Knowing how to read a financial statement and a few other basics of accounting is vital in an eCommerce business. Without basic knowledge of accounting, you may think you’re raking in the cash when you’re actually in the red.
We’re covering everything from the basics of reading an income statement to the ins and outs of your store revenue.
Andrew: Welcome to the eCommerceFuel Podcast, the show dedicated to helping high six and seven figure entrepreneurs build amazing online companies and incredible lives. I’m your host and fellow eCommerce entrepreneur Andrew Youderian.
Hey guys, it’s Andrew here and welcome to the eCommerceFuel Podcast, thanks so much for tuning in today. Today on the show, extremely gripping topic we’ve been wanting to cover for a long time. The absolute bare minimum you need to know about accounting. And joining me, an ex-finance guy who is the perfect man to geek out about this. Bill, I’m sorry we don’t have whiskey this time to chat but hopefully you’ll still stick around until the end of the episode.
Bill: I really should have put that in my contract, shouldn’t I have?
Andrew: Top shelf, $400 a bottle whiskey otherwise I’m not coming back to the show.
Bill: That’s right, I need whiskey or we’ll not record this stuff. I won’t hang out with you if we don’t have any whiskey.
Andrew: To keep things interesting without the whiskey and also, let’s be honest, accounting unless you’re Bill may not be the world’s sexiest topic, we’ve inserted a couple fun little secondary scenes shall we say throughout the episode. You’ll have to listen real carefully to hear them but yeah, just keep your ears perked for those. And Bill, should we get into it?
Bill: Yeah, we should get into it. We should call this episode “Front Lines Accounting.”
The Function of Your Income Statement
Andrew: “Front Lines Accounting,” I love it, I love it.
So Bill there’s really three crucial financial statements that you need to know. The income statement, the balance sheet and the cash flow statement. And we’re going to tackle each of those individually and we’ll go ahead and start with the income statement. So Bill, how do you describe the income statement in a nutshell? What is its function and how do you look at it?
Bill: The easy way to think about an income statement really is, this is the amount of money that your business made over a certain period. Most income statements you’ll see are kind of yearly or monthly. And you in theory could do a daily income statement but I don’t think it would be very instructive.
So most people will do monthly, will do an income statement and it will show a total for the year and then broken down by month. At the top you’ll see revenue and then you will subtract from revenue your cost of goods sold, which is basically the amount of money it cost you to make that revenue.
Then you’ll have a gross margin, and that’s basically the amount of money you have after selling your stuff, the amount of money you have available to use to pay overhead. And then you’ll have a section called expenses or sometimes you’ll see it called SGNA or selling general and administrative expenses and those are all the overhead expenses of your business, salaries, rent, your subscription to the eCommerce Fuel private members forum, all sorts of things like that go in the SGNA expenses section and then at the bottom you have a number called net income, also or hopefully known as profit and not loss.
Andrew: Yeah and it’s kind of important to clarify that revenue is equal to sales, revenue is at the very top. It’s not how much you make, it’s just the gross amount of money you collect from your customers before you pay any expenses. Sometimes you might hear that called top line, like if someone says “What’s your top line?” they’re talking about revenue, and revenue does not mean profit.
A lot of times people will interchange these, they’ll be like “Oh, hey, I’m making X” and you really need to clarify because there’s an enormous difference between revenue and profit and sometimes they just get thrown around interchangeably.
Revenue Versus Profit
Bill: Yeah in fact, oftentimes people ask me, they’re like oh, how big is your business? I’ll tell anybody who wants to listen how much revenue I do. The real sensitive number is how much money do you make, that’s the profit number.
But I think a lot of people don’t realize that revenue is not take home, and so sometimes you have mis-perception you don’t want to throw out a big revenue number because then people will think you’re crushing it and making lots of money and that could be awkward for you and your friends.
Similarly if you’re, I have seen this too many times, people puffing their chests up and trying to impress folks will quote a revenue number and their business could be not profitable. So I’m typically not that impressed by revenue numbers.
Variable Costs Versus Fixed Expense
Andrew: I think one important thing to understand and a mistake people make a lot of times is putting their variable costs and their fixed costs in the wrong spot. So you’ve got your revenue at the top, minus your costs of goods sold, so the costs to fulfill an individual order, that gives you your gross profit. And then gross profit minus all your overhead gives you your net income.
And you always want to try to put any variables costs, so costs that are really only associated with fulfilling a specific order, the cost of the product, the cost of perhaps the packaging, things like that, you want to lump that into your gross profit.
But you never want to put things like your overhead, your rent, your fixed salary, unless your team members are on some kind of commission that you can tie into a variable cost of doing business, you always want that to be below the line.
So a lot of times people will refer to, “is this an above the line expense,” meaning is it a variable cost? Or is it a below the line, meaning it’s a fixed expense.
Bill: And the variable expenses obviously increase and the reason you care about that is your gross profit margin, you can say for every incremental order I do this is the amount of profit that I make.
So as your business gets bigger and bigger and bigger in theory your net income kind of moves closer to your gross profit margin. Of course it never gets there because your fixed costs do get bigger, like you need to move into a bigger space so your rent goes up, or you need to hire more people.
I would love to see a business who had a net margin equal to their gross margin but that doesn’t ever happen. But as you get bigger you should expect your net margin to move towards your gross margin.
Andrew: Perfect, I think that’s about it. Any final thoughts before we move onto the balance sheet?
Defining Accrual Accounting
Bill: The income statement I think is the most famous financial statement, that’s the one people think, they’re like okay, this is how much money this business made. Well the thing to remember on an income statement, and I don’t want to get into too much accounting right now on this podcast, but the income statement is subject to what’s called accrual accounting.
Meaning, let’s make it simple and say if you pay your rent once a year, let’s say you owe $12,000 in rent and you pay it once a year. Your income statement, you’re supposed to make the timing of revenue and expenses match when they were actually received or incurred.
So instead of putting $12,000 of rent on your income statement in January and none for the rest of the year the proper way to account for that under accrual based accounting is to put $1,000 of rent on your income statement for every month.
So that gives you a more accurate picture because you used 1/12 of that rent payment essentially in each month. So it gives you a more accurate picture of a complete picture of how the business operated during the period by using accrual accounting.
However, it can be misleading because if you’re writing a check for $12,000 in January and then you’re not actually writing those $1,000 checks every month you need to understand that the other 12 months are going to be much more cash positive than January will be and we’ll talk about what statement you should use to track that later in the podcast.
Andrew: Yeah. And accrual accounting, the nice thing about it is it’s more accurate, it gives you a better sense month-to-month, year-to-year especially month-to-month, how the business is tracking. The difficult thing about it is it’s harder, it’s more work. Cash based accounting is much easier and there’s some kind of different rules about how the size of your business and some other things that determine whether you should be on cash based or accrual based, but it’s probably a little bit beyond the scope of this interview.
But just, yeah, good to know, accrual is more accurate but more difficult, cash is going to be easier because you just record costs as cash comes in, but not quite as accurate. So moving on to the balance sheet.
All About That Balance Sheet
Andrew:So the balance sheet, this is interesting Bill, because before we hopped on to record we were talking about a few kind of differences we had and you convinced me your opinion is the correct one. But a balance sheet shows, it shows all the assets of a business so it shows on one side, you can think about it like a T, on the left hand side of the T it shows everything that’s owned by the business.
Then on the right hand side, the right hand side is split up into two sides and it shows what the liabilities of the business are and liabilities means really what do you owe other people, you owe banks, you have accounts payable that you have to pay, how much do you owe other people and how much of the rest of the business do you own free and clear?
Bill: Yeah. I think an easy way that most people can probably understand to visualize a balance sheet is to think about your personal balance sheet. So let’s pretend you own a house, if you don’t bear with me, if you do you’ll probably understand this very intimately. If you own a house you probably have a mortgage. So on your personal balance sheet under assets you would have your house, and let’s just say you bought the house for $100,000 so you would have your house listed at $100,000 under assets on your personal balance sheet.
But you have a mortgage also, so on the other side under liabilities let’s say you put 20% down so you would have an $80,000 mortgage under liabilities. So you would say okay, well my balance sheet doesn’t balance, I have a $100,000 asset under assets and then an $80,000 mortgage under liabilities. The difference, assets minus liabilities, that’s called equity.
That means if you sold the house tomorrow, how much equity do you own in the house? So if you sold the house for $100,000 you would have $20,000 left over, that’s assets minus liabilities. And the same concept works in your business, except your assets are probably things like inventory or a checking account with some cash on hand, or the desk and computers and things in your office.
All sorts of things like that will be business assets, and the liabilities might be things like business credit cards or if you have a term loan from the bank or things like that. And then your equity is basically just those two subtracted meaning if you sold your business all the assets of your business and you paid off all your liabilities how much is left over? And that’s the equity.
Assets = Liabilities Plus Equity
Andrew: The reason it’s called a balance sheet is also because surprise, surprise, it has to balance. I think you said this Bill, but your assets is always going to be equal to your liabilities plus your equity. And not only does it have to balance, whenever you make an adjustment to one side of the balance sheet, let’s say you add an asset you buy a building, you have to make the same adjustment to the other side of the balance sheet.
So you add a building for $100,000 well you have to make a $100,000 net adjustment to the other side, it’s either $100,000 in equity, you paid cash for it, or maybe it’s a loan that you took on but you have to always, always adjust those. And they have to balance equally.
Bill: Yup, like for example let’s say that you had $100,000 of cash in your bank account and you had no liabilities, that would leave you with $100,000 of equity. Now let’s say you wanted to buy a house, that same house for $100,000 and let’s say you put down $20,000 and you borrowed $80,000. So what you would do is then your cash would look like $80,000 because you had put only $20,000 of it down, but then you would get a house on there for $100,000 because that’s what it’s worth.
So now you have your $100,000 of cash minus the $20,000 down payment and the $100,000 house. Now under liabilities you will have the $80,000 mortgage that you took out and under equity you will have that $100,000 which is the cash you have, $80,000, plus the value of the house, $100,000, minus the value of the mortgage, $80,000 equals $100,000 in equity. So it balances on both sides.
Andrew: And the balance sheet differs from the income statement. That income statement, like you said Bill, it covers a period of time, a month, a year. Balance sheet is always an exact date and time. It’s December 31st, 2015, it’s January 1st 2016, it always shows a finite exact day versus a period.
Bill: Yup, because it’s literally, it’s a balance sheet. It would be if you pulled up your online banking, you looked at the balances in the accounts as of today, that’s what a balance sheet is, it’s a snapshot in time.
The Cash Flow Statement
Andrew: So the final, final statement is the cash flow statement. And cash flow statement, do you hear something Bill?
Bill: Yeah, what is that?
Andrew: There’s some kids running around screaming or some birds?
Bill: This is accounting from the battle field front lines.
Andrew: I thought it was just me, but glad to know you’re hearing it too.
Bill: Yeah, we’re ducking cover for the cash flow statement portion.
Andrew: Okay, awesome. So the cash flow statement is the third and final statement, it takes your net income and adjusts it to show you, because your net income does not tell you how much cash comes in and out of the business. It’s just net income sometimes includes a lot of non-cash expenses like depreciation or maybe you prepay rent.
So the cash flow takes your net income, the stated net income and actually backs into okay, what actually happened in terms of the cash in your business? Because it’s possible to say on your income statement you made $10,000, but really your cash really only increased by $3,000, why is that? The cash flow statement reconciles those two differences.
And it’s funny Bill, because when we started, before we actually went on the air I had written in the notes saying this is probably the least important statement between the three, at least in my experience. And you were like “Whoa, whoa, whoa, whoa, whoa, no way, this is the absolute most important statement.” Let’s talk about that.
Arguably The Most Important Statement
Bill: Yeah. I think I’m a cash flow statement cheerleader here because it affects your life incredibly if you have certain kinds of businesses. Because a cash flow statement is helping you to understand the change in your cash position and some of that is not captured on an income statement. If you look down an income statement, you won’t see a line for “bought a whole bunch more inventory.” And this is something you’ll understand intimately if you own a business that holds inventory that’s growing.
Even though you might have had a profitable year, you could be looking at yourself at the income statement side of things. When you look at your bank balance at the end of the year you feel like you didn’t make any money, it’s the same as it was at the beginning of the year. And the reason is because you bought a whole bunch of inventory.
All of that growth, all the cash you generated from growing, you used to buy inventory. And those were increases in balance sheet accounts tracked on your balance sheet but they weren’t captured on the income statement.
So the cash flow statement helps you to see at the top of cash flow statement, you’ll see your net income number. But then you’ll see all of the non-cash things that happened in the same period and the cash flow statement, like the income statement, takes place over a period of time, a month or a year.
So you might see during a month, you might say, “Oh, I thought I made $5,000 this month,” but then you’ll see that actually, let’s take that same fictional January where you prepay your rent for 12 months, you might see hey, I thought I made $5,000 but that $5,000 of net income only accounted for $1,000 of the rent expense.
Actually an additional $11,000 went out this period because I prepay my rent. So your cash flow statement will show you that actually you didn’t make $5,000 in January, you lost $6,000.
I mean you didn’t lose it, but as far as your bank balance it’s $6,000 lower at the end of that January because you had to adjust for what the income statement wasn’t showing you, which is the actual cash movements. And for me as my business is growing, we carry inventory. So as my business grows, if your inventory let’s just say your business is, in your business you carry 20% of sales as inventory.
If you go from one million to two million in sales, that means that your inventory went from 200,000 to 400,000 over the course of the year.
That’s $200,000 of cash that you needed to buy inventory, that got sucked up by your growth, and that $200,000 that you spent isn’t going to appear anywhere on your income statement. The only place you will see it is if you looked at your two balance sheets, one balance sheet at the beginning of the year and one balance sheet at the end of the year.
You would notice the difference in the inventory account was $200,000. Or if you watched your cash flow statement, you would see that you spent that money, you would see it on the cash flow statement but it would never appear on the income statement.
And that’s why from my position, I think the cash flow statement, if you don’t understand it you’re setting yourself up to literally go bankrupt, to run out of cash, to not be liquid, because you’re not going to understand what your bank balance is going to say tomorrow.
Cash Flow Crucial to Stores With Inventory
Andrew: There’s a lot of things that aren’t ideal about drop shipping and we’ve talked about those a lot on the show, but I will say one really great thing about drop shipping is it’s a cash positive business. I don’t buy inventory until I have a purchase that’s already been approved with money coming to my bank, for a larger amount if I’m doing my job right, that pays for that balance.
It’s a cash flow positive business, it’s not something I have to worry about. But a lot of businesses Bill, yeah you’re right, it’s crucial, you can live and die by this and getting to know it is really important.
Bill: Yup. I would say the big difference is, if you’re carrying inventory this is probably your biggest red flag that you really need to understand your cash flow statement.
Andrew: Yeah, or similarly let’s say that if you’re a consultant and let’s say you go and you do a consulting gig and you bill somebody and you work for a month and you send them a bill. Well that bill, when you invoice them that will show up under your income statement as sales.
It says hey, I invoiced somebody for $5,000 this month, it’ll show up on your income statement as $5,000 and it’ll flow through to your net income after you pay your expenses.
But in reality you booked the sale but you didn’t get payment, so cash flow for someone like that too is really important to understand because if you’re generating sales but not collecting, again, something else that can just kill a business.
Bill: Yup, that’s a great point. If you ever give anybody terms you’re supposed to record that revenue when you earned the revenue, so when you did the work, but if they have 30 days to pay you you’re not going to see that cash for another 30 days. And if you don’t have a handle on that you could run out of cash and that could get ugly.
How to Handle Your Books
Andrew: So kind of in closing Bill, I thought we’d touch on just kind of what you should be doing in terms of keeping a handle on your books? So for me, we run everything monthly, so like you said you could check this stuff weekly but I found monthly is a really good time period to sit down and look at the books from the last month and kind of make sure you’re on top of things. Is that the period you usually review the books as well?
Bill: Yup, we shoot for monthly right now with our accountants. I have been trying, my pipe dream is to do weekly. I think the only way to get to weekly is with some pretty heavy automation, pulling inventory. The thing that always gets me is in order to do weekly books you need to know your inventory at the beginning and end of the week and it’s just a lot of counting if you don’t have it all totally automated, if you don’t have a great inventory system which we’re working on implementing.
So my pipe dream is that at the end of 2016 we will be doing weekly income statements, cash flow statements, balance sheets. But it’s going to take me awhile. But I would say for most people monthly is what you need to do. The trap that you shouldn’t fall into is yearly, a lot of people just sort of run their business on the bank balance, and then they do their financial statements in order to do their taxes.
If you’re rolling this way you’re cruising for a bruising as they say. Because you can’t predict anything, you don’t know what the hell has happened, you don’t see anything directionally. So I would, don’t fall into the yearly trap, really do it monthly.
Get a Xero Account
Andrew: Yeah. And if you’re setting this up, I would recommend having somebody do it in the long term because this is something where it makes so much more sense to outsource this, have somebody who knows it really well do it, but I would certainly recommend at least for the first two, three, four months do it yourself so you understand it. Get a Xero account, Xero is, I don’t know about you Bill but it’s what I use for accounting and it’s a thousand times better than Quick Books. It’s all cloud based, I think most of the people listening have heard of this
Get a Xero account. If you’re not familiar, pick up the book “Financial Intelligence for Entrepreneurs.” Little hat tip to Brandon Eley in the community, who’s recommended this as a primer. And it takes some work, it’s going to take some struggle, but do it yourself for three or four months.
It will make it so much easier when you bring on someone who’s going to do it on an ongoing basis, because it won’t be just like a black box, you’ll understand it more. And just like in anything usually before you outsource anything if you have at least an idea of how it works you’re going to be much more successful in the outsourcing side versus just blindly giving it to someone else and trusting them.
Benefits of an Outsourced Accountant
Bill: Yup, and you’re also not going to be getting a bad accountant. I’ve seen people outsource to bad accountants and they’re paying way too many taxes because they don’t understand their accountant’s doing it wrong. And you need to be able to read the reports your accountant gives you. I would definitely recommend at least understanding eCommerce accounting even if you’re not fully capable of doing it yourself. You should understand it very intimately.
And so often if you use an outsourced accountant you can say, “Hey, can I just pay you for an hour or two of your time and you can teach me what you do every month?” And if you’ve already outsourced your accounting and you’re feeling kind of clueless that would probably be worth $100 to call your accountant and say “tutor me for an hour.”
Andrew: Yeah, great investment, agreed. Bill, man it’s been fun. I need to head off, I’ve got some pretty brutal dinosaur wounds and bullet shots I need to recover from here, so yeah, it’s been fun. Thanks for risking your neck to do this episode with me.
Bill: Of course, doesn’t get much more exciting than accounting under gunfire.
Andrew: Always a pleasure, talk to you soon Bill.
Bill: All right.
Andrew: Want to connect with and learn from other proven e-commerce entrepreneurs? Join us in the eCommerceFuel private community. It’s our tight knit, vetted group for store owners with at least a quarter million dollars in annual sales. You can learn more and apply for membership at ecommercefuel.com.
Thanks so much to your podcast producer Laura Serino for all of her hard work making this show possible and to you for tuning in. Thank you for listening. That will do it for this week, but looking forward to seeing you again next Friday.
What Was Mentioned
- Connect with Bill: Rebel CEO | KP Elements | Ski Balm
- Financial Intelligence for Entrepreneurs: What You Really Need To Know About the Numbers by Karen Berman & Joe Knight