PCO Business Financial Statement Basics

THE PEST CONTROL INDUSTRY’S MOST TRUSTED ACCOUNTING FIRM

PCOBOOKKEEPERS

PCO Business Financial

Statement Basics

By: Daniel S. Gordon, CPA


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Intro To Cash or Accrual…..That Is the

Question

Financial Statement Basics

How does A Banker Look at Your Financials

Games People Play

How does a potential Purchaser or Equity Partner Look at Your

Financials

A word about getting money out of the

company – The Good the Bad and the Ugly

Case Study

Putting It All Together


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Introduction


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Remember a Time When Business Was Easy?

We Got A Call

Took Care of the

Customer’s Problem

Made a Profit for Doing so.


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Remember a Time When Business Was Easy?


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Then we decided to grow our Business. In growing we recognized the fact that we have stakeholders. These stakeholders need to be fed information. Who are these Stakeholders?

Stakeholders

Outsiders

The Bank

Taxing Authorities

Vendors

Prospective Purchasers of Our Business

InsidersThe Folks

Running Our Companies


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We Are Entrepreneurs; Not AccountantsObservation: The Most Successful Businesses

have a leader who is…A Great Marketer

A Motivator of People

Knowledgeable about The Product or Service They Offer

Can Deliver That Product or Service in an Efficient Manner


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Notice we didn’t say a business leader needs to be a great accountant. However, there is a requirement for a growing Business:

A trusted member of the Leadership needs to be intimately involved with Accounting. He must be able to access the quality of the accounting data compiled and he must be able to interpret a financial statement.


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On the Subject of Accounting Data:

On the Subject of GIGO:

“You can put Lipstick on a Pig, It’s still a Pig.” – Barack Obama

“Paper accepts all Ink” – Anonymous

This Information and presentation must be in accordance with a consistent method of accounting

Any Accounting System can produce Financials – What’s under the hood?


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To Accrue, or not to Accrue…..That is the Question


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The most widely used methods of Accounting for small business:

Modified Accrual

Accrual

Cash


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Cash

The cash method is simple in that the business's books are kept based on the actual flow of cash in and out of the business • Income is recorded when it's received, and expenses are

reported when they're actually paid

• From a tax standpoint, it's sometimes advantageous for a business to use the cash method of accounting

• That way, recording income can be put off until the next tax year,

while expenses are counted right away


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Accrual

Revenues are recognized when they are earned rather than when the cash is received. The balance sheet is also affected at the time revenues are earned as opposed to collected by:

Either an increase in Cash (if the service or sale was for cash)

An increase in Accounts Receivable (if the service was performed on credit); or

A decrease in Unearned Revenues (if the service was performed after the customer had paid in advance for the service).

Expenses are recorded when they are incurred as opposed to when they are paid creating Accounts Payable on the Balance Sheet


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Modified Accrual

A method mainly to accommodate timing of reporting such that we don’t have to wait for documents thereby delaying the closing process

While accruals can be made for these items, many times it’s worth it to record certain items when they arrive and as long as the item is recorded at least monthly, over time the accrual based income is relatively close

The most important idea here is that the information is consistently recorded period to period.

Cash or accrual is acceptable for Tax reporting. Modified Accrual is not and adjustments must be made at year end to convert data to one of the acceptable methods


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Accounting Methods – Which one shall I use to get the most useful information?

In all cases Accrual or Modified Accrual Accounting presents a much more accurate picture of the results of your operation as well as what you own, what you owe and the equity you have in your business.

Which Method Should the Growing PCO Use?

ACCRUALACCRUAL OR MODIFIED ACCRUAL TO RUN THE BUSINESS!!!

What about Taxes? The IRS allows us to use either method subject to certain rules which most of us will meet for reporting on a cash basis. So there are many good reasons to report on a cash basis – Taxes and simplicity for example.


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Are you telling me to keep 2 sets of books?


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YEP!


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Dan’s Approach to PCO Financial Statements


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Wealth Maximization!! That’s It!!

Your Financials need to be created using Generally Accepted Accounting Principles (GAAP) (with minor departures as required).

Definition:

Chart of Accounts (COA): A list of the accounts that describe items on your balance sheet and P/L.


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Think about increasing the value of your firm when devising your COA. How is it organized? It’s all about management of information that will allow you to manage your company to build maximum value.

You also need to manage your Financial Risk. Many companies have gone broke getting Rich!!

It’s irrelevant whether you want to sell or not. The value of your company is the scoreboard and you score runs by making annual increases. Will those increases be Singles? Doubles? Triples? or Home Runs?


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What is the most important formula in the world?


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A=L+OE

E=MC2

What is the most important Formula in the world?


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A=L+OE

E=MC2

It depends on if your objective is an explanation for the origin of energy in nuclear processes; or

You want to understand how a Balance Sheet works


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A=L+OE

E=MC2

Accounting Formula: A=L+OE


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Balance Sheet Basics


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Assets;What You Own

Liabilities;What You Owe

OE (Owners Equity);

Difference Between The

Two


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What does it tell us?

Assets;What You Own

Liabilities;What You Owe

OE (Owners Equity);

Difference Between The

Two

The assets (resources) that the company is using

How these assets have been funded with Owners Equity; or with

The liabilities the company owes to others


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AssetsHow much cash does the company hold?

Does the company sell on account?

How much inventory at year end?

How much machinery/buildings/etc does the company have?

Are those relatively old or new? (depending on the cumulative depreciation)

Assets;What You Own


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Liabilities;What You

Owe

OE (Owners Equity);

Difference Between The Two

Liabilities and Owners EquityThe current liabilities: how much needs to be paid within 12 months

Long term liabilities: how much needs to (re)paid in the long run

How much have the investors paid for their share

How much of profits are retained in the company (not paid as dividend)

How much potential (future) losses the company can absorb with their equity


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Example


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The Profit and Loss Statement


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Show Me The Money!!Revenues

Direct Costs

Gross Margin

Marketing Expense

Sales Expense

General and Admin Expense

Overhead Allocation (Firms with Multiple Branches)


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RevenuesIn the PCO world we speak in terms of valuing our firm as a multiple of revenues. While we speak this way, later I will show you how it’s really derived. However, in order to get to the answer quickly, we want to define our revenues in the following manner:

Com

mer

cial • One

Times• Initials• Route

Work• Renewals• Product

Sales

Resi

denti

al • One Times

• Initials• Route


Sales

WD

I • One Times



Sales

Oth

er • One Times



Sales

You can add divisions as needed, but you need to separate recurring vs. non recurring work


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Direct Costs – All costs associated with putting a technician on the road

Tech Labor

Vehicle Costs

Materials

Uniforms, Tech Workers Comp, Other Direct


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Gross Margin – The single most important KPI in determining what multiple you will get when valuing your company. It determines:

How well you price your services

How well you route your technicians

How well you control your costs on the job

What your breakeven point is

What should your Gross Margin Be? Why will it determine the value of your company?


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Marketing ExpenseAll amounts spent to bring in a Sales lead. What % of revenue should I spend on Marketing?

Marketing Math:

Lifetime Value of Customer = Annual Gross Revenue X Gross

Margin X Average Life Of A Customer

Lets take a look at an example…


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Marketing Expense Example

Lifetime Value = $500 x 50% x 5 Answer: $1250 (ignoring time value of money for the real financial junkies in class with us today)

• Annual Gross Revenue = $500• Gross Margin = 50%• Average life = 5 Years

What would you pay for this customer? It’s up to you but would $125 be unreasonable? What is the % of revenue?

How many customers do you want? Is it a function of a % of revenue?


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Sales ExpenseAll amounts spent to close a lead generated by marketing. Includes:

How much do you spend on Sales?

Sales Salaries

Sales Vehicles Exp

Sales Materials

Other Sales Costs


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General & Admin ExpenseEverything else that goes on in the office

What do you spend on G&A?

Office Wages

Management Wages

Rent

Utilities

Professional Fees

Interest Expense

Other


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Overhead Allocation (Firms with Multiple Branches)

For those who have multiple branches we allocate common expenses to all by:

% of Revenue

% of Payroll

A fixed dollar amount


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P&L Example


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How does A Banker Look at Your Financials?


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“Give a man a gun and he can rob a bank. Give a man a bank and he can rob the world” - Anonymous


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How Does A Banker Look At Your Financials

Liquidity

Strength

Efficiency

Using Financial Metrics and Ratios including:


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Liquidity

Lets us know if the Company has the cash available to pay its bills

Looks at Cash, Cash Equivalents and Accounts Receivable

Looks at Cash Requirements such as unpaid bills, and other current obligations

Current Ratio =Current Assets

Current Liabilities

Quick Ratio =Cash

Accounts Payable

Liquidity Ratios:


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Liquidity Example

Liquidity Ratios:

ABC CompanyBalance Sheet

Cash 500Accounts Rec 200Inventory 100

Current =Cur. AssetsCur. Liab.

=800500

= 1.6

Quick = CashAP =

500300 = 1.66

Machinery / Equip 25000Accum Depreciation (12000)

Total Assets 13800

Accounts Payable 300Credit Cards Payable 200

Notes Payable 8500

Current Net Income 800Retained Earnings 4000

Total Liabilities & Equity 13800


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StrengthMeasured by the percentage of the company that is owned by the owners (Equity) vs. the percentage of the company owned by creditors (Liabilities). Usually measured by Debt to Equity Ratios. Companies get Capital in 1 of 2 ways:

Debt

Shareholder Investments + Any profit left in the company (retained earnings)

Debt Ratio =Liabilities

AssetsDebt to Equity =

DebtOwners Equity

Debt Ratios:

Interest Coverage Ratio =

EBITDAInterest Expense


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Strength Example

Debt Ratios:

ABC CompanyBalance Sheet

Cash 500Accounts Rec 200Inventory 100

Debt =Liabilities

Assets= 9,000

13,800 = 65.2%

Debt to Equity = DebtOE

= 90004800

= 1.875

Machinery / Equip 25000Accum Depreciation (12000)

Total Assets 13800

Accounts Payable 300Credit Cards Payable 200

Notes Payable 8500

Current Net Income 800Retained Earnings 4000

Total Liabilities & Equity 13800

Interest Coverage Ratio

EBITDAInterest Expense

Minimum of 1.25 on SBA

Debt

==


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Efficiency

Accounts Receivable

A/R Aging – What does Your Over 90 Day look Like?

Days Sales in A/R – Are Customers staying within your terms?

A/P Aging – What Does Yours Look Like?

Accounts Payable / (Annual Purchases /365)

Accounts Payable

Accounts Receivable /(Annual Sales/365)


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Efficiency

How well do you manage growth?

Degree of Operating Leverage –

Are we Holding our Margins at the Incremental Revenue Dollar?

% Change in Net Income

% Change in Revenues


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Games People Play


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Balance Sheet

Assets LiabilitiesCash

A/R

Equipment

Total

100

200

1000

700

A/P

Notes Payable

Total

200

500

300

Current Income 50

450

Equity

Capital

Total

Total Liab. & Equity

500

1000

100%

50%

50%

Let’s Play WhoOwns TheCompany?


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A/R

Equipment

Total

0

200

900

700

A/P

Notes Payable

Total

100

400

300

Current Income 50

450

Equity

Capital

Total


500

900

100%

44%

56%

Let’s Play Who Owns The Company?

Take $100 of Cash and Pay $100 A/P – Debt Ratio 44%

Debt Ratio + 400 Liab /900 Liab +Equity = 44%


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A/R

Equipment

Total

100

200

600

300

A/P

Notes Payable

Total

0

100

100

Current Income 50

450

Equity

Capital

Total


500

600

100%

16.6%

83.3%


Sell $400 of Equip and pay A/P $200 and N/P $200 – Debt Ratio 16.66%

100 Liab / 600 Liab + Equity = 16.66%


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A/R

Equipment

Total

600

200

1500

700

A/P

Notes Payable

Total

200

500

300

Current Income 50

950

Equity

Capital

Total


1000

1500

100%

33.3%

66.7%


Owner Contribute $500 to Cash as a Capital Contribution – Debt Ratio 33.33%

500 Liab / 1500 Liab + Equity = 33.33%


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What happens if the Note Payable is from a Shareholder? Is it Debt or is it Equity?

Why do people play these games with their Balance Sheet? The CFO Function is about minimizing financial risk

It’s all about Managing Financial Risk!! And a good banker can cut through all this to understand how much debt a company can handle based on their parameters

Want a lot of cash on hand in the winter – debt doesn’t matter as much

Want minimum of debt during the busy season and minimum of cash as the cash is plentiful during season and debt costs money. So debt is paid down

As a Seasonal business you will:


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How Does a Potential Purchaser or Equity Partner Look at Your Financials?


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Value and Potential Return

Value – What is the company worth?

P/E Approach:

Earnings from a P/L prepared in Accordance with GAAP

Price / Multiple – Comparable Public companies

Lets take a look at an example…


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Conversion from Price to Annual Revenue to P/E

Multiple of Revenue

Net Profit %

P/E Ratio

0.8 5% 16.000.8 10% 8.000.8 15% 5.331 5% 20.001 10% 10.001 15% 6.67

1.2 5% 24.001.2 10% 12.001.2 15% 8.001.5 5% 30.001.5 10% 15.001.5 15% 10.00


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What about Operations?Revenue Per Employee…But how do we chunk it down to departments?Total Revenue / # of Technicians – Revenue per Technician

Commercial Revenue / # of Commercial Technicians - Commercial Revenue per Commercial Technician

Residential Revenue/ # of Residential Technicians – Residential Revenue Per Technician

WDI Revenue / # WDI Technicians – WDI Revenue Per Technician

Lawn Revenue/ # Lawn Technicians – Lawn Revenue Per Technician

# of Office People / # of People on the road (Sales & Techs)

# Supervisors / # of Technicians


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By the way when a business appraiser looks at your company does he value it this way?

Most Appraisers use a balance sheet approach ignoring most of the value in the customer list.

Ever try to tell a banker what your company is worth?

When is this approach good?


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How does a Potential Purchaser or Equity Partner Look at Your Financials?

Gift and Estate Planning

Divorces – depending which side you are on


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A word about getting money out of the company – The Good the Bad and the Ugly


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A word about getting money out of the company – The Good the Bad and the Ugly

Paychecks

Distributions

Distributions in excess of Basis

Loans to Shareholders


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Case Study


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Your Next Steps


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So You want to Grow Your Firm?

For Internal Management Reports – You Need Accrual Based Reports

For Banking Relationships• You need a profitable operation• You need a healthy Balance Sheet• You need a Well organized Chart of Accounts

For Tax Reporting – You need accurate information

For Tax Minimization – You need monthly income monitoring

For Tax Audits – You need Someone who can handle the tax man when he comes knocking

You want a plan for growth – You need Financial Budgets


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[email protected]

www.PCOBookkeepers.com

mailto:[email protected]

http://www.pcobookkeepers.com/


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PCO Business Financial Statement Basics

Business

Transcript of PCO Business Financial Statement Basics