Over the last year I have written several Blogs about cash flow, and I always make the point that Net Income at the bottom of a Profit and Loss Statement (P&L) does not mean cash in the bank. All the same, the P&L is an important window in to the health of your business, and the application of several common sense rules can help you use the P&L to great advantage. Three of those rules are: maintain a consistent Chart of Accounts, record expenses in the correct account and review Compound Annual Growth Rate frequently.
Maintain a consistent Chart of Accounts: one of the errors that I have seen frequently among entrepreneurs and small businesses is not maintaining a consistent chart of accounts, or any chart of accounts at all. The chart of accounts is a list of the categories into which you place income streams and expenses. If you are not consistent in using the same accounts year over year (or even month over month within a year), it becomes very difficult to make comparisons between income or expense categories, which is one of the benefits of a P&L.
It is one thing to send all of your information to the accountant at the end of the year, and let him deal with the issue as your tax return is prepared, and another thing to be consistent so that you can use your P&L to gauge the health of your business.
Record expenses in the correct account: in particular, I want to focus here on costs that can be directly associated with the production of your product or service. A good P&L will have a category named Cost of Goods Sold or Cost of Services Sold. Into this category go all of the direct costs that are involved in the products or services that you offer. These costs may include materials and labor among other things.
For those of you that have service companies, in particular consulting companies, the hours that you pay your consultants to provide services belong in this category, not lumped in with general salaries. For those providers that are on contract who only do billable work, this is not hard. However, you may have to do some extra work to determine the difference between the billable and non-billable hours of salaried employees. When all of their hours are lumped together in the salaries account, it becomes difficult to determine your true overhead.
Review Compound Annual Growth Rate (CAGR): Compound Annual Growth Rate is determined by dividing the balance of a particular year’s account by a previous year. Often, CAGR is determined going back for 5 years, to give a mid-term view of how the company is doing. Most often, this is done for revenues. However, I recommend that it should be done for every account in the P&L in order to make comparisons.
For example, if your revenues are showing a CAGR of 1.22% as compared to a year ago at 1.08% that could be a good thing. But, you may also want to know if Cost of Goods Sold is rising at 1.35%. Now, that may be on purpose because you are creating a new product line or some other reason, but if you were not expecting that account to grow at the higher rate, then you know that you must look in to the situation. This is true for all of your expense accounts.
Maintaining a consistent chart of accounts, getting income and expenses into the right categories and reviewing your progress year over year (or even month over month) will help you stay on top of how your company is performing.