The business case for a service business
With cloud applications, it is increasingly easy to have (almost) real-time access to the financial performance of our company. Of course, as an accountant, I am quite well equipped to analyze the numbers. On the other hand, as an entrepreneur, I must say that it takes on another meaning.
For what? Because it’s not just numbers and it’s not enough to make decisions based on the analysis we make of these indicators. In the past, as CFO, I gave my opinion, I issued recommendations, but ultimately, it was the CEO and the management team who made the decisions.
Since I founded Cofinia, I have asked myself the same kind of questions as the entrepreneurs I meet. My advantage, I know how to structure information to analyze results and make decisions. I must 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 not to make any decisions. At least we learn. And I must say that I learn every day!
If your charter of accounts is well structured, you should be able to calculate the cost of the services you offer and, by extension, the gross margin. Why is this important? Because it is the first milestone in the analysis of profitability. Turnover is important, but what’s really important is making a profit. Many companies record salaries and expenses in a single accounting account heading. I always suggest separating the accounts into at least 3 distinct sections.
Direct costs (related to services rendered)
Sales and marketing costs
In this way, it is possible to identify the gross margin (revenues less direct costs). A company generally owes a minimum of 50% gross profit.
The effective rate
I really like this indicator, because I find it very revealing about the performance to be achieved. It is calculated by dividing the income for the period by the number of hours worked. Note that if you have a lot of rebillable expenses, you must reduce the income 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 times that we are not able to charge our customers (learning about files, travel, resumption of work, etc.). It is therefore relevant to ensure that we are able to cover 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 the customer more to establish our credibility, provide good service and ensure that our customers come back and refer us.
Calculating the profitability by project or by client implies that timesheets must be made. For many, this is not a pleasant part, but it is essential. By assigning average rates to our resources, it is quite easy to determine if our projects/clients are profitable or if action needs to be taken.
Sales recovery time
Getting paid is the sinews of war. I often hear people say “I am making a profit, why is my bank account always empty?” “.
The first thing I validate is if the company is indeed making money. When the entrepreneur pays himself in dividends, we sometimes realize that the profits are not enough. If we added the contractor’s salary, we would see that the income would not be sufficient.
Then I look at the recovery period. No, I don’t look at the age of the accounts. It is useful, but it does not take into account the work carried out, but not invoiced. Indeed, it sometimes happens that we cannot systematically invoice all the work at the end of the month. According to accounting principles, it would be appropriate to recognize work in progress, but in general, small companies do not do this. Result, we do not realize, but we find ourselves recovering the costs between 60 to 90 days later.
To calculate the DSO, here is how I 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.
The burn rate or our monthly costs
The costs of a service company are mainly made up of salaries. Next come 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 has been established, simply add an amount to cover interest costs, debt repayments, taxes and the shareholder’s dividend if applicable to establish the income to be generated. to meet the company’s obligations.
I have, of course, simplified the explanation by not taking into account investments to be made and significant variable costs, but it can give you a good idea.
Why is it useful? To find out how many sales you need to generate each month to generate enough profit.
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