Say hello to your INCOME STATEMENT
Understanding your “P & L – Profit and Loss”
Would you believe me if I told you that a large percentage of owners of “Main Street and lower middle market” (companies with EBITDA up to $10 million plus) don’t read and understand their own company’s financial statements? It’s true, and it’s not just landscape companies. I certainly understand why an entrepreneur wants to outsource his accounting and financial function, BUT understanding your financial statements will help you run your company more profitably. This week we continue our overview of the basics of financial management for non-financial managers and owners.
You may be more familiar with your P&L, since it typically makes more sense to someone who doesn’t have an accounting background. Your income statement shows your sales, expenses, and profits for a period of time. (Recall your balance sheet is a picture of your company for a specific point in time.). The basic equation for the income statement is:
Revenues – Expenses = Income
Here is an example of a simple P&L. Note that it does not yet include the recommended Chart of Accounts for a landscape company. We will include that in a future blog. That chart of accounts is a sample of the types of information you need to capture to manage your company efficiently and effectively.
Sample P&L
Ideal Company Income Statement
Example for period Jan-Dec 2022
|
Accrual Basis |
(In 000s) |
| Revenue | 2,400 |
| Cost of Goods Sold | 1,200 |
| Gross Profit | 1,200 |
| Gross Profit Margin | 50% |
| Indirect Expenses | 640 |
| Depreciation | 110 |
| Interest | 10 |
| Taxes | 42 |
| Total Indirect expense | 802 |
| Net Income | 398 |
| Net Income Percent | 17% |
Accrual Accounting
Why use this accrual and not cash accounting?
Some small companies do use cash accounting, but that can result in a distorted and not-very-helpful view of the way the company is performing. Companies use accrual accounting to match the revenues that are earned to the expenses when incurred regardless of the timing of cash receipts and expenditures. In contrast, cash accounting only recognizes events that occur in the company based on timing and receipt of cash.
For example, using a cash basis, a company may take a large deposit in January for a job but may not have started the work yet. To recognize revenue when the deposit comes in means that revenue will be overstated in January and there won’t be any expenses that should show as incurred for that revenue. That will overstate the profit in January and understate the profits in the months when the work is completed.
The Matching Principle
The matching principle is an important accounting rule (a part of Generally Accepted Accounting Principles or GAAP) that revenues and related expenses need to be reported in the same period. This is a key component of accrual accounting. Again, in accrual accounting, a portion of the revenue or expense is recorded in the time being measured.
Fixed Assets and Depreciation
For fixed assets that will be depreciated, (such as a building or expensive piece of equipment for the business), the accountant will apply a portion of the costs of that asset to the expected life of the asset. If the building cost $20 million and is expected to have a useful life of 20 years, the accountant must spread the cost of the asset over its useful life. So, each year the company uses a portion of that asset as a cost of producing revenue. The cash may have been used, but the cost will be allocated over those years in one of several methods (we’ll cover that in a future blog too.). depreciation is a non-cash charge that reflects the reduction in the value of the asset as it is used over its useful life.
It’s important to understand how your bookkeeper/accounting team is handling the revenue and expenses using accrual accounting since there are various assumptions and interpretations that your accounting team may be applying to your financials that you don’t understand. You (and your management team) will want to understand how these assumptions and estimates are being handled to best manage the company.
Would you like to discuss what a buyer would like to see in your income statement? Do you have a solid understanding of how revenue and expenses are recognized in your company? Thinking about how your company can maximize its value? We’d be happy to have a confidential complimentary conversation with you about these or any other exit/sales/buying issues.
You can reach me via email: [email protected] or on my cell phone a: 224-688-8838.
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