In a familiar phrase generally attributed to Peter Drucker, profit is the sovereign criterion of the enterprise. The use of the word sovereign is right on the money. A profitable company charts its own course. If your company is profitable, you can run it the way you want to. When a company stops being profitable, other people—lenders, outside investors, suppliers, even customers—begin to poke their noses into the business. The company loses its autonomy.
Another familiar saying, this one attributed to Laurence J. Peter of The Peter Principle, tells us that if we don’t know where we’re going, we’ll probably end up somewhere else. If you don’t know how to make your company profitable, you’re unlikely to succeed in doing so.
In fact, too many entrepreneurs don’t understand what profit really is, let alone how it is calculated. Nor do they understand that a company’s profit in any given period reflects a whole host of estimates and assumptions. The art of finance might just as easily be termed the art of making a profit.
We’ll focus first on understanding an income statement because “profit” is no more and no less than what shows up there. Learn to decipher this document, and you will be able to understand and evaluate your company’s profitability better than you could before. Learn to manage some of the key lines on the income statement, and you will make your company more profitable than before. Learn the art involved in determining profit, and you will definitely increase your financial intelligence. You might even get where you are going.
We told you early on that we wouldn’t teach you accounting, and so we won’t. There is one accounting concept, however, that we will explain to you in this chapter, because once you understand it, you will grasp exactly what the income statement is and what it is trying to tell you. First, though, we want to back up one step and make sure there isn’t a major misconception lurking in your mind.
You know that the income statement is supposed to show a company’s profit for a given period—usually a month, a quarter, or a year. It’s only a short leap of imagination to conclude that the income statement shows how much cash the company took in during that period, how much it spent, and how much was left over. That leftover amount would then be the company’s profit, right?
Alas, no. To be sure, some small businesses do their accounting this way. It’s called cash-based accounting, and maybe that’s how you kept your books when your business was just starting up. You take in money, and you record a sale. You pay a bill, and you record an expense. For a one-person shop or a small retail store, cash-based accounting may be sufficient.
But just about every company in the world other than the smallest (or newest) uses what’s known as accrual accounting—and in accrual accounting, an income statement measures something quite different from cash in the door, cash out the door, and cash left over. It measures sales or revenues, costs or expenses, and profit or income.
Any income statement begins with sales. When a business delivers a product or a service to a customer, accountants say it has made a sale. Never mind if the customer hasn’t paid for the product or service yet—the business may count the amount of the sale on the top line of its income statement for the period in question. No money at all may have changed hands. Of course, for cash-based businesses such as retailers and restaurants, sales and cash coming in are pretty much the same. But most businesses have to wait thirty days or more to collect on their sales.
And the “cost” lines of the income statement? In accrual accounting, the costs and expenses a company reports in any given period are not necessarily the ones it wrote checks for during that period. The costs and ex- penses on the income statement are those it incurred in generating the sales recorded during the time period. Accountants call this the matching principle —that appropriate costs should be matched to the sales for the period represented in the income statement—and it’s the key to understanding how profit is determined.
The matching principle is a fundamental accounting rule for preparing an income statement. It simply states, “Match the costs with the associated sale to determine profits in a given period of time—usually a month, quarter, or year.” In other words, one of the accountants’ primary jobs is to figure out and properly record all the costs incurred in generating sales.
The matching principle is the little bit of accounting you need to learn. For example:
You can see how far we are from cash in and cash out. Tracking the flow of cash in and out the door is the job of another financial document, namely the cash flow statement (part 4). You can also see how far we are from simple objective reality. Accountants can’t just tote up the flow of dollars; they have to decide which costs are associated with the sales. They have to make assumptions and come up with estimates. In the process, they may introduce bias into the numbers.
Why go to so much trouble? Wouldn’t it be easier just to stick with cash-based accounting? It would indeed be easier, but for most companies cash-based accounting wouldn’t give an accurate picture of reality. That ink-and-toner company, for instance, might record a huge loss in the month when it paid for the truckload of cartridges and correspondingly higher profit in the other months. The owner of the business might know the reason, but nobody else looking at the company’s income statement would understand why the bottom line was bouncing around so much. As the business grew—as it added other locations, for instance—even the owner might not understand what caused the volatility. Accrual accounting matches costs to sales, so it gives you a more accurate picture of whether you’re really making money on your sales.
In other words, the income statement tries to measure whether the products or services that a company provides are profitable when everything is added up. It’s the accountants’ best effort to show the sales the company generated during a given time period, the costs incurred in making those sales (including the costs of operating the business for that span of time), and the profit, if any, that is left over. Possible bias aside, this is a critically important endeavor for any company owner. If your company is big enough to have a management team, it’s equally important for the members of that team. Your sales manager needs to know what kind of profits she and her group are generating so that she can make decisions about discounts, terms, which customers to pursue, and so on. Your marketing manager needs to know which products are most profitable so that those can be emphasized in marketing campaigns. Your human resource manager should know the profitability of products so that he knows where the company’s strategic priorities are likely to lie when he is recruiting new people.
At the same time, however, an entrepreneurial company can’t rely on profitability alone. Since profit is an estimate, a company can be profitable and still run out of cash—just as the company that we described in chapter 1 did.
Here’s why. Profit is based on revenue. Revenue, remember, is recognized when a product or service is delivered, not when the bill is paid. So the top line of the income statement, the line from which we subtract expenses to determine profit, is often no more than a promise. Customers have not paid yet, so the revenue number does not reflect real money and neither does the profit line at the bottom. You can be making money as shown by the income statement, but you may not be generating cash fast enough to pay your bills.
Say you are running a fast-growing business-services company. The company is selling a lot of services at a good price; its revenues and profits are high. It is hiring people as fast as it can, and of course it has to pay them as soon as they come on board. But all the profit that these people are earning won’t turn into cash until thirty days or maybe sixty days after it is billed out! That’s one reason why even a highly profitable company may find that cash is tight. And it’s one reason why many entrepreneurial businesses run out of cash.
Over time, the income statement and the cash flow statement in a wellrun company will track one another. Profit will be turned into cash. As we saw in chapter 1, however, just because a company is making a profit in any given time period doesn’t mean it will have the cash to pay its bills. Profit is always an estimate—and you can’t spend estimates.
With that lesson under our belts, let’s turn to the business of decoding the income statement.