Three Key Financial Reports for Creative Services firms

Posted in topics: Operations

In this article, we will share three key reports to manage your marketing and advertising agency financials, along with how you should be interpreting key financial statements. Armed with this info, you’ll have your finger on the pulse of your business and will be able to quickly and confidently make decisions.

We work exclusively with creative service firms, the brilliant souls serving clients of their own in marketing, brand and business strategy, architecture, design and more. Most owners want to be financially successful but are understandably unequipped with the skills and experience to know what good looks like and how to get there. (Fair point. You should see us try to build a house or design an ad campaign!) That’s cool, different strokes and all that. But here’s the skinny: as a business owner, finance is just one of the many facets of your business you need to understand. Learning essential financial management and reading spreadsheets doesn’t have to be tedious and scary. The risk of not getting involved at the right level is far scarier!

Picture this.  You’ve been running your agency for a few years now, and you’ve had some success. But, your financial performance isn’t quite what you’d hope.  Sometimes your bookkeeper gives you some accounting data, but you struggle to understand it, so you go on running your business the way you always have – on instinct.  We get it – unless someone simplifies this stuff and shows you how to read and interpret it so you know the “so what?” of it all, how is this supposed to be helpful? 

You’ve probably heard about or even seen evidence of reports like The Income Statement, The Balance Sheet, or the rare Efficiency Report. As a small business owner in the professional services space, these are the ticket to understanding how your business performs. If you’re working with someone experienced in service-based businesses, they should be able to easily produce these for you.  Review them monthly!

In this article, we break down the what’s what on these three key financial reports, including samples: 

The Income Statement

NOTE: There is a sample income statement included at the bottom of this section. All equations and exercises will use figures from the sample report.

The income statement – also known as profit and loss statement – is pretty straightforward and primarily covers what the name implies: income. Income statements have three main pillars: revenue (money coming in), costs (money going out), and profit (what remains). But, it’s kind of like getting a credit card statement without any transaction details. It doesn’t answer who is sending and receiving funds and on which occasions.

The income statement provides the scaffolding upon which you build financial insights. When used correctly, the income statement is a powerful tool. However, too often, in small businesses (especially the ones still growing), we often see this tool collecting dust, entirely inaccurate, or delivered so late, you made your decisions without it.

 Quick notes:

  • Revenue is all the money coming in from client billing, but revenue alone is a vanity metric.  You should care most about your Gross Margin; that’s your revenue minus the cost of sales incurred to generate that revenue.
  • Cost of sales includes all of the non-salary and non-overhead costs to deliver that revenue.  For example, stock photography, media, and printing costs. These days, they generally pass through; you don’t mark them up, but you also don’t lose money on them. 
  • The critical metric is Gross Margin, or AGI (adjusted Gross Income)This is the money you keep to pay for your staff, your overhead, and hopefully, keep some for profit.

The goal of financial statement preparation is to tell the most accurate story of financial performance.  In marketing and advertising agencies, this means:

  • You can trace all revenue and related costs back to a project and a client. In the accounting world, we call this project accounting.  You can’t possibly understand the financial performance of your project-based business without this level of detail.  Even if you aren’t reviewing the project-level details, someone in your business must be.
  • Accrual-based accounting.  WTF is that?  We like to call accrual-based accounting  the “give credit where credit is due method.”  Most agencies get paid for work in advance.  Nice! Let’s say you receive 50% of payment in February for a project that will finish in July. February looks great! But the February payment isn’t quite income yet – it is a liability. It is a liability because that income (and subsequent payment) is contingent on work you have not yet completed.  The correct method is to recognize that invoice when the work is completed vs. when the work was billed.
  • How you organize the data will have a dramatic difference in how quickly you can interpret the data.  We’ll show you an example of this below.
  • Benchmarking your performance against yourself is the best way to see patterns in your business’ success.  Gross Margin going up month over month, but profit is going down?  If your statements are presented in an organized and thoughtful way, you should quickly understand why and make decisions to reverse that trend.  Presenting monthly data, year-to-date data, year-over-year data and last 12 months’ data are some of the ways that you can quickly see trends in your performance and respond to good and bad changes.

Reviewing your income statement is a pulse check on your performance. It’s like when you were a kid coming down with something. Your mom would feel your forehead to determine the best course of action, which could include: Call the doctor, R&R, stay home from school, or this kid is faking. Mom science.

Income Statement Ratios and Equations

Hopefully, by now, we’ve convinced you that reviewing your income statement monthly is a worthwhile exercise that you can’t run your business without.  Now let’s simplify what you should look for. There are some standard metrics that professional services businesses need to achieve for optimal financial performance.  Because we know you’re busy and you may not love this stuff like we do, we’re showing you the three ratios that you can quickly calculate to understand if you’re performing within best practices, better than, or worse than. Our confidence in guiding clients through these benchmarking practices comes from decades of experience learning what good looks like for service-based businesses. We will use the below example for real-world numbers.

Staff Cost Ratio

In professional service firms, there are specific best practice ratios. If these ratios are maintained, there is a high probability that your business will be profitable at desired margins.  The best performing firms spend less than 60% on staff costs.  How is this calculated?

NOTE: equations use numbers from the sample income statement  

Overhead Ratio

Overhead costs are all the non-project, non-salary-related costs invested in running your business.  Like the staff cost ratio, there are industry best practices. Ideally, your overhead ratio shouldn’t exceed 20% of your gross margin (fee revenue) for optimal profits.  Examples of overhead costs are rent, marketing, legal fees, insurance and Dale’s disco ball. 

EDITDA Ratio

The EBITDA (a fancy term for profit) is the golden ratio – represents what remains after staff and overhead deductions. This ratio tells you your profit before taxes, interest, and depreciation. Top firms achieve an EBITDA of at least 20% of gross margin (fee revenue)

The Balance Sheet

The Balance Sheet is the more important of the two most commonly used financial statements.  But we don’t see firm owners using it enough.  It’s like a dog standing on its hind legs. Impressive, but why? What does it do?

The balance sheet provides a snapshot of your business’ health.  It is divided into three sections –  assets (what you own), liabilities (what you owe), and equity (the difference) at a given time.  Think of the balance sheet as a house (asset), you have a mortgage you pay to the bank (liability), and equity is how much of the home you own. 

What kind of insights can you get from a balance sheet? 

  • How much cash you have on hand, and is it enough to cover at least two months’ operating costs
  • How much your clients owe you
  • How much you owe your suppliers
  • How much your clients have paid in advance (remember accrual-based accounting from before?)
  • How much you have to cough up to the government for payroll, sales and income taxes. Don’t like paying the government? Didn’t know your bookkeeper wasn’t doing it? File that under “Too Bad”. Besides, owing taxes is a sign that your business is generating profits!
  • Whether you have more assets than liabilities
  • How much equity you have accumulated in your business over time

So while the Balance Sheet can be the more intimidating of the two statements, when you learn to read it, it tells you a lot about how you’ve been running your business over time and ideally, how to use it to  back up decisions for the future.

The Efficiency Report

NOTE: There is a sample efficiency report at the end of this section to serve as an example.

Meet the efficiency report – the report we seldom see bookkeepers producing or management teams reviewing.  But this is the one report that provides some detail about where your fees are coming from and which clients are the most valuable. The efficiency report gets its mojo from the income statement – together, they are quite the force. 

Remember how we mentioned the income statement is like a credit card bill without the transaction details? Well, here you have it: the efficiency report is the bill with all the juicy details. This report is the simplest way to understand your clients’ profitability at a management level without incurring all sorts of additional calculations that most likely won’t make the information much more accurate anyways.  In this report (see example), we compare the billable value of all the time you spent by client to the fees that you generated from each client.

Additionally, this report will allow you to easily see: 

  1. Fee revenue break-down by client
  2. The relative size of each client.  Is any client making up more than 30% of your total revenue?  If so, you have an economic dependence issue.  You better plan to have four months of cash on hand if this is your situation.
  3. Economic dependence – this occurs when a single client makes up more than 30% of your revenue. If this is you, you should work to fix it.
    • Example: Shopping malls typically have their anchor stores and a variety of small stores in-between. Have you ever noticed that most malls have a Hudson’s Bay or a Sears? If either of those anchor stores leaves, the mall is in trouble. 
    • Example: Mad Men (we are accounting for marketers and advertisers, after all). Remember when Sterling Cooper Draper Price lost Lucky Strike? Yeah, it was mostly a business thing, or Roger was just dumb. Or both. Either way, the loss of Lucky Strike nearly sank the ship. Do your best to avoid this situation.
  4. Which clients are doing a great job recovering the time you’ve invested and which clients need to be improved.  
  5. Your best-performing clients – Kudos! You need to protect them. 
  6. Your worst clients from a profitability point of view.  Can this be addressed? If not, will you retire them?

The efficiency report is the only report out of the three that will require your bookkeeper or accountant to combine information from two different sources.  You will need to combine your timesheet data with your gross margin (fee) data into one report.  If your bookkeeper did nothing else with your timesheets but provided you with this info about how your clients were performing, you’d be laughing (all the way to the bank).

With long-term clients, we hope to see at least a 90% efficiency or better. This means that 90% of the time spent on your client is recovered by your fees. With newer clients, 80% recovery is common – as there is often a lot of time spent onboarding, learning about the client, research etc.  But you should be regularly monitoring this and pushing for 90% or better as quickly as you can.

Here’s a simple example.  Let’s say you work 10 hours on a project and your billable rate  (to the client) is $100 an hour. The client then pays you $900.00 for your work. You have just produced work at 90% efficiency.

So, why should you care? 

Suppose the rates you use to bill your clients are accurate, and your team is fully utilized. In that case, the efficiency report is the quickest way to determine your clients’ overall profitability.  Many accountants like to get fancy with this stuff and overcomplicate this calculation by assigning all sorts of assumptions around overhead costs.  So much so that you never even get visibility to your clients’ profitability. When you do, more time is spent debating the assumptions vs. actually using the information to direct your decisions around resourcing, pricing, and best clients for your business.  Our thing is reducing busy work so you can focus on the vital metrics moving your business forward. While this isn’t a perfect calculation of client profitability, it’s fast, and it’s good enough to be making good decisions about your business.

Just like the income statement report, we suggest that your efficiency reports include:

  • Fees by client for the month vs. billable value of time spent by client in the month, with % of time earned calculated.
  • Fees by client for the year vs. billable value of time spent by client for the year, with % of time earned calculated.
  • If available, the same information vs. the same period last year.

CONCLUSION

So, there you have it – three critical financial reports that will aid your understanding and ensure your creative business is in tip-top shape! 

  • The Income statement gives you broad strokes of your revenue, costs, and profit. It is a credit card bill without transaction details.
  • The balance sheet summarizes assets, liabilities and equity broken down by individual client or recipient.  Your equity is a pretty good indicator of how well you’ve run your business over time.
  • The efficiency report gives you a macro-level view of the size of each of your clients and how profitable they are.

Remember, good finance brings good finance. 

Fiscally provides the financial leadership your service-based business has always needed. Backed by decades of experiences working for firms just like yours, we believe financial success comes from building accountability in your organization by making the financial results visible, translating financial information into insights for leadership decision making, and establishing the right financial infrastructure so that your financial operations run smoothly.