Controller, 8+ Years of Diverse Accounting Experience & Consulting
February 26th, 2019
Financial statements are the lifeline of your business.
In a later article, I will go into more detail about the processes you can put in place to ensure accurate financial reporting, but the main takeaway is that you must be able to rely on the fact that the reported amounts are accurate.
Your agency must be able to rely on your financial statements for three reasons:
to know the condition of the business
to understand your performance for a given period;
and to identify your ability to grow to sustain your business in the future.
But, how do you read financials effectively?
In this article, we will walk through the Balance Sheet (BS) and Profit & Loss Statements (P&L) and discuss how to identify positive and negative trends in your year-end review.
The main goal is to arm you with some easy-to-use tactics to help you better understand your performance, identify levers that you can pull to achieve your goals in the coming year, and assess the overall financial health or your organization.
For us, “The Great Game” is played weekly during the beginning of our All-Hands meetings. Each line Profit & Loss line item will have an owner, and that owner is responsible for weekly forecasting of their line item (i.e. Service Revenue, Agency Compensation).
We did this to not only improve the accuracy of our forecasts and financial reporting processes but to also involve every employee in the financial operations and success of IMPACT.
As a result, our employees have embraced an ownership mindset and feel more in the know with what’s going on with the organization.
We want everyone to think like an owner of IMPACT and we coach them on how to make financial decisions that are in the best interest of the agency.
This system helps empower our employees to understand the true value they add to the agency and arm them with the tools to figure out how to deliver that value more efficiently and more effectively.
The first step in implementing a system like The Great Game is to fully understand what goes into your company’s financial statements (specifically the balance sheet and profit and loss statements) and understand what the numbers mean.
The balance sheet is a summary of your company’s assets, liabilities, and equity, as of a given period. It’s called a “balance sheet” because assets must equal liabilities plus equity.
Assets are anything of value owned by the business, liabilities are debts owed to outside creditors or other parties, and equity is the amount owed to business owners.
To review the financial condition of your business after the previous year, It’s important to understand the balance sheet and the relationship between your assets, liabilities, and equity.
Assets - Remember that an asset adds value to your business.
You should look at how well your business manages its assets by reviewing the balances of cash, receivables, short-term and long-term investments, inventory, fixed assets, furniture and fixtures, land, and building.
It’s important to note the breakdown of liquid vs. non-liquid assets. Liquid assets include cash or other assets that are easily convertible to cash (i.e. marketable securities, accounts receivables). This is important because in order to sustain your business, you must have the assets available to meet your business obligations, otherwise known as your liabilities.
Liabilities - Take note that liabilities consist of all outstanding obligations of a business. Obtaining loans is one of the ways to generate capital to support a business operation.
Liability accounts will enable you to look at the balances of the accounts payables, bills payables, notes payables, and all other payables.
Most often, depending on a given situation, when you see that a business has a high amount of liability, it may be a sign of trouble and inability to sustain its operation.
Equity - Equity represents the capital of your business. It is the major source of money to support and sustain your business operations in the future.
In your balance sheet, you will be able to see the real value of a business in terms of ownership.
When you see a high equity balance, it can be a good indicator that the business is able to sustain and grow. The opposite means it is in trouble of closing down its operation.
In my opinion, when reviewing your balance sheet at a high level, the most important ratio to calculate is the current ratio (Current Ratio = Current Assets / Total Liabilities). The current ratio is a liquidity ratio that indicates whether your company’s current assets will be sufficient to meet the company’s obligations when they come due.
Reviewing liquidity ratios is an important analysis at year end because it can help identify potential cash flow issues in the coming year.
Profit & Loss Statement
The profit & loss statement (P&L) is a financial report that summarizes your company’s revenues, expenses, and profits/losses over a period of time (usually a fiscal quarter or year).
Under the accrual basis (or method) of accounting, service revenues are recorded in the period they are earned or delivered. The expenses that match the revenues, which include salaries, costs of good sold, and operating expenses, are recorded in the same accounting period as the related revenue.
When reviewing the profit and loss statements, or income statements, the goal is to understand the overall performance of your business over a certain period.
Revenue - This account will show you the number of sales derived in a given period.
In the agency world, your revenue could include service revenue, sponsorship revenue, event revenue, etc.
Understanding the items that make up your revenue is important, but it only tells a part of the story.
Cost of Goods Sold (COGS) - In the agency world, cost of goods sold represents the cost of delivering your service to clients. It is likely made up of salary costs, client-related travel, agency tools, and tech, and other agency costs.
Your gross profit is calculated as revenue less cost of goods sold and represents how efficiently you are delivering your service.
Further, it’s important to also calculate your Gross Profit Margin. This ratio tells you how efficiently you are delivering value to your clients. It represents the remaining revenue, or profit, leftover after your costs of goods sold.
Marketing agency gross profit margin would likely be calculated as service revenue less agency salaries and other cost of goods sold.
Operating Expenses - These are the normal costs of running your business. For example, this includes administrative salaries, professional fees like legal and accounting, interest expense, office expenses, etc.
When you fully understand the ins and outs of your Operating Expense accounts, you can verify whether the business is spending on improving its product, spending on their employees, or just plain wasting money.
Profit(Loss) Before Tax - Remember that revenue alone doesn't necessarily mean the business is profitable.
Because of the expense account, even if the business has high revenue, if it spends just the same level, it wouldn't be as profitable as it should be.
Here are the guidelines to know if a business is profitable or not when looking at your income statement from the previous year:
Profit means the amount of revenue was higher than the amount of cost to produce (Revenue > Expense).
When there’s profit, it means the business is operating efficiently.
On the other hand, a loss is incurred when revenues are lower than the cost to produce plus the costs of operations (Revenue < Expense). When there’s a loss, it means the operation of the business was inefficient.
Profit(Loss) After Tax - Finally, once you determined the income tax to be paid, you'll be able to compute for the real amount of profit or loss after deducting the applicable amount of tax.
Overall, when reviewing these areas of your income statement from the prior year, it’s important to understand the positive and negative trends. Here are three simple questions you can ask yourself:
Did the balance increase or decrease from prior year?
Was this a positive or a negative change for the business?
What drove the change during the year?
By answering these three questions for each P&L line item, you will have a much deeper understanding of what drove your financial results in 2018.
While I’d love to tell everyone to implement an open-book financial management system like The Great Game, it’s just not feasible for everyone.
However, everyone now has the tools and resources at their fingertips to teach financial literacy to every member within your organization.
You can start by taking a deep dive into your company’s 2018 financial statements.
Gain a deep understanding of what drove your performance last year, identify things that you can do differently in 2019, and execute on that plan.
After you perform your review, I’d love to hear what you discovered about your 2018 operations. Feel free to email me and share your breakthroughs, questions, or financial review tips and tricks! (and connect with me on LinkedIn!)