Management by the Financial Statement
As we work with small and emerging businesses, one of the most rewarding milestones is when the business leader is able to read and evaluate the state of their business by reading and understanding their monthly financial statement. Most start-up business leaders manage their businesses by the balance in their checkbook. This is understandable since they must have the funds to pay employees, supplier and feed their family. As they grow, this is not enough to control and manage their business. They must develop an understanding of the profitability of the work that they do and its ability to cover the expenses generated. Is there enough income to pay for advertising, administration salaries, rent, taxes, etc.?
The first caution we provide is that we are not accountants. As students of business and managers, we have learned to read a monthly financial statement in depth. A depth to which one can identify the issues reported within the numbers and lead to the development of corrective actions plans to improve profitability. We always caution our client/partners to consult with a professional accountant before incorporating any of the ideas we present. They will understand the changes necessary and format them in a way that allows for each to be properly reported without affecting tax liability.
The Engine of Profitability
The engine of profitability is Gross Margin. There are many other items and accounts on the Profit and Loss Statement, but without a significant Gross Margin, profitability is unlikely. Shown below are the elements which provide for the calculation of Gross Margin:
- Revenue or Sales
- Labor Cost
- Material Cost
- Gross Margin
These four items are easy to understand. Labor and material are the variable costs. Variable costs increase and decrease directly with the amount of work or services being provided. The more work you perform the more material and labor is incurred. These are different than fixed costs which are constant such as rent, taxes, insurance etc. These fixed cost are not included in the calculation of Gross Margin.
It is sometimes the case that the individual performing the work is the owner and they often do not recognize their time as a variable cost. To properly understand profitability the owner must put a value on their time and charge it into the Labor Cost. There may be occasions where funds are not available to write a check to the owner. An accountant can show you how to include those costs as Labor Costs and set up a payable account. They know how to do that.
Another term for Gross Margin which has been used is Contribution Margin. This term provides additional insights and begs the question, “is this firm generating enough profit to cover the programed or ongoing expenses.” If not, one must consider reducing expenses by items such as not launching that expensive promotional program, hiring an administrative person, or other somewhat discretionary items.
The Balance Sheet
As previously stated, new businesses manage cash using the bank account. Mature businesses manage cash using the Balance Sheet. The Balance Sheet is a list of Assets (Current and Fixed) and Liabilities. Current Assets include the cash on-hand, and money owed to you by others (receivables). Current Liabilities are the funds you currently owe someone else. Efforts in this area are to collect receivables to generate cash and don’t get behind on paying off liabilities, but don’t pay them too early.
The purpose of this very brief article is only to call attention to the needed read and understanding a business financial report. A complete understand comes only with further education and experience. As business coaches and managers, we work with our partner businesses to help unwrap the information sometimes hidden within the reports. This understanding leads to improved planning and greater profitability. It’s all part of the service we provide.