Company financial statements are important. They help investors, company owners, and other stakeholders better understand business performance. They’re used for accounting purposes, sure, but beyond that, they can be useful tools that aid in the decision-making process of business owners and operators.
The three financial statements that every company must prepare are the income statement, balance sheet, and the statement of cash flows. However, for SaaS companies, the most important one to understand and analyze is the income statement. This is because this report, also known as the “statement of financial position,” tracks all revenue, operating expenses, non-operating expenses, taxes, and profit.
A SaaS business doesn’t normally have a lot of assets or other items that are found on the balance sheet and statement of cash flows. However, almost all of a SaaS company’s information is contained on its income statement.
In this article, we discuss the best ways to structure an income statement so it becomes more useful to SaaS business owners.
Cash Basis Versus Accrual Basis
Before we dive into the nuts and bolts of the income statement, it’s first important to define how it’s going to be prepared. Statements of financial positions can be prepared using either the cash basis of accounting or the accrual basis of accounting. The difference between the two is the timing of which revenues and expenses are recorded.
- Cash Basis – This method of accounting records revenue when cash is actually received and records expenses when they’re actually paid. So, if you sell a $100 SaaS subscription payable in 30 days, you can’t record your revenue until the 30-day period is up and money hits your bank account. The same goes for expenses. If you purchase a new computer on credit, payable in 30 days, you record the expense only when you actually pay the bill.
- Accrual Basis – This method, on the other hand, accounts for revenue when it’s “earned” and for expenses when they’re “incurred.” This means that if you sell the same SaaS subscription for $100 in January and expect to receive payment in February, you record the $100 of revenue in January. The same principle applies to expenses. If you purchase a new computer on credit in January, you record the expense in January, and not when you pay off your credit card.
For a SaaS business, it’s best to use the accrual basis of accounting. This is because it ties your revenues and expenses together in the same period. For example, if you sell a SaaS subscription in January, payable in 30 days, but the server cost to host the software is payable in 60 days, you’ll still want to record both the revenue and the expense in January. This makes it easier to analyze your business performance.
Structuring Your SaaS Income Statement
All income statement are broken down into three broad categories: revenue, expenses, and profit.
However, there is a very specific way in which these categories are structures, which we’ll go over below.
We’ll also discuss the strategic reasons why you’ll want to format your income statement in this manner.
Remember that all income statements are prepared with monthly periods, meaning that all the revenues and expenses for January, for example, will be displayed in a single column. The same goes for each proceeding month.
The first line of your income statement is your revenue. This is why sales are often referred to as “top line revenue,” since it’s the first number you see on your statement. Revenue accounts for all sales within a specific period. What this means is that revenue is recorded in the period it was earned, and not received. This is called “revenue recognition.” For example, if you sell a 12-month SaaS subscription model for US $120, you recognize US $10 of revenue for each of the 12 months rather than the full US $120 when the customer pays you.
However, for SaaS businesses, you’ll also want to break out your revenue into subcategories.
For example, if you have a subscription model, chances are that your SaaS business has both monthly recurring revenue as well as one-off, non-recurring revenue. It’s smart for you to categorize your recurring revenue and non-recurring revenue into two subcategories, shown here:
- Recurring Revenue – US $100.00
- Non-Recurring Revenue – US $25.00
The reason for this is that your SaaS income statement should help you better understand where your revenue is coming from.
Having US $1 million in revenue is great, but if US $900,000 is non-recurring, you might not have a stable business. Instead, look to increase your monthly recurring revenue.
This will also help you see your customer churn from month-to-month. If you have US $100.00 in recurring revenue in January and US $50.00 in recurring revenue in February, and your monthly subscription costs US $10.00, then you know that you lost five out of 10 recurring customers.
Cost of Goods Sold
Normally, a company’s cost of good sold, or COGS, are the costs of the materials needed to produce a product. However, with a SaaS company, the product isn’t physical, making it harder to identify the input costs.
COGS is the line item below revenue, which is subtracted from a company’s top line revenue to derive its gross revenue (Revenue – COGS = Gross Revenue).
For a SaaS business, the rule of thumb is that your hosting costs or server costs are categorized as your COGS. So, if you rent space from AWS, Google, or something similar, the monthly cost would go here.
Operating expenses, also known as “overhead”, refers to all the expenses needed to run a business. Each operating cost should be broken out as a separate line item on your income statement, so you know exactly where you’re money’s being spent.
This is important because you can see things such as the number of engineers needed to service a specific number of customers or servers, for example. You’ll want to structure it like we show below.
- Operating Expenses
- Rent – US $1,000
- Salaries and Wages – US $25,000
- Office Supplies – US $500
Subtracting your operating expenses from your gross revenue gives you your earnings before taxes, or EBT. Taxes are then assessed on the EBT, which is a percentage of the total. Then, you’ll subtract your taxes from your EBT to derive your company profit.
Understanding the inputs needed to calculate your profit is important because you can identify the ways to increase your company’s profitability. This is either done by increasing your revenue or decreasing your expenses.
Hopefully, by now, you understand the importance of a properly formatted income statement for your SaaS business. Use it as a tool to make more informed decisions for your company.