For a long-time there was no uniform method to present financial information. Companies were free to present their financial statements in whichever format they pleased.
As executive bonuses are tied to financial performance, executives would often manipulate the financial statements and present them in the most ‘ideal light’. The most common approach was to account for certain ‘expenses’ as assets, which resulted in higher profit and asset position.
As a result of these creative accounting practices, investors were often misled. I’m sure you’re familiar with Enron — history’s most scandalous example of fake accounting. They were able to post profits as they were going bankrupt. How does that make sense?
The ability to manipulate accounting had catastrophic impacts to the economy. The 1929 great depression in the USA for example was attributed to manipulative accounting among business. Fake accounting.
The great depression prompted the government to implement of a set of uniformed Accounting Standards — a set of principles to govern accounting.
Accounting standards govern the accounting treatment of revenue, expenses, liabilities, equity and assets. These standards change all the time, but the core system stays the same:
Start with sales. Subtract Direct costs. Deduct wages and other costs….and you’re left with ‘profit’.
In theory, having a uniformed set of financial principles better allows investors to understand the true performance of businesses, irrespective of geography or size. It supposed to allow investors and owners to compare the profit of one operation to another.
The problem with these accounting standards is that they have taken us further away from understanding the underlying mechanics of a business. Yes, traditional financial statements tell us what ‘profit’ the company generated — however they don’t tell us much else. The problem is they’ve been established to ensure consistency, not to help us make decisions — like when to hire your next team member, how much you should spend on sales and marketing.
I’ve outlined below a few tips on how to structure your profit and loss so that you can use your financial statements to make decisions.
1. Dissect your revenue
Most businesses will have multiple revenue streams. Most commonly, these revenue streams comprise of sales from different types of products and services. When accounting for revenue, each type of revenue stream should be distinguished.
For example, the company below is a full-service marketing agency that provides SEO services, Social media management, Digital strategy and Website development.
Looking at revenue per service line is helpful for owners to understand which products and services generate the most revenue.
What it doesn’t show, however is the predictability of these sales of occurring in the future. To help us understand the predictability of sales, and therefore cashflow, each product should be further defined by Recurring and Non-recurring revenue.
Recurring revenue includes all sales and income that are recurring in nature. These typically include retainer based contracts, subscriptions and managed services. Recurring revenue is the holy grail for businesses. Having predictability on sales can provide comfort on cashflow and help you forecast capacity for when to hire new staff members or invest in more stock.
Non-recurring revenue includes sales and income which are one-off in nature. This comprises mostly of project work — projects that you do for customers are unlikely to repeat again.
It’s useful to understand the split of our revenue. But how do we know if we’re selling these products, profitably?
We assess this in our Cost of Sales.
2. Correctly allocate your Cost of Sales
Cost of sales are all the operational costs your business incurs to provide the product and service. This includes the costs of the materials, web hosting, along with the direct labour costs used to produce the product or service.
Cost of sales for service based businesses include the salaries of the professional services team responsible for doing the work. In other words, the wages and on-costs of your staff who are responsible for delivery the work to your customers.
In addition to wages costs, Cost of Sales include other direct customer related costs including disbursements and payment processing fees.
Not all revenue is created equal
A dollar is a dollar is a dollar, right? $1 of Sales is the same in comparison to another? Not quite. Not all revenue dollars are created equal, but all Gross Profit dollars are.
Gross Profit is calculated as Total Revenue less Total Cost of Goods Sold.
Gross profit is the most important metric that every business should be measuring. It is vital because it can help us understand the opportunities to improve your business performance. The biggest gains are in improving gross profit.
In our marketing agency example, the Gross Profit margin is 50%. This means that for every $100 of sales, the business is generating $50 of gross profit.
Having a high Gross Profit margin can give your business a competitive advantage because it allows more profit to reinvest back into your business growth, via sales and marketing, or returns to shareholders (ie. You). However, having a high Gross Profit margin isn’t always an indicator of a robust, valuable business. Companies like Amazon intentionally price their products to operate on low gross profit margins to win more customers and take market share.
In the words of Jeff Bezos:
“Your margin is my opportunity”
Gross profit margins will vary depending on industry and size. Software companies, for example have high gross profit margins, around 70% — 80%, compared to wholesale businesses that have margins as low as 30%.
If your Gross Profit margins are negative, it means you are losing money on every sale you are making. This indicates your business model is broken and needs to be reviewed.
3. Operating Expenses
Operating expenses comprise of all the other expenses that are not directly related to delivering your businesses products and services. These can include rent, utilities, wages for administration staff, insurance. We can further categorise these operational expenses into two buckets:
- General Administration and Product Costs
- Customer Acquisition Costs.
General administration costs are all the other costs that are incurred in running the general business. Besides showing how much you’re spending on day-to-day running expenses, don’t spend too much time analysing these.
Customer Acquisition Costs are the costs your business incurs to acquiring/winning new customers. These can include wages for your sales and marketing team, advertising expenses and new customer onboarding expenses.
It’s important to separate Customer Acquisition costs from general costs because it allows us to understand how much you’re spending to acquire customers. This allows you to measure how efficiently they are being acquired and provides clues as to how to improve it.
As you can see above, not categorising your expenses correctly can significantly skew your ability to understand your profit margins. For example, if your sales expenses are categorised under Cost of Sales, this will skew your Gross Profit margins.
This could drive you to make decisions based off wrong information!
If you’re unsure on whether your bookkeeping and chart of accounts are setup for performance reporting, contact me at firstname.lastname@example.org for a complimentary review.