory = (Inventory X 365) / Cost of Sales

Days Payable Outstanding
Days payable outstanding shows the amount of time it takes for the business to pay off its creditors (See Creditor Days)

 

Days Sales Outstanding
Days sales outstanding is the amount of time it takes for converting debtors/receivables to cash. (See Collection period)

 

Debtor
A person or persons who owe money to the business are collectively known as debtors.

 

Debtor Days
Debtor days is the average number of days taken to convert receivables to cash. (See Collection Period)

 

Depreciation
Depreciation is a charge for the use of fixed assets which reflects the book value of the amount of the assets consumed every year in generating revenue or simply due to the reduction in its value caused by wear and tear, obsolescence etc

 

Dividend
Dividend is a portion of the earnings of the business that is paid to the shareholders

 

Fixed Asset
Fixed assets are those assets that are required for normal conduct of business and will be on the Balance Sheet for more than one year

 

GAAP
GAAP is the acronym for Generally Accepted Accounting Principles, which is an accepted set of accounting procedures, policies and rules.

 

Going Concern Concept
Going Concern Concept of Accounting assumes that the business will remain in existence for the foreseeable future.

 

Gross Profit
Gross profit is the excess of sales over production costs. It is calculated as follows:

Gross Profit = Sales – Cost of Sales

 

Intangible Asset
An Intangible asset is an asset that cannot be physically seen or felt, but its presence delivers economic benefits the business, e.g goodwill.

 

Inventory (Stock)
Inventory is the stock of raw materials, work in progress and finished goods

 

Liability
Liability is a loan or a debt of  the business that has not yet been discharged.

 

Matching Concept
Matching concept is the concept in accounting that says that  revenues should be matched with their related costs in the income statement. ( See Accrual Concept)

 

Net Profit
Net profit is the excess of income from all sources over all expenses.

Net Sales
Net sales is the amount of sales attained after deducting VAT,  sales returns, allowances, discounts etc.

Net Worth
Net Worth of a Business = Total Assets – Total Third Party Liabilities

 

Operating Profit (Earnings before Interest and Tax , EBIT)
Operating profit is the excess of Gross Profit over other operating expenses ie

                              Operating Profit = Gross Profit – S G & A expenses

 

Prepayments

Prepayments reflect amounts paid in advance to service providers for services which have not yet been received eg Rent paid in advance. They usually are treated as Current Assets on the Balance Sheet

 

Profit after Tax (Net Profit)
Profit after tax is the excess of revenue over all the expenses and after payment of tax.

Profit Before Taxes
Profit before tax is the profit earned by the business before making the deduction for tax.

It is calculated as follows:

 Profit before Tax =  Operating Profit – Interest Charges

 

Quick Assets
Quick assets is the sum of the current assets minus inventory.

 

Receivable
Receivable is the money which is due to the business and has not yet been received.

 

Retained Earnings
Retained earnings are that part of the profit which has not been given to the owners, but retained in the business for future use.

Return on Capital Employed
Return on Capital employed is a measure of how effectively a business is using its capital. Return on Capital Employed = Operating Profit  / (Total Assets – Current Liabilities)

                                                     or
Return on Capital Employed = Operating Profit  / (Shareholders Funds +  Term Liabilities)

 

Return on Equity
Return on Equity = Net Income / Shareholders Funds

 

Selling, General and Administrative Expense (S,G & A Expenses)
Selling, general  and administrative expenses reflect all the non production costs incurred in  selling and distributing the goods and the administrative expenses of the business. They do not include interest or tax.

 

Shareholders Funds (Shareholders Equity)

This reflects the total amount owed by the business to the owners. It includes Share Capital, Share Premium, Retained Earnings and Revaluation Reserves

 

Tangible Assets

These are all the physical Fixed Assets of the business including Land and Buildings, Plant and Machinery, Office Equipment and Computers, Fixtures and Fittings, Motor Vehicles

 

Term Liabilities

Term Liabilities are those liabilities which are payable more than one year after the Balance Sheet date eg Bank Term Loans, Pension Liabilities

 

Total Assets
Total assets is the sum of all the fixed and current assets.

 

Trade Debtors
Trade debtors are those who owe the business money, on account of goods sold to them on credit.

 

Turnover
Turnover is another name for net sales.

 

Useful Life
Useful life is the approximate amount of time for which an asset is assumed to be useful before it is fully depreciated.

 

Variable Costs
Variable costs are those which vary with an increase or decrease in production.

 

Working Capital
Working Capital = Current Assets – Current Liabilities

DDIH Pre-Accelerator Program

About Drogheda Digital Innovation Hub (DDIH)

The Mill is partnering with Louth Co. Council on the delivery of the Drogheda Digital Innovation Hub, (DDIH). The program will involve the delivery of a pre-accelerator program, a town centre hub and a dedicated program manager to promote enterprise development in the greater Drogheda area.

What is a Pre-Accelerator?

A pre-accelerator is a program focused on early stage startups, taking them from concept to MVP (minimum viable product).

A big part of the program is mentorship. Experienced mentors will come in and give the team guidance with product and customer validation, marketing, product development, pitch and anything else needed to build the product to a place in which it can attract investment and attention.

About DDIH Pre-Accelerator

DDIH is a pre-accelerator program designed to target the high skilled workers in Drogheda or who currently commute from Drogheda to Dublin each day. Drogheda and Co. Louth are in the heart of the M1 Economic corridor which is the most densely populated area of the island and home to some of the most innovative companies in both the traditional and new technology sectors.

The DDIH Pre-Accelerator will provide existing skilled workers within the Drogheda catchment with a viable option to develop their concept to help launch and scale their idea.

Benefits of a Pre-Accelerator
  1. Help develop your concept and establish your MVP (Minimum Viable Product)
  2. Get into a lean startup mindset
  3. Meet potential co-founders and other like-minded individuals
  4. Get easy access to the startup ecosystem
  5. Access to equity-free knowledge
Start Dates & Selection Process

The program which will commence in mid 2023 and we will provide more details on the application process in Q1 2023.