It’s ok, you can be totally honest with me. And I will be honest with you, too.
Most business owners hardly ever look at their financials. There are several reasons for that:
- The financials are not very accurate
- It’s difficult to read the financials because they are so messy looking
- It’s difficult to understand how those financial results ended up on the financials
- The info on the financials is too old to be useful
How in the world can you implement our Profit First Cash Management System (PFCMS) without accurate financials? Answer: It’s almost impossible.
Let’s look at your financials one by one. You good with that?
Let’s focus on the P&L to start…
Does everyone in the class know what a P&L is? Hey, get used to this term if you don’t. The P&L is another name for the Income Statement (AKA Profit and Loss Statement or P&L). The P&L shows business activity between 2 points in time. It can be weekly, monthly, quarterly, or annually. And as everyone knows, the shortest distance between 2 points is a straight line.
Did I throw you a curve on all that straight line talk? I can fix that if I did… It’s the PROBLEMS that can throw you the curves. So let’s deal with the problems…
Problem 1: The WACKY way transactions are recorded, Can make the P&L useless. After all, how can you make sense from summations of numbers that are showing up in different lines on the P&L (HINT HINT: You can’t…)
Am I being serious? You bet your sweet bank account we are… We see this constantly when we pick up a new client. Most of the time, it’s because the person doing the books isn’t very skilled (yes, I’m trying to be nice here). The problem is one of consistency. Transactions are recorded differently (coded to different accounts). And the results? Financial weirdness…
Problem 2: The Wacky way the accounts show up in the P&L. Ok, so some peculiar transaction shows up. Yes, it really does happen from time to time. And how does the bookkeeper handle it? Ha, they create a new account. When that happens over time, the P&L becomes a huge cluster of mess (Oy, all those wacky accounts…), and it overwhelms the senses when you try to look and make sense of it.
Problem 3: Ok, now that we addressed Problem 1 and 2, there’s more? You didn’t think I’d let you off that easy, did you? The P&L must still be formatted properly from a management standpoint (and not always from an income tax standpoint). One of the biggest problems we see on the P&L comes when determining the company’s Cost of Goods Sold (COGS), and PROFIT MARGIN (Sales-COGS). Ooooh, that sounds important, right? Well, it is important, and here’s why: Most companies have a rather vague idea on how much it really costs to produce their products and/or services. What’s that you say? Really? Yes, it’s true. Materials and supplies get coded all over the place, direct labor is mixed with office labor, etc.
It is highly CRITICAL (does that sound like I really mean it?) that management knows how much profit margin they are making on their main customer offerings. And that’s why we carefully calculate COGS and Profit Margin. When the P&L gets formatted properly, management can really begin to understand how much it costs to satisfy customer needs, and how much money they can make from doing it by watching the profit margins. How would you like to know if you are pricing your offerings properly? Well then you’ll need to know your profit margins. And if you really suck at doing what you’re doing, then at least you know what you have to do to fix that.
Problem 4: EBITDA is not clear. Oh, did that term throw you a bit? Ok, let me explain what it is and why it’s important. EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. So what’s the big deal about EBITDA? Am I just trying to confuse you? No way. I would never do that. Alright then, let me explain. Every business owner needs to understand how profitable their business is from an operating point of view. In other words You’re trying to see if your normal operations are making money. By moving taxes, interest, depreciation, amortization below “Income From Operations (or EBITDA) management can get a more clear picture of how their business is performing before clouding the picture with financial lending, taxes and non-cash items like depreciation.
BANK ALERT: Banks ALWAYS look at EBITDA when making lending decisions. That should tell you something about its importance.
In the next article we will look at how to analyze your P&L, and make better business decisions with that info, and how to use it when deploying our PFCMS.
