In this session, we simplify the financial jargon surrounding a boutique professional service firm’s Profit and Loss (P&L) statement. Join us as we decode revenue, expenses, EBITDA, and net income, offering insights applicable to any member, regardless of their financial expertise. Whether you’re a consulting firm, marketing agency, systems integrator, or another type of small service firm curious about financial matters, this exploration into the world of P&L statements provides valuable insights into understanding and interpreting financial health.
TRANSCRIPT
Greg Alexander [00:00:15] Hey, everybody, this is Greg Alexander, the host of the Pro Serv podcast, brought to you by Collective 54, the first mastermind community dedicated to serving the unique needs of a unique set of people. Founders and leaders of boutique professional services firms. On today’s episode, we’re going to walk down memory lane and get into some finance one on one. Many of our members are not finance experts, and a reminder of the fundamentals is warranted. And we’re going to talk about how to deconstruct a PNL or profit and loss statement. And we have a long standing, well-liked, well respected member. His name is William Lieberman. This is what he does for a living, and he’s going to help us, guide us through this conversation today. So, William, it’s good to see you. Please introduce yourself.
William Lieberman [00:01:06] Thanks, Greg. William Lieberman Company is the CEO’s right hand, and we provide outsourced finance and HR services to small and medium businesses throughout the US.
Greg Alexander [00:01:18] Okay, so let’s talk about the profit and loss statement. So first, what is it?
William Lieberman [00:01:25] So the PNL profit and loss Damien or income statement represents how your company makes money, spends money and generates profit. So it shows you all the money that’s coming in and the money that’s going out and at the bottom, how much profit you are making at the end of the day over a period of time could be a day, a week, a month, a year. Typically it’s a month or a quarter or a year.
Greg Alexander [00:01:48] Okay, perfect. And for what it’s worth, listeners, to me, it’s the most important of all the financial documents. It’s the thing that you should be reviewing regularly. It, it is the health checker of the business. Okay. So I’m going to ask you some directed questions. These questions come from members who I’ve talked to that have struggling with this. So the top line of a panel is revenue of course. And I think that’s self-explanatory. However, people are running into an issue of revenue recognition. So for somebody who might not be familiar with that term, what is revenue recognition and how is it relevant to the founder of a services firm?
William Lieberman [00:02:25] When you earn money. When you generate business, you need to recognize that revenue over the period that that money is earned. So if you deliver a service over a period of three months and you charge a flat rate for that service. One way to recognize is divided equally over that three month period. So that that revenue matches over the time period when you’re delivering that service.
Greg Alexander [00:02:53] Right. I had a member who sells an annual subscription. For $50,000 and collects all the money at the beginning, and then spends it all and thinks that, you know, everything looks great. And I had to remind him, I’m like, you realize you have a liability here, right? Like that really wasn’t your money that was paid in advance, but you’re on the hook to provide the service for the next 12 months. So that’s an example of where revenue recognition can get, get out of whack. All right. So the next one, which is probably the biggest issue and this is what’s most often called Cogs cost of goods sold. We refer to it as cost to serve, and we define it as the direct labor expense associated with delivering the service. And the way you calculate a gross margin number is revenue minus cost to serve equals gross margin. And I raise this issue, William, because so many people struggle with what goes into cost to serve a Cogs like the contractors go in yes or no, do IT services go into it, yes or no. So help the audience think through what you believe should be in that Cogs number.
William Lieberman [00:04:02] Sure. So let’s start with some obvious ones. So if you have a consultant who’s providing a service to a client and you’re billing out for that consultants work, that would be in cost of revenue. If that consultant is an FTE full time employee or a contractor, that person stays in that cost of revenue bucket. It gets a little trickier when you have other types of expenses that may or may not be directly attributable to generating revenue, and it gets a little gray. So for example, customer service, customer success. There are a variety of ways that people think about customer success in a professional services business. So for example, there are customer success folks that focus in on upselling, right? They’re account management and they’re trying to generate more revenues through your client base. Well, that’s really sales and marketing. So that’s not cost of revenue. But there are other companies where customer success is more about, doing maybe technical work or delivering subtype of service that is, being billed to the client. And, but they call it customer success because they’re not necessarily hourly billable people, but they’re still responsible for delivering some body of work. And in those cases, those customer success folks belong in Cogs or cost of revenue.
Greg Alexander [00:05:27] Yeah. Okay. Very good. How about allocating, overhead. So let’s go there so that we’re now we just walk through revenue. Revenue recognition cost of revenue. In Williams terms we call that cost to serve in a product company that because a good sold that gives you a gross margin line. Then what gets subtracted from the gross margin line is a series of things that gets you to an even a number. One of those is overhead, and there’s an awful lot of confusion as to what is considered overhead and how overhead gets allocated, etc. so help the audience think through that.
William Lieberman [00:06:03] Well, you have a variety of buckets of what’s called operating expenses or, you know, let’s say overhead things like general and administrative expenses. That could be your insurance or bank fees or internet fees and things like that. There’s selling expenses, sales and marketing. So the cost to actually pay a sales person a commission would be, a sales expense. There could be marketing materials or flying to a conference, things like that, all in the sales and marketing bucket. And you could have customer success. Like we mentioned before, customer success is another big bucket that’s under operating expenses. And in some cases, you might even have product development like or service developing. If you’re creating a new service, you need to generate work and spend money to develop that service that would be under operating expenses. So those are the four main ones that you typically see in a professional services business.
Greg Alexander [00:07:02] And the slang here is that what you would call opex.
William Lieberman [00:07:06] Opex operating expenses?
Greg Alexander [00:07:08] Yep. Yes. And opex is different from CapEx. Oh.
William Lieberman [00:07:12] Yes. So CapEx and capital expenditures are when you’re buying typically a piece of equipment or you’re spending money on a large purchase that’s amortized over years. Maybe you’re buying a company and you’re going to capitalize that company. There’s goodwill and there’s other types of things there. But CapEx typically is referred to in, equipment, hard things that you can kick and touch in, in feel, like a manufacturing business has a big piece of machinery and that’s capital expenditures. In professional services, you don’t really see it too often. Sometimes you have a lot of computer equipment and you might, put that under CapEx, but not often.
Greg Alexander [00:07:52] Right. And in terms of the owner’s expenses, maybe things that the owner is running through the business like, automobile lease or Plane tickets or what have you. Where would they sit and what advice do you have? People around add backs.
William Lieberman [00:08:12] So, I’ll tell you how I do it. Okay. So what I do is I have all the owner’s expenses, what I call below the line. So under other expenses. So you have all your operating expenses. And so you have, backing up revenue minus cost of goods sold gives you gross margin. Gross margin minus operating expenses gives you operating income. And then below that, you can have other expenses in there. You’ll have things like interest expense if you borrow money. You’ll have interest expense to the bank or a lender. I also the way I do it is I put any owner’s expenses under there so that I can easily separate out. How much am my is it truly take to operate the business, versus how much am I running through the business for tax benefit only? And that way I can easily say, okay, month by month, here’s how much I’m spending on my plane tickets or, you know, dinner for my wife.
Greg Alexander [00:09:11] Yep. Very practical way to handle that. I like the other category. I hope all of our members that are listening to us embrace that. So someday when you’re presenting your financials in a potential exit, it’s pretty easy to calculate the add backs. It’s pretty easy to do a Q of equality of earnings. And you know, you have good records. Okay. One thing that I see over and over again.
William Lieberman [00:09:35] I think I want to I want to just clarify one thing or add one thing on the owner’s expenses. Owner’s compensation is a really important number, and it can be very large and can be very significant piece to what goes under, your PNL. So you want to have in your, income statement, you want to show owner’s compensation, how much it really, you know, you would need to get paid, or you would have to pay somebody to do your job for you. That would be an operating expense under op X. Any additional compensation that you pay yourself would be under other expenses. As you say, Greg, it would be an add back. So it’s really that’s a really important thing because when you get to adjusted EBITDA or EBITDA as a and you’re trying to figure out how much your company’s worth or can sell, that’s the sum number you’re really gonna want to hone in.
Greg Alexander [00:10:27] Yeah, that’s a good call out because the buyer of your firm is saying, what is the cost to operate this business going forward? So if you’re leaving after the sale, they’re going to have to replace you. And there’s going to be real costs associated with that. So distinguishing between those is really good. All right. So just we try to keep these podcasts short I have one more question for you. And then we’ll save all the rest of this good stuff for the member Q&A.
William Lieberman [00:10:47] Yep.
Greg Alexander [00:10:48] The difference between accrual and cash accounting. And when does somebody need to make the switch?
William Lieberman [00:10:56] So my opinion is that you should always be unapproachable. You should never be on cash base unless you’re operating a small bricks and mortar business. You know, you’re dry cleaner, where you’re paying. Your customers are paying you cash for business, and it’s just widgets that are going in and out the door. Everybody else really should be on accrual basis. And the reason being accrual basis accurately matches the revenues with the expenses on a monthly basis, so that you can easily measure the health of your business if you do it on a cash basis. You’re just measuring when does cash come in. Versus when does it go out? And to your point, earlier when somebody gets a $50,000 check at the beginning of the year for a year subscription, that’s not all recognizable revenue, when you get the money, it’s recognizable over that 12 month period. So if you do it on a cash basis, you would say, oh, I made $50,000 this month, but that’s not true.
Greg Alexander [00:11:50] So I hear you, but the reality is, is most people start off not knowing that. And they they know cash is king and they’re worried about paying the bills. So they run their books on cash and then something happens. Like, for example, they hire you and you say, hey, you need to switch to accrual. And here’s why. And they have an oh shit moment. Right. So how painful is the conversion from cash to accrual?
William Lieberman [00:12:14] Well, we’re doing this for a few different clients currently and it can be very painful depending upon how far back you go. And in some cases you have to go back several years. If you receive cash and you still haven’t delivered the service and you’re still, you know, keeping it on the books or it’s still a liability because you owe somebody that service. It can be very painful to switch that over. And so you want to do it as soon as possible because, you know, as you say, when somebody something comes along, you have that oh shit moment like a lender. Let’s say you want to go get funding from a bank. They’re not going to look at you if you have cash based books.
Greg Alexander [00:12:47] Right. And when you have cash based books and you present them to a lender or a potential acquirer, what you’re saying to them is you’re not very sophisticated. You don’t know what you’re doing. So it’s got to be really careful there. So if you’re not on accrual basis right now, get there. If you need help to go from cash to accrual, call William who can help you do that. And, you know, you probably need to pull it off. All right. So on the private member Q&A, which will be an hour long Q&A session with members, we can talk about a lot of other things. Let me let me tease the audience with a bit of though. So for example, there’s this whole debate between what’s recurring, what’s reoccurring, what’s repeat in terms of revenue. We’re going to have a whole debate around that. We’re going to talk about the balance sheet and how you can calculate what the real worth of your firm is when you talk about the mental model shift, to go from thinking in income terms to thinking about enterprise value, we can talk about the cash flow statement and how that’s different than the PNL, etc.. So lots of things we’re going to talk about. So if you’re interested in that, please, tune in. But William, it’s always wonderful to see you. I know this stuff for you is, you know, very, very fundamental. But for entrepreneurs who are really domain experts in other areas, this is, very valuable. So thanks for being here.
William Lieberman [00:14:01] Absolutely. Thanks, Greg.
Greg Alexander [00:14:04] Okay, so with that, that’s the end of the show. If you want to learn more, go to Collective 54.com. If you want to read about this kind of stuff, check out my book, The Boutique How to Start Scale and Sell a Professional Services Firm. You can find that on Amazon. But until next time, I wish you the best of luck as you try to grow, scale, and exit your firm.
