Once you have the Income Statement prepared, see The Income Statement: How to Read it post, it is time to compare your results from the current month to the prior month. Using the same logic, compare your current results to the same month of the prior year. In what areas did your business improve? What areas didn’t do as well?

First compare the prior month and same month the prior year by looking at the gross dollar amounts. You can gain some basic information about how your business is doing. While the dollar figures provide some information as to what areas to focus on in the future, it is helpful to convert some of this information into percentages to get a more accurate picture. For example, let’s assume that your Gross Revenues decreased slightly from May to June. It should follow that your Cost of Goods Sold decrease too. Assume that in May the Gross Margin was 60% but in June it was only 55%. What happened? Did your vendors increase their costs? Or did you sell your products at a discount in order to generate more sales? What is the trend in the Gross Margin over 6 months? Over 3 years?

There are many other ratios you can use to evaluate your business using the Income Statement. Since every business is different there is not one ratio that is necessarily more important than the others. Two of my favorites are:

1. Receivables Turnover (Net Credit Sales/Average Net Receivables) – provides the number of times per year that you are collecting your outstanding Accounts Receivables. You can convert this into days using the following formula: (365/Receivables Turnover ratio)=days.*

2. Profit Margin ratio (Net Income/Net Sales) – provides the rate of the conversion of sales into profits.

It is important to monitor the balance of cash in your checking account. However, a review and ratio analysis of the Income Statement will help determine how effective you and your business have been generating and using cash.

*Note, the Receivables Turnover ratio includes an item, average Net Receivables, from the Balance Sheet.

Many business owners follow the motto that “cash is king.” And while cash is extremely important, the ending balance in your bank account does not tell you much about how you generated or used cash. Looking only at your cash balance may cause you to miss some key indicators on how your business is doing. The Income Statement is full of useful information about how the cash is flowing into and out of your business.

When reading an Income Statement start at the top, see a summarized Income Statement below. Gross Revenue is the first line item on the Income Statement. Gross Revenue is the accumulation of your sales. You can review your Income Statement monthly (required), weekly or even daily (depending on the accuracy of daily recording keeping).

If you own a business that sells products, i.e., you have inventory, you should have the line item Cost of Goods Sold. Cost of Goods Sold is the expense associated with the products you sold. You would have purchased these inventory items to sell in your wholesale/retail or online stores. Once these inventory items are sold you convert the asset into an expense, i.e., Cost of Goods Sold. If you have a service business you may report direct costs in the Cost of Sales account.

The Gross Profit is determine by subtracting the Cost of Goods Sold (or Cost of Sales) from the Gross Revenues. The Gross Profit is the amount of “money” you have left over to pay for operating expenses such as rent, utilities, staff salaries, insurance, phone, etc.

After you calculate the Gross Profit, you need to subtract the Operating Expenses. Operating expenses are the indirect cost incurred to run the business, such as rent, utilities, phone, and marketing expenses.

The last line on the Income statement will be the Net Profit. Hopefully this line item is a positive number. The Net Profit tells you how much “profit” you have per every dollar in Gross Sales. This is not necessarily your cash profit, especially if you had depreciation or made large purchases of equipment during the period.

Summarized Income Statement

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What does your cash flow look like right now? Are you still worried about the economy? Have you been putting off purchases or hiring a new employee because cash is a little tight? What about that new computer you need because the one you are using is 2-3 years old?

A friend of mine recently told me he has become a cash buyer. If he doesn’t have the cash, he doesn’t buy. In my personal life I follow this logic, to some extent. Our home is financed as is one of our cars, but everything else is paid for in full at the time of purchase. My husband and I are both simple people so this work for us. However, this might not work for you in your personal life, but can it work for your business?

What would happen in your business if you only made purchases when you had the cash to do so? Note, we are talking about big purchases, not your daily operational costs associated with inventory or supplies to provide your products or services. Would your manufacturing process suffer because you don’t have the most modern equipment? Can you get by with the computer equipment you current have?

We have all heard the saying that you have to spend money to make money. And while this saying does make sense, especially for advertising and outsourcing, we should strategically plan for how we use our cash. Incurring debt to buy a new laptop creates additional burdens on the business owner for how they manage the cash available for daily operations or emergencies.

I challenge you to only make purchases when you have the cash on hand for one month. Can you do it? If so, does the “cash only” negatively or positively impact your gross sales? If your sales are not negatively impacted, could you use this strategy for one more month? What changes do you notice in your bank account? To your stress levels?

Share your story here.

Gross profit and profit margin sound very similar, yet they are very different and serve distinct purposes for analyzing your business.

Gross profit is found by taking the net sales minus the cost of goods sold. For example, to find gross profit, a dressmaker make add up all of the receipts for the dresses sold, then subtract the cost of the fabric, thread, thimbles, the wages paid to a junior dressmaker who helped sew the dresses. The result is the amount of profit made only considering direct costs, i.e., gross profit. To convert the dollar amount into a percentage, take the gross profit divided by net sales, and multiplying by 100. While you can compare your result to other companies in your industry, it is generally difficult to accurately compare across companies using this calculation, so this is often done as an internal measure to see how the business is doing from year to year. Compare this ratio to the same month of the prior year or the previous month to spot any significant trends.

Net profit are the earnings remaining after you have accounted for all expenses, including depreciation and taxes. Net profit margin is found by taking the net profits (which is the profit after taxes have been paid) divided by revenue, multiplied by 100. Net profit can be used to compare your results to other companies within your industry. Since all items have been accounted in calculating the net profit margin, it allows for more comparability to the industry standard or your competitors.

Ratios provide a great means for measuring and monitoring business performance. These are just two of the many ratios that might be applicable to your business.

Financing is typically divided into two different categories, Debt Financing and Equity Financing. Understanding the different financing options is a critical step in a company’s financial planning strategy. Debt Financing involves borrowing money that will be paid back over time. The debt can be short term (less than one year) or long term (more than one year). The only obligation to the lender is the repayment of the loan. Equity financing involves the receipt of funding in exchange for ownership shares in the company. The “borrowing” company does not incur additional debt and thus will not have to repay the loan amount.

There are several advantages and disadvantages to debt financing and maintaining an appropriate debt-to-equity ratio is essential for securing future financing as well as for long term financial health. Financial experts cite numerous advantages to Debt Financing. One of the main advantages is that debt financing provides funding without diluting the ownership of the company. Additionally, with debt financing, lenders do not have a claim on any future profits of the company; the lender is limited to receiving an amount equal to the loan principal plus interest.  Most business owners find that raising capital from debt financing is much easier than equity financing as business owners do not have to comply with state and federal securities regulations. Debt financing also provides tax benefits in that the interest paid to service the debt is tax deductible.

Companies often find that there are disadvantages to debt financing. One of the obvious disadvantages is that funds financed through debt must eventually be paid back. In debt financing the principal and interest payments become fixed costs that must be accounted for when a company is determining its break-even point. Although debt payments occur on a fixed schedule, the payments require careful budgeting of cash flow which can be difficult for new businesses or business with highly varying business cycles. Debt financing also negatively affects the company’s debt-to-equity ratio causing lenders to view the company has a higher risk. With debt financing there is generally a requirement to offer company or personal assets as collateral to secure the loan. Small business owners often have to personally guarantee the loan, in full or in part. A personal guarantee means that if the company cannot pay back the debt the owner pledging the personal guarantee will repay the loan with his personal funds.

The decision to borrow funds from a bank or find an equity investor can be a tricky one. With debt you are only obligated to pay back the principle plus and interest component. With an equity investor you give up a portion of ownership in your company and your payment of dividends/distributions are variable over the life of their investment. An analysis to determine which option is best for your company should be completed before making a lending decision.

In my local paper today there was an article about a night club owner who is being sued by the neighboring businesses. As I was reading, I couldn’t help but lecture the business owner for not doing his research or more of it before spending ALL that money, $1million to be exact, and opening his doors. I feel bad for him, but at the same time it doesn’t appear that he did everything he needed to prepare the business for success.

When my husband and I noticed that a night club was opening in this particular area we both thought it was an odd choice for its location. However, the building is prefect for a night club/concert venue. While the building itself is perfect that doesn’t matter if it cannot attract clients or doesn’t meet city code/regulations. I wonder why type of research Sam did to determine the demographics and geographics of his target market. The night club would have to attract a decent population that does not reside in the area, mainly because it is a suburb with a lot of families.

According to the article the night club owner, Sam, was given a list of 10 things that the three neighboring businesses asked him to do so that his business didn’t impede upon their business. Sam said that he did “most” of the items on the list. This was one of his many mistakes. There either should have been an agreed upon compromise on the 10 items or Sam should have conceded to all 10. By not doing so he created an adversarial relationship, either intentionally or unintentionally, with others.

In the article it mentioned that Sam applied for a liquor license and signed some sort of agreement with the landlord acknowledging the type of business he was going to establish there. No where did Sam defend that he applied for the appropriate business licenses or followed the covenants of the strip mall location. So, I have to wonder if his business was doomed from the beginning. An agreement by the landlord is technically irrelevant if the business itself doesn’t meet the requirements of the covenants, codes, and/or regulations.

In addition, the article stated the neighboring businesses did not care for the type of “clientele” the night club served. Duh! What did Sam do to minimize their fears? It appears nothing, as he didn’t even fulfill the 10 items they asked him to. It does not appear that Sam took the time to build relationships with the other business owners. Sam owned another business for 20 years. Shouldn’t he have known better?

Even if you think a business plan is a waste of time, at least take the time to verify you can actually operate your business with no risk of being shut down shortly after opening your doors.

You need some new equipment or an new vehicle for your business. Do you lease or buy? The last blog post discussed the pros to leasing, which can be attractive when you don’t have idle cash available to make a down payment or the risk of obsolescence is high (i.e., when technology changes fast).

It makes sense to buy rather than lease an asset when:

1. You have the ability to use your cash reserves to pay for the asset. Or you have the ability to finance the asset through a bank or seller without hurting your debt covenants. You do not want to create too much debt for the business so take a look at the debt already outstanding before buying a new asset.

2. The asset will have a long estimated useful life and there is little risk of obsolescence.

3. You can take advantage of double-declining depreciation* in the early years of the assets useful life. This accelerates the benefit of tax deductions in the first few years of the asset life. *Double Declining Depreciation is a method commonly used for income tax purposes. Many businesses use Straight-Line for book purposes and Double-Declining for tax purposes.

4. You can afford the cash down payment or have the ability to obtain financing because the overall cash cost of the asset is less when you purchase vs. lease.

When you purchase an asset a few things happen from an accounting standpoint. The item is recorded on the Balance Sheet as an asset. The asset will be subject to depreciation so you’ll need to track the Depreciation Expense (which is reported on the Income Statement) as well as the Accumulated Depreciation (which is recorded on the Balance Sheet). In addition, as mentioned in point #1, you’ll have to record any related debt for the asset purchase as a liability.

The decision to lease vs. buy is not always an easy one. Compare the lists on the Lease blog post to this one and decide which option makes the most sense based on your current cash position.

Is it time to replace an outdated computer, piece of equipment or automobile? If so, are you going to lease or buy the new asset? There are pros and cons to both options. The blog post on June 3rd will discuss the pros associated with buying an asset.

When you lease an asset the transaction is fairly simple from an accounting standpoint. Since you don’t own the asset you are leasing there is no impact on the Balance Sheet, meaning you do not record the asset nor a corresponding liability for the debt (i.e., lease payments). You simply make monthly payments to the Lessor. Keep in mind, this is true for operating leases, not capital leases. With an operating lease you have no intent to own the asset at the end of the lease agreement along with a few other accounting tests to verify the lease is in fact an operating lease.

It makes sense to lease an asset when (i.e., operating lease):

1. Your cash flow is fairly low. Since you don’t have the ability (or willingness) to make a large payment to purchase the asset outright, a lease allows you to have access to the asset you need via monthly lease payments.

2. The asset is one where the risk of obsolescence is high, meaning that the technology will be outdated quickly. For example, many businesses lease rather than purchase computers/laptops for their employees because technology changes so quickly. Rather than being stuck with outdated technology they replace their computers every 2-3 years through lease agreements.

3. The debt on your balance sheet is a little too high or you have exceeded debt covenants by your lenders. If the asset you want to purchase is expensive, you might pay for it using some cash and financing the rest either through a bank or the seller. If you buy the asset, then you will need to record the corresponding debt on the balance sheet. If you lease the asset, you do not record any debt on the Balance Sheet.

Leasing an asset can be a good business decision, especially if you like the idea of no down payments and replacing the asset at the end of the lease term. Generally the overall cash cost of a leased asset is higher than that of a purchased one. There is no correct answer, it depends on what is the best option for your business.

A few months ago my business coach asked me to make a list of strategic business partners. I used my contact database to evaluate who I knew in my local area that could be a good referral source for my business as well as my ability to refer business back to them. The criteria I used was based on the type of service they provide along with my perception of their professionalism and quality of work. I suspect we all do this during the process of referrals.

Our impression of someone is not always right. Sometimes we make judgments about people before we really get a chance to know them. Sometimes we might even change our perception of someone based on either a really good or really bad experience either directly or indirectly.

The other day I offered to make an introduction between two people, I’ll call them Bob and Sally. Sally discounted the possibility of a quality business relationship with Bob. Sally gave me a list of reasons of why Bob wouldn’t be a valuable referral for her without knowing anything about Bob or his business. Bob happens to be the type of professional that Sally targets for strategic business relationships. I shared with Bob that I was going to introduce him to Sally and how she discounted him without knowing anything about him or his client base. Bob laughed and stated that he could send her more business than she would probably ever send him. Sally made a huge networking mistake.

From my point of view, it never hurts to have a cup of coffee or a short phone conversation to see if there is synergy between two businesses. You might find that the person/business is not a good fit, but at least you took the time to find out. Or you could determine the two businesses are perfectly aligned to create a strategic relationship. Sometimes it is not a matter of who you know, but who knows you. In Sally’s case, Bob doesn’t know her and therefore will never send her any business. Too bad for Sally. Don’t be a Sally.

I’m currently reading a book called Parenting with Love and Logic Teaching Children Responsibility by Foster Cline, M.D., and Jim Fay. You are probably wondering what in the world this has to do with business, let alone a blog post here. In reading this book, I realized the concepts could be applied to any relationship.

The book Everyone Wins! that I posted about last week was about conflict resolution. The Love and Logic book is about teaching children how to think for themselves so that they can problem solve and make good decisions on their own. Sometimes letting a child fail teaches them more than if we were to forcing them to succeed. One of the examples in the book discusses letting a child miss the bus and being confined to their bedroom for the school day. Their parents inform them they need to explain to the teacher (and the school) why they missed class as the parent doesn’t write an “excuse” letter for them. Most children don’t miss the bus again.

What if you let one of your staff miss a deadline for a major project? Would you have the guts to let that person explain to the other employees why they missed the deadline or would you try to finish the project yourself so that the deadline could be met? If that staff had to take responsibility for failing to complete a project as promised and there were consequences (such as an CEO or deductions in pay/missed bonus opportunities) it is unlikely that they would miss a deadline again.

If these concepts were applied in the business environment it might be a little frustrating for the supervisors at first, but in the long run they would end up with better employees. Even though Love and Logic is not a business book, it is about creating positive and respectful relationships as well as teaching the “younger” (younger does not necessarily mean a young person) staff responsibility. Don’t we need these skills in business too?