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Accounting & Finance

How To Make Good Use Of The Paper Your Accountant Gives To You (part 1)

Every company has an accountant. They are often seen as gray men, with round glasses and little social skills. Many think that their existence is justified by bookkeeping, which, in turn, is a law enforced requirement, right?

accounting

Every company has an accountant. They are often seen as gray men, with round glasses and little social skills. Many think that their existence is justified by bookkeeping, which, in turn, is a law enforced requirement, right?

Wrong.

They can do a lot for your business, even preventing critical failures that could potentially put you out of business.

They periodically produce three sheets of paper, the balance sheet, the income statement (or Profit & Loss statement, P&L) and the cash flow statement.

The balance sheet is a summary document which gives a very aggregated view of assets and liabilities, that is, of strengths and weaknesses of the company. It is principally aimed to the external observer.

The income statement summarizes revenues, expenses and other costs and shows you the profit (loss) over a period of time.

The cash flow statement tracks the actual amount of money cashed and spent, and helps you explain why, even if you are selling good, you don’t have much money in bank.

Building and analyzing those sheets is a science by itself and requires specific knowledge. Nonetheless, there are some ratios which are simple to analyze and give an insight of how the company is going.

The first numbers to focus on are the margins which derive from the income statement.

The gross margin is defined as revenues minus direct costs. The revenues must include only the revenues deriving from the current activity (i.e. do not include, for example, the sale of a warehouse building, that is an extraordinary revenue). The costs must be the sum of direct costs, that is, all the costs that can be directly associated with an item of what you sold (the cost of raw material to manufacture an item is a direct cost of the item; phone bills are not directly associated, the phone is used for other than selling).

If your gross margin is negative, you are in huge troubles. Actually, the more you sell, the more you lose money; you should stop what you’re doing and reconsider, it’s no use keep throwing money away. This is the worst condition for your company to be in.

The net margin (also known as “the bottom line”) is defined as revenues minus all the cost in a given period. If this margin is negative, is no good news because it obviously means that the company is losing money, but it might not be due to bad operations but to other financial aspects. For example, debt interests might be too high. The net margin mixes costs of all natures, both financials and operations-related.

That’s why, sometimes, there’s another margin taken into consideration, the EBITDA that stands for “earnings before interest, taxes, depreciation and amortization”. The idea is to leave out everything that smells financial in nature to measure the operations of the company as whole.

These margins can be calculated for the whole company (this is what accountants do routinely) or for company subsets. Slicing the income statement may become a very difficult exercise. While it is rather easy to slice the revenues for customers and products, as you go down the income statement the figures become more and more aggregated and, sometimes, splitting them is a totally arbitrary decision.

In theory, you can have a net margin by customer or by product. This is the holy grail of VP of sales and Comptrollers, but, as I said before, it may be largely the result of guesswork.

Good comptrollers, though, can reach a very high detail level up to the gross margin, and it’s enough to take some good business decisions.

We just scratched the surface of the topic. There’s more to say about margins and there are many other numbers to control, but I save the topic for the next post.

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