If you are a CEO and want to scale your business, it is crucial that you allocate your time and money to the areas that will generate the highest return possible. To do this, you need to develop a solid understanding of the income statement and how you can analyze it effectively to fuel growth.
Accurate and Complete Data:
- Every Transaction Properly Recorded: The first step in analyzing your income statement is to ensure that you have every transaction properly recorded in your accounting software and that all of your balances reconcile with your bank statement.
- Garbage In, Garbage Out: This is obviously crucial since if the data in your income statement is incomplete or not accurate, you will not be able to properly assess how you are doing or what changes you need to make.
- Keeping Your Books Up-To-Date: It is also imperative that you constantly maintain your finances so that they are always up-to-date.
- Little Insights with No Categorization: Just because you have all of your transactions accurately recorded does not mean you can answer some crucial questions from your income statement.
- General Insights with No Categorization: If nothing is properly categorized, you are able to determine your revenue and profit, but many critical questions cannot be answered. The reason is that the transactions or data is not structured properly to gain meaningful insights. This lack of information will keep you from making informed decisions which will ultimately impact your growth.
- Example: Analyzing Sales and Marketing: One important question that we believe every CEO should be able to answer is what % of revenue is spent on sales and marketing. See below the difference of answering this question with or without categorization.
- Without Categorization: If you have 20 transactions related to sales and marketing that range from spending money on media, to taking prospects out to dinner, to purchasing swag, it will be difficult to determine the total amount spent specifically on sales and marketing activities. You would need to identify every transaction associated with sales and marketing and then manually total everything together.
- With Categorization: By categorizing all of your transactions that relate to sales and marketing into a “Sales & Marketing” group, you can easily determine the total amount of money spent on sales and marketing. This will allow you to easily answer the question: What percent of revenue do you spend on sales and marketing?
- How to Create Categories:
- Changing the Chart of Accounts: Every line of the income statement is created by something called a “Chart of Accounts” and you have the ability to change the name of each chart of accounts to your liking. For example, if you spent money on “Google Adwords” to generate traffic to your website, you could name the chart of accounts associated with every transaction from Google Adwords whatever you like. You could call it “Google Adwords”, “Digital Media”, “Media” or any other name that you think makes sense.
- Assigning a Category for Multiple Transactions and Sources: If you have multiple transactions from multiple sources (i.e. customers or vendors) that relate to each other, then you can assign a “Chart of Accounts” to all of these transactions. For example, if money is spent on both Facebook and Google, these can both be grouped under one chart of accounts called “Digital Media”. This way you know the total amount spent on digital media even though it came from multiple vendors.
- Ungrouping Categories: You may also have expenses that show up in one chart of accounts that you will want to group into multiple accounts. For instance, payroll is often placed into one chart of accounts called “Payroll Fees”. Ideally, you can re-group each employee into their department so you can get a true idea of what is being spent in each department. For example, if you have two employees and one works in operations and the other works in marketing, you will want to move the payroll of each individual to their respective department. This way you know the true cost for each department.
- Creating Primary Categories: Another thing that can be done when creating the chart of accounts, is that a cluster of accounts can be grouped into one major category. For example, you can create a category for “Sales and Marketing” and then have everything related specifically to marketing under the “Marketing” category. This is crucial when you’re asking yourself important questions such as “What percent of revenue do we assign to sales and marketing-related activities?”
- Recommended Primary Categories: There are generally 7 major categories that I suggest a company should create:
- Executive, and;
- Client Service
By grouping all of your expenses accordingly, you can easily determine the amount of expenses spent in each field, detecting over-investment or underinvestment in a specific area.
Before and After Comparison:
If you compare an income statement with poor categorization versus one that is properly categorized, you can see the difference this will make in running your business. By having all of your transactions nicely categorized, you are in a position to answer crucial business questions that will allow you to allocate your resources more effectively.
If you want to grow faster, it is critical that you are able to analyze your income statement on an ongoing basis. To do this you have to constantly adjust the categories so that you are able to gain the necessary insights into your business.