With cloud apps, it’s becoming easier to have (near) real time access to our company’s financial performance. Of course, as an accountant, I’m pretty well equipped to analyze the numbers. However, as an entrepreneur, I must say that it takes on a different meaning.
Why? Because they are not just numbers and simply making decisions based on the analysis of these indicators is not enough. In the past, as CFO, I gave my opinion, I made recommendations, but ultimately, it was the CEO and the management team who made the decisions.
Since I started Cofinia, I ask myself the same kind of questions as the entrepreneurs I meet. My strength is that I know how to structure the information to analyze the results and make decisions. I have to say that I don’t always make the right decisions, but as I’ve been told before, it’s better to make decisions and make mistakes than to make no decisions at all. At least you learn. And I must say that I learn every day!
If your chart of accounts is well structured, you should be able to determine the cost of your services and therefore the gross margin. Why is this important? Because it is the first step in analyzing profitability. Sales are important, but what is really important is to make a profit. Many companies keep salaries and expenses in one accounting line. I always suggest separating the accounts into at least 3 separate sections.
- Direct costs (related to the provided services)
- Sales and marketing costs
- Administrative costs
This way, it is possible to identify the gross margin (revenues minus direct costs). A company should generally have at least 50% gross margin.
This indicator is very revealing in terms of the performance to be achieved. It is calculated by dividing the revenue for the period by the number of hours worked. Note that if you have a lot of rebillable expenses, you have to reduce the revenues by these amounts to give a more accurate picture.
Thus, if you charge a rate of $100/hour, you will have an idea of the real rate realized on your mandates by calculating the effective rate. There are often hours that we are not able to charge to our clients (file review, travel, rework, etc.). It is therefore pertinent to make sure that we are able to cover the overhead costs and this will not be possible if our effective rate is lower than what is required and anticipated.
Profitability by Project or Client
Profitability is the key. It sounds simple, but when you start a business, you always want to give more to the customer to establish your credibility, give good service and make sure your customers come back and recommend you.
Calculating profitability by project or by client means making time sheets. For many, this is not a fun part, but it is essential. By assigning average rates to our resources, it is fairly easy to determine if our projects/clients are profitable or if action should be taken.
Sales Collection Time
Getting paid is the key to success. I often hear people say “I’m making profit, why is my bank account always empty?
The first thing I check is whether the company is actually making money. When the entrepreneur pays himself in dividends, we sometimes realize that the profits are not enough. If we were to add the entrepreneur’s salary, we would see that the income would not be enough.
Then I look at the collection period. I don’t look at the age of the accounts. It can be useful, but it doesn’t take into account the work that has been done, but not billed. Sometimes you can’t systematically invoice all the work at the end of the month. According to accounting principles, work in progress should be recorded, but small businesses generally do not do this. As a result, you don’t realize it, but you end up recovering the costs 60 to 90 days later.
To calculate the DSO, here is how to proceed:
- Monthly income / Accounts receivable * 30 days
- Monthly income / (Accounts receivable + work in progress) *30 days
This gives us the number of days to recover our costs.
Burn Rate or Monthly Costs
The costs of a service company are mostly composed of salaries. Next are administrative expenses such as rent, software costs, insurance costs and professional fees. It is quite simple to make a monthly average of these costs.
Once this amount is determined, simply add an amount to cover interest expenses, debt repayments, taxes and the shareholder’s dividend if applicable to establish the income that must be generated to meet the company’s obligations.
I have, of course, simplified the explanation by not taking into account important investments to be made and variable costs, but it can give you a good idea.
Why is this important? To know how many sales you need to generate each month to make enough profit.