This is Part 1 in our “Know Your Numbers” series, which will help you read your financial statements, better understand the numbers that drive your business and ultimately make better decisions.
When people think of numbers in business, they think about sales, expenses and net income. Knowing what those numbers are is a good start. Knowing how they’re calculated and having the systems in place to produce them at a moment’s notice could help you make more informed decisions. Let’s look at the primary numbers every business must know and understand.
Your revenue might look different based on the type of business that you operate. A company that sells goods or products produces sales. If you’re in the services industry, you generate fees for your services. A property owner/landlord collects rent from their tenants. Each one of these income-generating activities represent revenues. Your total revenues each month represent the sum of your individual sales, fee-generating activities and tenant rents.
There are three types of business expenses: direct, indirect and non-cash.
- Direct expenses are costs that you incur to produce a sale, such as the materials used to make or resell a tangible product, or labor and software expenses used to deliver services.
- Indirect expenses are also known as variable expenses because they are not directly related to the production of revenue. They are often categorized as Overhead, Occupancy, Selling and Staffing expenses.
- Non-cash expenses can be confusing because they are reported as a deduction against your revenues just like your direct and indirect expenses. However, they don’t require an outlay of cash to recognize the deduction. Rather, non-cash expenses are depreciation and amortization. Amortization involves spreading out an expense when acquiring long-term assets (such as equipment), buildings or intangible assets (such as goodwill or covenants). Non-cash expenses or income also results when there is a gain or loss on the sale of an asset. This gain or loss number is the total income received minus the remaining unamortized cost of an asset.
This number is calculated by subtracting your total expenses from your total revenues. This is also known as your net profit. When your total expenses exceed your revenues, this number is reflected as a net loss.
In addition to knowing what these numbers mean, it’s equally important to understand when the numbers are recognized in your financial statements. There are two accounting methods for recognizing revenues and expenses: accrual basis and cash basis.
- Accrual basis recognizes revenue when an invoice is sent to a customer and recognizes expenses when the cost is incurred.
- Cash basis recognizes revenue when you receive payment from a customer and recognizes expense when you actually pay a bill via cash or credit card.
We find that each method of accounting serves a specific purpose. The accrual basis method gives you a good reflection of your business activity as the work is being done, which can help with measuring monthly productivity. With the cash basis, you’re merely seeing a summary of your bank account deposits and withdrawals over a period of time. This is often sufficient for smaller and less involved businesses, and is also helpful for special tax basis reporting and cash flow planning.
So now that you understand the basics of your revenues and expenses, how do you know where those numbers could be improved so you can earn a profit? Stay tuned for the next installment in our series to find out!
For more information on how to calculate these numbers and use them to make more informed business decisions, get in touch with us.