What Are Your Financial Statements Saying?
authors Ken Peterson | February 9, 2010
It’s been my experience that most kitchen and bath dealer/owners don’t understand the importance of their financial statements. That’s because most have grown up on the design and selling side of the business. That’s their passion. That’s their focus.
But until dealer/owners comprehend the financial side of the business, they will never ever realize their full income and profit potential. Most only rely upon their accountants to produce a year-end financial statement to be filed for income tax purposes. Indeed, most accountants are number-crunchers and largely unavailable to tutor small business owners as to the meaning of these financial statements and what should be done to improve company performance.
So, a little basic education in this arena will set the stage for understanding the six important values derived from knowing what your financial statements are saying about the state of your business. These are values that every owner should embrace.
Understanding the Difference in Financial Statements.
First, you need to know the difference between an Income Statement and a Balance Sheet. The former measures your company’s financial performance in the current year. It’s measured by how much revenue has been recorded versus how many expenses have been incurred in support of generating that revenue (or income) level; the difference is called Net Profit. Bankers like to see an 8-10% bottom line after an owner’s market-rate salary. I rarely see this Net Profit percentage achieved in this industry – even in boom times. So, to be brutally candid, one could surmise that most dealers are just “buying themselves a job.”
The latter measures your company’s cumulative performance since you started in. It’s measured by how many Assets you have acquired over these years minus the Liabilities incurred in the process; the difference is called Net Worth.
The Net Worth is usually made up of several elements: Initial Capital, Retained Earnings and the current year’s Net Profit, which is the common link between the Income Statement and the Balance Sheet in any given year.
The Importance of Retained Earnings.
Most Dealer Balance Sheets I have reviewed show very little in the way of Retained Earnings. One can only conclude that (a) owners have taken out bonuses or “distributions” to supplement their salaries, (b) owners have earned insufficient Net Profit over the years or (c) both events have taken place.
Retained Earnings are essential to finance growth or survive a debilitating recession. Otherwise, capital has to be infused into the operation from other sources – such as a price increase, bank loan, sale of stock, or owner’s home equity loan – which can be both expensive and problematic. The absence of adequate Dealer Retained Earnings is a major reason why this industry has remained fragmented since its inception in the mid-1950s.
The Proper Accounting of Displays.
Frequently, when analyzing Financial Statements, I have discovered that most dealers have not accounted for their displays properly in accordance with NKBA’s position paper. In some cases, they have expensed the displays on their Income Statements in the year that they were purchased. Perhaps, these dealers have done this to reduce their tax liability in a year they made a decent Net Profit, but there are other creative ways of accomplishing this same objective.
Technically, any purchased asset that will have its value last longer than one year should be capitalized on your Balance Sheet; otherwise, you are not reflecting the true value of your business. Indeed, owners have been able to use display assets as collateral for a loan up to 80% of their original value.
In 1978 a team of accountants hired by NKBA discovered in their research that most kitchen and bath dealers enjoy much deeper discounts from vendors on displays (often an extra 20-50%) than on products for resale to customers.
In fact, the accountants found that most dealers could make a profit when the displays were sold years later, provided they were marketed properly. As a result, their professional recommendation was that displays should be posted as Current Assets not to be depreciated. Listing displays as Current Assets – as opposed to Fixed Asset – makes them more valuable in the eyes of bankers because they can be converted into cash more rapidly.
The Need for Accrual Accounting.
Most accountants encourage small businesspeople to recognize revenue when they receive a check. Known as cash accounting, this methodology is recommended because it’s easier for bookkeepers to do with the accounting software packages today. However, cash accounting in the kitchen and bath industry produces inflated income, gross margin and net profit figures – all of which can lead to ill-conceived, even disastrous, business decisions.
Accrual accounting, on the other hand, recognizes revenue only when the job is substantially completed. Information has to be inputted into these software packages in special ways to be accurate, which the average bookkeeper – even an experienced one – rarely knows. Accrual accounting is the only way that a dealer in this industry will have an accurate financial picture of how well his or her company is performing.
The Six Values of Knowing Your Financials.
Every dealer-owner in this industry must be adept in reading, interpreting, and using their financial statements to make the wisest of business decisions. They should seek as much education as possible in this arena, for there are six important values that emanate from this financial know-how.
First, you will protect yourself from possible embezzlement. Yes, I’m sure you trust your bookkeeper. But so did a California dealer who lost $1,000,000+ to such a trusted individual over a span of 13 years. Second, you can better measure your financial performance against others in a group, identifying weaknesses where your business can be shored up.
Third, you can ask better questions of professionals so you can secure better advice. Fourth, you can set more intelligent and realistic goals for your company.
Fifth, you can furnish more confident leadership, attracting and retaining quality personnel as well. And sixth, knowing the financials as well as you know the designing of kitchens can definitely make your firm a lot more profit!