Gross profit is a very underappreciated metric in the startup world. Gross profit is the difference between your revenue and the cost of goods sold. So it’s how much money you have left over after you service your customers. And that leftover money is what you use to run the rest of the business. If you have too little money left over, you won’t be able to grow into an efficient business that generates profits.
We definitely found that this year in 2024, and in 2023, venture capital investors really swung back into appreciating businesses that had good unit economics and in particular, ones that had good gross profit margins. However, your startup needs to use accrual accounting, not cash accounting, to give you a more accurate picture of your gross profit. That helps you as a startup founder run your business better.
What’s the difference between cash and accrual accounting?
Cash accounting is an incredibly straightforward way to do accounting. You record transactions when the cash changes hands. It’s really simple. Your bank account balance goes up, you’re recording the revenue, your bank account balance goes down, you’re recording your expenses.
But does this really give you a true picture of your financial health? Not really, particularly if you’re trying to run a high-growth startup. Accrual accounting, on the other hand, is really the way that we recommend that startups do their accounting. It’s the only way we manage books here at Kruze. What accrual-based accounting does is record your revenues and expenses when they’re earned or incurred. And that’s not just when the cash changes hands.
Accrual accounting aligns with Generally Accepted Accounting Principles (GAAP), and it gives you a much cleaner picture of what your financials are, which is crucial for startups that are scaling. And also, really importantly, your investors or the VCs you might be courting are going to expect you to do accrual-based accounting.
How do cash and accrual accounting change your gross profit?
Let’s look at some of the gross profit calculation challenges you have when you use cash accounting. Think about it this way: Imagine you sell a product in January, but you don’t pay your supplier until February. Well, with cash accounting, your January profits will look awesome, but then in February, of course, things will whip around the other way and you suddenly look like you have a really bad profit margin because all the costs are going to hit your books.
Another thing that we see a lot with SaaS companies, is they have deferred revenue. So a client prepays for the year, but it actually costs that SaaS business something to service that client throughout the year. So if they were doing cash-based accounting, the cash would jump up when the client first pays, and then you would see really bad gross margins throughout the rest of the year when they’re actually servicing the client.
Cash accounting is misleading - especially with gross profits
Evaluating your business based on these cash-based figures can really mess up how you think about how your business is doing. In one month, you might think you’re really profitable. And the next month you might think you’re losing money. That’s not really what’s happening.
So you should use accrual-based accounting. Accrual-based accounting makes a lot more sense when you’re looking at your gross profit. It’s called the matching principle. It ensures that the revenue from selling a product in January is matched with its production costs, even if you paid that supplier in February. Accrual accounting helps you smooth out the revenue payments over the length of time that you’re servicing a client, which is great for SaaS businesses that are getting prepaid, and that have deferred revenue.
How does accrual accounting work?
Accrual accounting is a method of financial reporting that recognizes revenues and expenses when they are incurred, regardless of when cash transactions occur. This means that revenues are recorded when they are earned, and expenses are recorded when they are owed, rather than when payment is made or received. Let’s go back to our SaaS company that’s selling annual subscriptions. If a customer pays a subscription fee for an entire year in one payment, the full payment is divided by the length of the contract and one-twelfth of the revenue is recognized each month.
By matching revenues with the expenses incurred to generate them, accrual accounting provides a more accurate picture of a company’s financial performance over a given period. So this method of accounting actually reveals the real profitability of your sales and it gives you a much more solid foundation for making a decision, interacting with investors, and thinking strategically.
Accrual accounting smooths out gross profit
With accrual-based accounting, your startup won’t have wide swings from positive revenue to negative revenue. You (and your investors!) can see how much revenue you’re earning each month on average, balanced against the expenses you incurred. Your gross profit will help you understand how to set your prices better, help you understand how to manage your costs better, and help you evaluate which customers or products or services are most profitable. It’ll build investor confidence because you’ll have accurate, more GAAP-like financial reports, which are what investors are used to seeing. And finally, it’s just really essential for budgeting, forecasting, planning, and understanding your growth.
So cash-based accounting may be appealing to a startup founder because it’s easier, but you really have to switch to accrual-based accounting when you’re playing the venture capital game. It helps you level up the management of your business and the analysis of your startup’s metrics. It also helps you communicate honestly and effectively with VCs, and it’ll make you look a lot more professional.
If you have any other questions on cash or accrual accounting, gross profit, accounting metrics, or taxes, please contact us. You can also follow our YouTube channel and our blog for information about accounting, finance, HR, and taxes for startups!
