My Business is Killing It. Where's the Money? - Part 2
At Benjamin Leo + Associates we often have to explain to our clients why the profitability of the company is so much better than what's going on with their bank account. At the end of a month we tell the client that they made $15,000, and they respond "So where is it?" The short answer is, "You reinvested it."
For example: Let's say you make jewelry and sell it, and also sell some jewelry made by other people. In December you sold $16,000 worth of jewelry you made and $4,000 worth of jewelry that other people made. You spent $8,000 on a shipment of jewelry made by someone else, $3,000 on precious metals to use as raw materials, $2,700 paying one employee to cover the register 40 hours a week, $4,000 on rent, $4,500 on a new kiln, and another $2,000 on utilities, office supplies, fixing a broken window, meals while you were working, etc. Plus you had to pay $4,400 in sales tax. That would look like this:
It looks like you lost $8,600.00 in a month when sales were good. You think "Wow. I'm an idiot. I should close this shop and get a job."
However, there are a lot of lines here that are not technically expenses. They are related to you investing in your business, or paying back loans.
The most complicated part is taking out the product order and raw materials and figuring out the cost of the items that you sold.
Previously, you made sure that you were pricing the jewelry you made yourself at 5 times the cost of the materials going into them. So if you spend $100 on silver and an stone for a ring, you make sure that you price it at $500. However, the jewelry made by others has been marked up before being sold to you. So you price it at double what you paid for it. These are standard markups.
That means that your cost for selling $16,000 worth of your own jewelry is $3,200, and your cost for selling $4,000 worth of other people's jewelry is $2,000. So your total cost of goods is $5,200.
The kiln is equipment, not an expense. You are going to have that kiln for a long time. For accounting purposes, it is assumed you will have it for seven years. So instead of having a $4,500.00 expense the day you bought the oven, you have a $642.86 expense at the end of each year for seven years. This is called depreciation.
Sales tax is a liability, not an expense. For most retail sales, you have to collect sales tax. However, for accounting purposes, the sales tax is not income. In New York City if you sell someone a magazine that costs $10 they have to give you $10.88. For you, the $10 is sales, and the 88 cents is for the state and city governments. You didn't earn that 88 cents. You're just holding it for the government. So when you pay your sales tax, it isn't an expense. You're just handing over the money you were holding.
So when we take out these payments that are not technically expenses, the report looks like this:
You made money! In fact, you made a profit margin of 30.5%. That's very good for retail.
This is not some accounting magic. These numbers reflect your Operating Profit. This is what actually happened in the store. You still have items that you bought in the product order to sell later. You still have raw materials to make more jewelry. You will have the kiln for years. You collected the sales tax in previous months and just handed it over in December. You collected another $1,700 in sales tax that you will hand over later, that is not part of the $20,000 in sales.
The first advantage of viewing your sales and expenses this way is being able to see how your business is actually performing. This report is not based on what's going on with the bank account, but what is happening in the store on a day to day basis.
The second upside is you can take this report about your operating profit and show it to potential lenders or investors. They will want to see other reports (balance sheet, statement of cash flows, etc) to fully assess your business as a risk or opportunity, but you can show them that what you are doing is working, even if you bank balance doesn't look great.
This doesn't mean it is good to have no cash in the bank, but it can be good to have less money in the bank than you made in profit, because you can continue to make profit. In this example, the fact that you only sold a quarter of your product order means you can keep selling that product without spending anything. The fact that you bought the kiln means you can use it to make more product, without having to buy another kiln for seven years.
In fact, if we extrapolate what happens in January for this same business, we can see how the opposite can happen. A bank account may perform better than the business. For this we'll look at the reports side by side:
As you can see, your bank account recouped, even though your margin was smaller. Again, you calculate your cost of goods as you sell items. So you didn't have to buy new product or raw materials, but you realized the expense of what you had already paid out in December for the items you sold. So your operating profit was only $1,600, but your bank account recouped $5,300.
Please let us know if you have any questions or comments about this article. This really just scratches the surface. We will be posting follow up articles in the coming weeks. Our next article will more specifically address financial reports, namely the Profit & Loss Report and the Balance Sheet. Then you'll be able to see the way that the expenditures that don't go on the Profit & Loss are tracked on the Balance Sheet.