Most MSPs and Small Businesses don’t start with someone who is a business financial wizard at the helm. Often entrepreneurs start as a competent person in the field, but not necessarily a business person. During the first few years of their business, they work to level up the business side of their practice. It can be quite difficult. I want to help people shortcut their learning so they can get on with growing their business.
Today is the day that you level up your financial awareness. Today we are talking about the core financial info you need to know to move your business forward.
We are going to talk about the core concepts around understanding your financial statements. The sooner you get good at this the faster you can level up your business decision making.
Let’s start with some terms that you just need to know. I’ll start with at the top of your Profit and Loss Statement (also known as your income statement).
Revenue/Income
At the very top of your P&L you start with Revenue. Also known as income. Simply stated: This is all the money you make. Generally speaking, more is better.
You might consider splitting up your revenue into different buckets based on what you do. Having one big bucket of revenue if you sell multiple different types of products or services makes it hard to parse the data.
In the MSP space you probably separate this into at least three categories: Hardware/Product Sales, Cloud Sales, and Service. You might even break down the service into other categories like Break-Fix, Fixed Fee, and Projects. The key here is to not break it down too far. Only break it down as much as you need to make better business decisions.
If you run a laundry service/laundromat you might want to separate regular laundry revenue from dry cleaning revenue. You may even want to separate the vending machine that sells detergent and dryer sheets.
It’s all about separating the income into categories that make sense to track.
Cost of Goods Sold (COGS)
The next term that is important to understand is Cost of Goods Sold also known as COGS. These are the direct expenses in order to drive the revenue forward.
For my MSP friends this aligns to the revenue categories mentioned above. COGS includes things like the hardware you resell, the cloud services you resell, and the labor and tools for your services.
In the laundry service example I would expect the cost of detergent, dry cleaning supplies, and maintenance on the equipment to hit COGS. Also, the labor performing the laundry services would land in COGS as well.
Gross Profit and Gross Margin
This leads us to Gross Profit and Gross Margin. I covered this in a different post, but I’ll also quickly cover it here.
To determine Gross Profit you simply take your Revenue and Subtract your COGS. That gives you Gross Profit in dollars. Then you can take that Gross Profit dollar amount, divide this by Revenue, and multiply by 100 that gives you Gross Margin as a percent.
Gross Profit = Revenue – COGS
Gross Margin = Gross Profit / Revenue * 100
The short version of the Gross Margin concept is that as you grow Gross Profit dollars it’s possible that you’re working harder to generate the additional revenue. You track this by watching your Gross Margin percentage to see if you are becoming more efficient (the percent goes up), staying even (it stays the same), or becoming less efficient (the percent goes down). There may be good reasons for any movement there, but it’s important that you understand WHY it’s moving in the direction it’s moving.
One of the smart things to do with Gross Margin is to track it overall, and then by line of business; or the buckets that I described earlier.
As you grow Gross Profit dollars it’s possible that you’re working harder to generate the additional revenue. You track this by watching your Gross Margin percentage.
This is also where the concept of “the line” comes in. Gross Profit is the line. Anything that you hear folks talk about things being above the line are what we’ve covered already. Items “below the line” will be covered next. Basically anything above the line is what drives the business forward. Anything below the line supports the business in a more general sense.
Expenses or SG&A Expenses
Now that we’re below the line we talk about our expenses or Selling, General, and Administrative Expenses (SG&A for short).
These are the “other” expenses that help support the business efforts and are important. These include things like your bookkeeper, CPA, executive salaries and related expenses, and things like rent, your own IT support, internet services, insurance, and things like that.
This also includes sales and marketing if you’re a service business. Again, your mileage may vary if your business is heavily sales based, but for my MSP friends and other service based businesses you will find your Sales and Marketing expenses below the line.
It’s basically everything that costs the business money that doesn’t directly relate to delivering revenue. Said differently, if it costs the business money and wasn’t in COGS it’s likely an expense.
EBITDA and Net Profit
We’re just about done — we just need to talk about two more terms: EBITDA and Net Profit.
EBITDA is an acronym that stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It’s a fancy algorithm that takes some of the specific variables out of the equation to determine how heathy your organization is. This is the number that you can use to gauge profitability before your accountant gets in there and adjusts for the interest, taxes, depreciation, and amortization.
To calculate EBITDA, take your Gross Profit, subtract your expenses that aren’t in the acronym, and that gives you your EBITDA dollars. You can then take those EBITDA dollars, divide that by the revenue, and multiply by 100 to give you a percentage very similar in concept to Gross Margin. This allows you to understand if you’re working harder to generate more money or not. The same guidelines around Gross Margin apply here: if the number is going up you’re getting more efficient, if the number is even you’re staying equally as efficient, and if it’s going down you’re becoming less efficient.
EBITDA $ = Gross Profit – SG&A Expenses
EBITDA % = EBITDA $ / Revenue * 100
For many small businesses this is a great way to compare yourself against yourself, and yourself against the industry if your industry has benchmarking services.
Let’s get to Net Profit quickly and I’ll wrap up. Net Profit is what you get when you account for all of the Interest, Taxes, Depreciation, and Amortization. Basically, the number after your accountant gets in there and works their magic.
Net Profit = EBITDA $ – Interest – Taxes – Depreciation – Amortization
Wrapping Up
Small Business / MSP Finance is a topic that you will likely have to revisit on a regular basis. In fact, the best way to get good at this is to spend time with your own numbers doing analysis. If you are a member of our Pax8 Peer Groups we help with this data collection and analysis every quarter.
Just remember that this will take some time and some reps to get a grasp on it. Don’t worry if you don’t pick this up right away. It took me a couple of years to understand it well enough to explain it to someone else. Now that I’ve spent about a half-dozen years with it, this has become second nature.
With that, thanks for coming on this ramble with me and I hope to see you on the next one!