Agency financial basics for owners

The following is a computer-generated transcript. Please listen to the audio to confirm accuracy.

Hello and welcome to today’s SAGA webinar. I’m Chip Griffin, the host of your webinar today. I’m also the founder of SAGA, the Small Agency Growth Alliance, and I am delighted to have you all here with me today. In just a moment, we will get started. I’m letting everybody have a chance to come into the room here, but I already see a bunch of familiar names here.

So great to see you all. And I’m looking forward to today’s session, where we’ll be covering something that’s, that’s very important. And you know, maybe not the most exciting topic and the, you know, the kind of thing that I know a lot of owners will tell me, geez, I don’t like numbers. I didn’t get into this for the numbers.

But It’s so important, and so I’m happy that we’ll have some time to focus on that today. So, with that, let’s go ahead and we’ll start with some housekeeping items while people are making their way into the webinar. And so from a housekeeping standpoint, a replay of this webinar will be available.

It’ll be available on the SAGA website in the next day or two. So be sure to check there if you would like to watch it there. Obviously, if you’re watching this on replay, you already know that and you know where to find it. If you’re watching live, use the Q& A function that should be at the bottom of your screen so that you can ask questions.

at any time. We’ll try to gather them all up throughout the session, and I’ll answer them all for live attendees at the end. If you’re watching on replay, you won’t have the Q and A session, but you can email me at chip@sagaimpact.com. I’d be happy to answer any questions that you may have. We also have a free community on slack.

The SAGA community there is a great place for you to ask questions and get feedback, not just from me, but from other agency owners and your peers. So, if you’re watching. live and you still want to use those, feel free to do that as well. Sometimes you might have a question that you’d rather ask me privately and I’m happy to address it there.

If you’re talking about this webinar on social media, I’d encourage you to use the hashtag agencyleadership to make it easy to discover. And finally, any of the resources that I may mention today, as well as numerous others, are available on our website at sagaimpact.com.

So let’s talk about what we’re going to be covering in today’s session.

We’ll be taking a look at three key things. First of all, we’ll be looking at why we do financial reporting, what we’re trying to get from it. I’ll go over some of the basic terms and concepts so that we can demystify some of the jargon that you may hear thrown around. And finally, I’ll take a look at some of the key metrics that I like to look at when I’m working with agency owners or when I’m first beginning to work with an agency and I want to evaluate where they stand so that I know where we need to go with our engagement.

The bottom line is that financial reporting has three primary purposes for most agencies. The first is the one that probably most of you think about when you think about your financial reports and what you’re getting from your bookkeeper or your accountant, and that is your tax filings. So most of your reporting, when I go into an agency and look at it, is really centered on the tax p erception of things and we’ll talk about what’s good and what’s bad about that in just a minute. But the other reasons that you want financial reports are for management decisions, making better, more informed decisions about where to go with your agency and what kind of investments you can make. And we’ll talk about that today as well.

And then finally, your financial reports are used if you ever want to do something where you need a valuation for your agency. That might be for getting a loan. It might be for selling the business. It might be for merging with another agency. It might be for transferring equity for estate planning purposes or other things.

There’s all sorts of reasons you might need a valuation and financial reporting can help you with that as well. So those are the three broad buckets that most financial reports for agencies fall into. Obviously there are other things that you can use them for, but those would be the three things that we’ll focus on today with a particular focus on the management decisions piece, because really that’s the most important thing that I think you can draw from your financial reports is the information and insight that you need in order to be a more effective business.

So let’s talk about these, these Goldilocks goals for agency accounting, because those three kinds of reports that I talked about, you come at them from very different angles, when you’re putting them together and they don’t always look the same.

So, when we think about tax accounting, we’re trying to typically minimize our profits so we reduce our tax burden as much as legally possible. So if I look at a profit and loss statement that’s been put together, and we’ll talk more about P& Ls and those kinds of things later, but when I look at something that’s been put together from a tax perspective, the goal is to find as much as you can on the expense side of the ledger, minimize as much as possible the profits, because that’s how you cut down on how much you have to pay your local, state, federal or other government entities. And so it’s really focused on that one thing, which is drawing down your profits, which is kind of counterintuitive, right? Because we think when we’re running a business, we want to maximize the profits. And in fact, when we think about the accounting that we would do for evaluation, where we’re trying to do something typically in the mergers and acquisitions space, M and a, we would want to try to maximize those profits.

So if we’re putting together something that we’re going to give to a potential acquirer, we want to try to find as many ways as possible to characterize things, not as expenses, but well, that’s just, that’s for me personally, I just happened to run it through the business. So we’ll take it out of there.

And so all of your effort goes into making that profit number as big as possible. And so we can see, you know, one of these is trying to maximize your profit number. And one of these is trying to minimize your profit number. So they’re very, very different objectives. And then ultimately management accounting, which again I will focus on for the most part today.

It just seeks the truth, the unvarnished truth. It’s helping you to understand what’s really going on in your business. It’s not doing anything that is trying to achieve a predefined outcome as you might be. If you’re looking for a valuation for selling the business or you’re looking for, a statement to put together to minimize your tax burden.

So management accounting is all about the truth in the business. And if you have good reporting, if you have this truth, it allows you to make smarter decisions. And what do I mean by smarter decisions? Basically what I mean is you are able to answer key questions that you might have. And so the key questions that you would typically have from a financial standpoint would be, these are probably the four biggest buckets that they would fall into.

Can I afford to? Can I afford to hire? Can I afford to sponsor an organization? Can I afford to pay myself more? These are all things that you might ask yourself and you would use the financial reports to help answer that question. Are there warning signs of? In other words, looking at your financial reporting, particularly as you look at it month over month or quarter over quarter or year over year, you can begin to spot things where you see, I don’t have a problem today, but maybe I’ll have a problem in the future.

Maybe it’s a capacity issue that I can see from my financial reporting. Maybe it’s a cashflow issue that I can see from my financial reporting. So there’s a lot of things that you can do to get that early warning and make your decisions, not just smarter, but sooner. because that allows you to make a more effective business.

Should I reduce spending on? And so we often think in terms of we’ve lost a client, we need to go out and get additional revenue. Or we thought we would be able to add a certain number of new clients, new revenue this year, and we’re not hitting that. So now you can use your financial reporting to help you figure out Not only should I reduce spending, but where can I reduce spending?

Because it allows you to spot those areas where you have some discretion in what you’re spending and, and that discretion can actually make a difference in whatever goal that you have for curbing expenses. And finally, am I on the right track for? In other words, am I on the right track for retiring in five years?

Selling in three years? Adding a new hire or a new line of business in six months? It helps you to take a look at those things, and you’re able to set some targets for them and understand if you’re achieving them over time. And good financial reporting from a management perspective will give you that information.

So now let’s take a moment just to demystify some of the jargon. I’ve already inadvertently thrown out some of it at you and, and, I’m not going to go through every term that you’ll ever hear from an accountant or a bookkeeper or from a tax advisor or even folks like me, but I’m going to go through some of the big ones that you might hear in a financial context so that it starts to make sense for you when you’re consuming my content, when you’re talking with your professional advisors or in any other venue. So first we’re going to take a look at cash versus accrual accounting. And so when you use a service like QuickBooks or FreshBooks or something like that, you’re typically immediately given the option when you’re setting things up to set up as either cash or accrual accounting. And so let’s talk about what the difference is between these two approaches.

From a cash accounting basis, that’s what we typically think of in our personal lives. So, if we have a checking account, cash accounting would be when money comes in and money goes out. That’s when you have revenue and expenses and it matches the date of the withdrawal or the deposit in the bank account.

Same thing on the business side of things. It really tracks where the cash is flowing and when the cash is flowing. With accrual accounting, it’s different. With accrual accounting, you do what’s called recognize the revenue, and you recognize the revenue at the time that the transaction actually is impacting.

So, for example, let’s say that I have a client prepay me 12, 000 for the entire year, and so they make that payment in January. In cash accounting, that 12, 000 would hit my books in January, and QuickBooks would show 12, 000 of revenue. committee to review the executive order in January. if I’m using cash accounting.

If I’m using accrual accounting, that 12, 000 will be spread out over the course of the year because it’s being used to be applied to each of those individual months, even though it’s prepaid. So what that would show is a thousand dollars of revenue in each of the 12 months of the year. So you can see for January, your numbers in cash and accrual in that particular instance would be wildly different.

One would show revenue of 12, 000. The other would show revenue of 1, 000. They each have their purpose, and typically from a tax perspective, agencies are going to use cash accounting. It is, generally speaking, the most advantageous. But accrual accounting is actually the best way, generally speaking, to make management accounting decisions.

Because you don’t want to have these peaks and valleys that show up simply because of when a client pays. Because it can also be the case that, let’s say that that 12, 000 payment doesn’t get paid until March. You would actually show no revenue at all, in January and February on a cash accounting basis.

Whereas accrual, you would still show that you had that thousand dollar a month client with you. And so it tends to even things out and show you a more accurate picture of the directionality of the business. It helps you to uncover trends better and it’s not dependent upon all of the uncertainty of when a check comes in or a deposit comes in or money goes out.

So, You need to understand those two different concepts, and it’s one of those things where typically you can work with your bookkeeper and accountant to make sure that from a tax perspective, they’re getting what they need so that you can minimize your tax burden. You can use cash accounting for that, but you can still look at things from an accrual accounting basis for your management decision making.

Now, even if you don’t have two proper approaches to this, where you actually are generating true accrual accounting. At a minimum I would suggest that you take your books and you look at it in accrual accounting ish terms. In other words, don’t look at where the money is flowing from a deposit standpoint, particularly on the revenue side.

You really want to look at more what you’re billing on a monthly basis that matches up to the services you’re providing that month, so that you can see what’s going on. those trends more easily. Otherwise, you’re going to see this wild roller coaster of revenue that doesn’t really depict what’s going on in your business, and it may cause you to make bad decisions.

Because financial reporting should be used to make better decisions, but used incorrectly, it’ll actually help you make worse decisions. Profit and loss statement. Something I’ve already mentioned here on, this webinar. A P& L statement is the basic business reporting that you’ll see in just about any kind of business.

And you probably, if you don’t have this already in your business, you should. But if you don’t have it, you’ve probably seen it in other places at one point or another. And basically, you start simply with the revenue at the top, and it will show all of your revenue. It’ll show all your expenses broken down by category, and then you see the profit at the bottom really simple.

Hopefully it’s profit, but it’s called profit loss because it could also show a loss, obviously. And so profit and loss statements are really the fundamental building block that you’re going to be looking at on a monthly basis, a quarterly basis in an annual basis to evaluate how your business is doing.

is doing. It’s the first thing that a potential acquirer will ask for. It’s the first thing typically the bank is going to ask for if you’re applying for a line of credit or something like that. It is truly fundamental to your business and you want to make sure that you have them and they’re as accurate as possible.

We’ll talk a little bit later about some of the specific ways you want to break it down and some of the specific things that you want to include in it to make sure that it’s as useful as possible. But just know that this is the basic building block of your financial reports as a business. Balance sheet.

So this is something, that, that you will often have, produced by your accountant as well. and your balance sheet is going to have, information. I see that someone has, raised their hand. If you can just submit questions through the, the Q& A and I can try to address them as we go through here.

That way, and or take them at the end as, as we’re able to, so from a balance sheet perspective, what you’re basically getting there is your assets and liabilities. So if you think about this in personal finance terms, your liabilities would be things like mortgages, credit cards, that sort of thing.

You have the same sort of thing with your agency business. You have liabilities that you may have in terms of money that’s owed to vendors, to taxing authorities. To credit cards. You might have a line of credit. All of these kinds of things would be your liabilities. Your assets would be the same kinds of typical things that you might have again, in your personal life, checking account, savings account, you might have some sort of a longer term investment vehicle. Most small agencies don’t have that, but it’s some do and some have rainy day funds that are set up in longer term of investments, mutual funds, those kinds of things. But mostly it’s going to be your banking and checking.

It’ll also be any outstanding invoices that you’re owed. Those would typically be listed as assetsas well. And then you’ll also see on your balance sheet that is typically included, an equity line, which shows basically, what your equity in the business is, frankly, that’s something more to work with your accountant on doesn’t tell you all that much, as a lay person about the business itself, but you really want to focus on, the liabilities and assets side of things so that you understand how much do you owe?

How much are you owed? How much do you have in the bank? This is what helps you to understand your day to day decision making around cashflow and be able to spot issues with, Hey, I don’t have enough money in the bank to cover payroll in a month. So I need to figure out how to make sure that that cash is continuing to flow in there.

So that’s really the purpose of your balance sheet. And from an acquisition standpoint, if you were required, your balance sheet would typically be used to try to, to figure out how much of the, the purchase price is actually paid to you, how much, you know, gets washed out by, cash that’s, that’s, owed or on the books or liabilities, those kinds of things.

So it has an impact on the acquisition side of things as well. EBITDA, this is something that I’m sure many of you have heard of and you’re like, what is that? And so EBITDA is earnings before interest, taxes, depreciation, amortization. Basically the simplest way to think of EBITDA, it’s your profits, right?

It’s, it’s your profits before you pay any taxes on those profits. So whenever we talk about profits in agency terms, we’re always talking about pre tax profits. We’re not talking about how much you put in your pocket after the business has paid out its income taxes or more commonly, you’ve paid it out of your own pocket, because in the U. S. most agencies are structured from a tax perspective in such a way that the owners themselves, pay the taxes, on the business. They are, pass through entities from that, from a taxing perspective. But in any case, your profits are, are pre tax. When we say EBITDA, we’re typically talking profits, most agencies don’t have a lot of things that impact it, from the, the other parts of, of the EBITDA, it’s really the T that is the most important, in, the case of most agencies, because most agencies, particularly today where so many are virtual, there aren’t a lot of fixed assets, that are owned that would be dealing with things like depreciation, amortization, and all that kind of stuff.

Gross versus fee income. And, and you’ll also hear, I call it fee income. Some other advisors, you’ll hear call it, agency gross income. I don’t like that because that’s, that’s AGI, which is also adjusted gross income, which is a different thing. It’s not exactly the same. So, but let’s understand gross versus fee income.

So basically fee income is anything. It’s exactly what it sounds like. It’s the, the fees that you are paid by your clients. But some clients, particularly if you do advertising or other things, events, they may pay you more, they may pay you things that pass through to pay for the advertising. So particularly if you’re a pure advertising agency, you will typically be receiving, a substantial amount of revenue from your clients, which really just sits on your books temporarily before it goes to pay, Google or a magazine or a newspaper or something like that.

You get a commission on it, and that commission is part of your fee income, but the, the money that simply passes through your agency, would go into the gross income category. When you’re assessing the size of your business, it’s really the fee income that matters. Because if you’re, I mean, I can funnel all sorts of money through my books that just sits there temporarily and moves on.

It can make my total revenue number, my gross income number look really big, but it’s not really an accurate picture of what’s going on in the business. So anytime you’re, you’re looking at your business, you really need to be focused mostly on the fee income, because that’s the money that you have, that you get to choose jow to spend it that helps you to control what your profits are and ultimately as an owner how much you’re putting in your pocket

Another gross item here gross versus net margin.

So your gross margin would be You take your total revenue and you subtract out the expenses that are used for the delivery of those services. So for example, if I have got a client who’s paying me 100, 000 a year and I’m spending 50, 000 on contractors and vendors and labor costs and all that that are devoted specifically to that client, I subtract that out.

Basically anything that I wouldn’t spend if I didn’t have that client, right? That’s the easiest way. If you would not spend it, without that client, that’s an expense that you would subtract from the revenue. That gives you your gross margin. Your net margin factors in all the costs of doing your business.

So, your gross margin might be 50%. In other words, you might spend 50, 000 to service that 100, 000 client. Your net margin, though, your net profit is going to be that 50, 000 of gross profit, but subtracting out the cost of overhead of the business. We’ll talk about overhead in just a minute. But we’ll, we’re taking out the, the costs of management and bookkeeping and benefits and business development and marketing and all of these other things that go into your mix that you have to have in order to run the business to keep the lights on.

And that’s what gives you your net margin, your net profit. And that’s typically from an agency wide perspective, what we’re talking about when we say what’s your profit margin? Typically we’re talking about your net margin, your net profit, not your gross margin or gross profit. The gross number still matters, but I’ll talk about a little bit later where that matters the most, and that’s going to be when we’re looking at client and project profitability.

Aging reports. So, in whatever software accounting package that you’re using, it will have an aging report that helps you to understand what invoices are outstanding, that’s your money that is owed to you, and how old are they. You’ve probably looked at these reports. If you haven’t looked at them, I would encourage you to look at them on a regular basis because it can help you to understand how timely are your clients paying because you always want to be monitoring those aging reports so that you can spot any of those slow payments so you can address them sooner rather than later. And I’ll talk specifically about some of the standards that I look at when I am, working with agencies to understand, the importance of the aging report and what it’s showing me about the health of their business.

Overhead, I’ve already mentioned this. So overhead is also sometimes called G&A or General and Administrative. But basically it is all of those things I talked about, the keeping the lights on things, whether that is rent or internet service or any of the administrative functions that you have as a business, your bookkeeper, your accountant, those kinds of things.

All of those expenses go into the overhead or general administrative. And those are the things that you would have, the expenses that you have regardless. of whether you have a client. So it’s not something where if you have a client goes away, you would make an appreciable dent typically in your overhead and G&A expenses.

So that’s the best way to think of that. It’s just that the general expenses of running the business separate and apart from any client service that you might be doing. It does include sales and marketing activities that does factor into the overhead piece of it. So that’s where that number would go.

Although we’ll talk a little bit later because I like to track that expense separately, as well. But the overhead does include that when you’re looking at it from a net profit perspective, which we were talking about before. All right, let’s talk about some of the benchmarks that are commonly thrown around, the things that we take a look at, in our agency community to understand the health or success of a business.

And so some of the most popular benchmarks that you may hear people talk about are things like gross margin, and you need to have a gross margin of 50, 60, 70%, whatever it is, and different people will throw out specific benchmarks. They’ll talk about profit margins, and you know, you might hear that you need to have a profit margin of 20 to 30 percent in order to be a successful agency.

There are also growth margins. In other words, what is, what is the rate of growth rates rather? So what is the rate of growth of your business? How much revenue are you adding year over year? And sometimes folks will say there’s a certain minimum percentage of growth that you should have to be healthy.

Also, revenue per employee is a very popular one. So you’ll hear as a PR agency, you ought to have a, revenue per employee of 150, 000 to 250, 000 per person, per employee. You’ll hear benchmarks around employee utilization and what different titles should have as far as utilization. In other words, utilization is the percentage of time that they’re spending actually servicing clients.

So some will say that a very junior employee should be 85 to 90 percent utilized or sometimes referred to as billable. And so those are, those are benchmarks that you’ll often hear. What I will tell you about benchmarks is that you need to be very, very careful. Because benchmarks vary in their effectiveness, depending upon a lot of specific items within your business.

Let’s take revenue per employee. If you look at some of the lists of the largest agencies in the world, let’s take PR for example, and you look at the O’Dwyer’s report that they put out each year on the largest independent agencies in the United States. And if you go through there and you look at the total revenue numbers and the employee headcount numbers, you’ll see a giant difference in what those numbers show from a revenue per employee basis.

Does that mean that just because one has a higher revenue per employee, it’s that much better than the other? In other words, if it shows 250, 000 in revenue per employee and another agency shows 125, 000, does it really mean that that agency is twice as good, twice as profitable? The answer is probably not.

In fact, sometimes you’ll do those and you’ll take a look and you’ll see that the numbers are astronomically high from a revenue per employee standpoint. And that’s often because they have a slightly different business model. And maybe they have some additional lines of service or maybe they use contractors heavily so their actual employee headcount is lower.

There are a lot of things that go into the mix here. And, and frankly, even if you took those things out of the mix, revenue per employee for an agency where you’ve got an office in New York City and everybody works in the office and lives in New York City and has a high cost of living, and you have high expenses from a business perspective there as well, your revenue per employee needs to be higher to put the same amount of money in your pocket as an owner.

Versus someone who is in, say, New Hampshire, where I live, where you have much lower cost of living, much lower business expenses, much lower cost for office space and those kinds of things. Then you start throwing remote agencies into the mix. It becomes even more murky. So you really need to be careful about looking at some of these, you know, industry standards, if you will.

And I think you need to pay some attention to them. You need to understand generally speaking what they are, but I wouldn’t be making decisions in a vacuum based just on what you hear other people might have. And in particular, you need to be careful about some of the vanity metrics or vanity benchmarks that are out there.

And these are the kinds of things that the people love to share at cocktail parties or networking events. So you know, geez, we’re, we’re a 5 million agency, we’re a 2 million agency, we’re a 10 million agency. Oh, we just hired our 25th employee, and we’re going to have 30 by the end of next year. Who cares what your revenue and your number of employees are?

That’s pure vanity. It doesn’t tell me anything about the health of your business. It doesn’t tell me about how good your work is. It doesn’t tell me about what your profits are because nobody talks about their profit margins typically. It doesn’t tell you anything about how much you’re putting into your pocket as an agency owner and how that compares to your own personal goals.

So be really careful about these vanity metrics and don’t get sucked in by watching some YouTuber who’s talking about, you know, building a 10 million agency. I’ve seen plenty of 10 million agencies that have absolutely awful profit margins. And in fact, there are many cases where the owner of a 10 million agency is putting less money in his or her pocket than someone who’s got a 1 or 2 million agency.

So don’t get all wrapped up in these numbers, focus on your own books, your own trends, your own needs. And we’ll talk a little bit more about that later as well, because I think it’s just so vitally important. So if I’ve told you some of the things that don’t matter, and you shouldn’t focus on some of these benchmarks that people like to talk about, the vanity metrics, what should you be focused on? And the first thing is the most important, and this is, let’s set aside the finance side of things. When I work through my AIM-GET framework with agency owners, when I begin to work with them, the A is for ambition, and that’s because I want to know what your goals are as an agency owner.

If I know what your goals are, I can help you to achieve them. You need to know and understand your own goals. What do you want from the business? How can the business help you to achieve your own goals? What do you have for minimum compensation requirements? What’s the, what’s the minimum number you need to put in your pocket in order to pay the bills to keep your family supported?

That’s an important number. That’s a number that your, your financial reporting should be driving you towards being able to make sure that you’re able to attain. But you also want to know what are your stretch goals? What are your, what are your goals for exiting succession? Those kinds of things. How do your financials need to match up with that?

And what questions can you get answered by effective financial reporting to help you achieve those goals? So if you don’t know your own goals, You’re never going to be able to get the most out of your financial reporting. So make sure that you start there. The second thing when it comes to financial reporting is worry a lot less about what the benchmarks are that someone else says you should be achieving and instead focus on the trends.

Are you improving the amount of revenue per employee over time for your agency? Or is it decreasing? Those tell you things. I still wouldn’t overreact if you saw that your revenue per employee was decreasing that would simply lead to the follow up question which is why and maybe there’s a good reason behind it Maybe there’s a good story to be told but use your financial reporting to look at trends focus less on You need to have 20 percent annual growth in order to be successful.

Instead, focus on what is your annual growth? What is your quarterly growth? Are you consistently growing? If you’re not growing, what’s holding you back? How can you knock down those obstacles? Can you explain dips in your revenue? What lessons can you take from it? So the trends that you can see in your financial reports will tell you more than any other benchmark could ever hope to do for you.

You need to see that directionality, and by looking at your financial reporting on a regular basis and making sure that it is accurate, you will see those trends, and it will allow you to make much better decisions much more quickly. So focus on that. You also need to understand your true profit margin.

I think this is, this may be the most important. piece of today’s webinar, because I talk with a lot of agency owners and they will either say, I don’t know what my exact profit margin is, or they’ll throw out a number. And typically they’re wrong. They’re just straight up wrong. Because the problem with understanding your true profit margin is it is in most small agencies, it is driven substantially by your own compensation.

As an agency owner. And I have some other webinars where I talk about owner compensation and those kinds of things there are plenty of resource sources on the SAGA website that I would encourage you to look at in terms of how to think about compensation, but let me just boil it down as quickly as I can so I don’t go over and have plenty of time for the questions I see are coming in. From a compensation perspective you need to be paid for two things. You need to be paid for the work that you’re doing. On behalf of the agency and its clients, and you need to be paid or compensated for the risk that you’re taking as an entrepreneur. So that means that you need to have what is equivalent to a salary, and it may well not be a salary.

In most jurisdictions, your financial advisor is going to tell you either to take no salary or minimize your salary for tax purposes. That’s fine. I don’t, do what you need to do from a tax perspective. But you need to be honest with yourself, and you need to factor into your management accounting reports what your actual compensation is for the work that you’re doing.

In other words, how much would you have to pay someone else to do the work that you’re doing? That’s, that’s the simplest way. There’s a lot more things that go into it if you want to get a true, fair compensation number, but just start there. And if you factor that in, that’s typically going to lower the profit margin that most agencies tell me they have when I first start working with them.

Because most of them are either not paying themselves fairly or they’re not paying themselves at all. And so they’re just saying that everything is profit that goes into their pocket. But you have those two streams. And the only way that you’re going to make really good decisions about how to grow the agency, how to price your work, how to invest in business development, is if you understand what your true profit margin is.

So make sure that you’re getting that right, largely by making sure that you are accurately compensating yourself, at least on paper in those management reports, so that you know what it costs for you to be helping those clients. Because there’s nothing worse than when I go into an agency. And I, they tell me, yes, we’ve got a 35 percent profit margin.

We’re doing great. And I’m like, that’s fantastic. Great. And then the owner says, but you know, I just, I feel like I’m just, I’m working too hard. I’m doing too much work. You know, we’ve got these projects coming and I have to do them because I can’t afford to pay someone else to do it. If you’re truly tracking your own compensation correctly, you will never tell me that you’re doing work because you can’t afford to pay someone else to do it.

Because your time is, or ought to be, more expensive than anyone else that you’re paying to do work for your agency. So make sure that you’re getting that true profit margin by accurately doing all of your accounting, but particularly your own compensation. The other place that I see agencies trip up on, and I think you ought to be focused on, is what is your cash reserve?

And your cash reserve ought to be a minimum of three months of operating expenses. So if all of your clients went away and you were able to shed all of the costs related to servicing those clients, do you have enough cash in the bank to just keep the lights on to do the bare minimum that it takes to keep the business alive for at least three months?

Obviously it’s never quite that simple and generally speaking never quite that drastic, but that’s how you think about it in terms of how much is that number. And if you could survive for three months with a really catastrophic hit to your revenue, you’re going to be generally in a position where you can make more intelligent decisions.

If something bad happens, right? Because part of the reason why agencies have real struggles when they lose a big client or a group of clients is because they don’t have the runway. And so they have to make decisions in a panic. If you have a good solid cash reserve, it allows you to make rational decisions to think through how can I downsize my operation in a reasonable fashion?

How can I continue to invest in business development, even as I’m trying to curb my expenses, right? So I can bounce back more quickly. That cash reserve gives you that room, that space to make more intelligent decisions and not make those panicky ones that often can have a much longer term, much more damaging impact on your business.

I would also tell you that you need to be looking at your client and project profitability. So we’ve talked about P & L’s. We talked about balance sheets. These are all things that at the enterprise level at the business level, but you’re making a mistake if that’s the only kind of financial reporting that you’re looking at. You need to look at the individual component parts.

And that is the individual projects and clients that you serve and how profitable that work is. Because if you don’t know what your most profitable clients are and you don’t understand. You know, whether going out of scope on some of them is causing them to be either unprofitable entirely or just not as profitable as they should be, then you’re going to be in a position where you can’t make the best decisions about what kind of clients to pursue, about how to draw the line more effectively on scope creep, about how to educate your team on scope creep and staying within scope, right?

So you need to make sure that in addition to these, these business wide financial reports that you’re doing, you need to have individual client and project profitability reports that you’re keeping track of and that you have whoever is the account lead managing so that they can understand how profitable that work is.

It helps you with, with, with everything from the day to day management to your overall position, right? Your positioning as an agency, ideally should be driven around finding clients who you can do work that is really, superior work for them that gets them the results they need, but it’s also profitable for you to deliver.

And if you don’t have this kind of breakdown, the individual client and project profitability, you can’t make that decision as intelligently as if you’re looking at just the enterprise level reports. So do that. And I have webinars, resources, workbooks, all sorts of things. on project profitability because I think it is just so vitally important and makes such a giant difference in the overall success of your agency.

Another thing that you want to be thinking about when you’re doing financial reports is that you need to understand that you’re selling time. And I, I know that, that a lot of folks will say, well, you can’t do billable hours because if you, if you bill by the hour, it’s going to be a problem. You’re never going to be able to hold yourself, but you need to do value pricing and all that kind of stuff.

We’re not talking about pricing today. Again, I’ve got webinars and other trainings on, on pricing. At the end of the day, we’re talking about financial reporting here. And your financial reporting needs to understand, and you need to understand, that you are fundamentally selling time as an agency. At least the vast majority of you are.

The vast majority of you do not have a piece of software or a physical product or something like that that you’re selling. You are simply taking the time of your employees and contractors and yourself And you’re marking it up in such a way that you can charge a client more. And they should be, it doesn’t mean you have to bill them by the hour.

It doesn’t mean you have to tell them how many hours you’re working. But from a financial reporting perspective, you need to understand that you’re selling time. And the only way that you’ll be profitable is if you’re able to charge more for that time than that time costs you. Partially you get that from those, those project reports that we’re talking about, but you also need to make sure that you have some component of time tracking to help you with your financial reporting.

Because if you don’t know how your team is spending its time, then you don’t truly know what the cost is. And if you don’t know what the cost is, there’s no way you can price it correctly. And that doesn’t matter whether you’re billing by the hour, as lawyers do, and by the way, make a lot of money doing it that way, or use value pricing, or fixed fee pricing, or cost plus, all these different models that you can use out there.

You need to recognize you are selling time, and you need to track that because that’s a key financial metric for you. And finally, you need to know the questions that you want the answer to. And the reason why this is important is because otherwise you will create elaborate financial reports, you’ll pay your bookkeeper to break things down into a gazillion different categories that you’re never using.

And one of the mistakes that I often see made is, setting up profit and loss statements with a million different categories that make things so complicated that it takes away the ability to do things accurately, but more importantly it takes away the ability for you to truly see things. Because if you’ve got a category where you’ve only got one expense that ever goes in there, and it’s not a substantial one, that doesn’t tell you anything.

It needs to be rolled up with other like expenses so that you can see. And so you typically want to be looking at things in larger buckets that can tell you something. And you can always break it down into component parts. But you need to start with, What questions am I trying to answer? What information do I need from my reports?

Then you build your categories around that. Then you build your reports around that. You build the frequency of those reports around that. In general, I think you should be looking at some of your numbers on a monthly basis just to make sure that, you know, there are no big bad things that are, that have immediately cropped up that you can nip in the bud, but you should be taking a much more thorough deep dive on a quarterly basis and a really thorough dive every year on your numbers. And you need to understand what am I looking for in here?

What do I want to do with this? And we’ve talked about some of the questions that you can ask and get answered, but be specific about what you want from it. Because that’s how you’ll get the most out of it. And you need to communicate that to your bookkeeper, your accountant, whomever you’re working with to pull these numbers together.

So, let’s take a look at what I look at when I’m first going into an engagement with an agency to help them either reset their business or just take it to the next level or just give them an assessment of how things look. So the things that, that I immediately look for when I’m asking for the financial reports is I want to know the revenue.

The reason why I want to know the revenue is, is not from a vanity perspective, but just because it gives me a good baseline to understand, right? If, if a business is making, or generating 250, 000 to 300, 000 in revenue a year, I’m not going to bother with some of the more detailed type, analyses that I might do if, if it’s at 2 or 3 or 4 million a year because there’s just when you’re at a smaller revenue number, there’s just less insights that you can draw because such small things will change and we’ll move the needle much more significantly. And it doesn’t necessarily mean that it’s as big a deal. So I need to know fundamentally what kind of, what size business am I looking at?

so that I can then ask the right followup questions. I then typically look at liabilities. I want to know on the balance sheet how much is owed. And typically I’m looking to make sure that the business isn’t saddled with a lot of debt, either for credit cards, lines of credit, loans, that sort of thing.

In general, agencies shouldn’t be running with much in the way of liabilities. I do not encourage the use of lines of credit or loans or credit cards to grow the business. They should be there simply for emergencies to, to make smoother the transition. If you’ve got a client that that goes away and you just need to pay out some severance and just kind of you know, even things out or you’ve got a client who’s slow to pay.

That’s what lines of credit are for. They’re not for making a giant investment, hiring a new employee because you think that they’ll be able to generate business or you think that you might be able to launch a new line of business. That needs to be done out of cash. It needs to be done out of the actual revenues that you have from the business, not from money that you, that you owe to someone else.

That’s why I look at liabilities because I want to make sure that there’s not something, there’s not a headwind on the liability side of the equation that will impact things. I then look at cash on hand again from the balance sheet to make sure that, you know, there is cash in the bank to weather some kind of storm, it may not be three months or six months, it might just be a month, but understanding how much flexibility there is in the business to handle bad news is useful.

I do look at that aging report. I want to know unpaid invoices and particularly I want to know unpaid invoices over 90 days, because in my experience, once you get past the 90 day point on that aging report, your odds of being paid drop dramatically, particularly if it’s, if it’s someone who is not an active client with you today.

And so if I’m working with a new client and there’s stuff in that, that over 90 a column, and it’s not an active client, they’re going to have to convince me. with, with some sort of real information that that’s, you know, not just a bad debt that needs to be written off. And so that’s something I look at very closely.

We’ve already talked about owner comp, but I always ask about that. I need to know how you’re compensating yourself because it impacts, as we’ve talked about, so much on the, the profit margin side of the equation. Labor costs. I want to know, how much you’re spending on labor, what the mix is between employees and contractors, tells me how the business is structured, but it also starts to help me understand if it’s wildly different from about 50 percent of revenue, why? Is there something different about the model?

So I usually use that 50 percent as the rough neighborhood that I’m looking for labor costs to fall into. And I don’t, I don’t draw any conclusion if it’s not in that 50 percent neighborhood, but I do start asking more questions. And finally, with all of this information, I then start looking at what your profit number is and understand how does that profit percentage, generally speaking, stack up.

And I also want to look at the trends for all of these numbers, but particularly profit, to see how has it been performing, particularly the last three years. The three year number is the way that most people are going to evaluate the finances of your agency, whether it’s from an acquisition standpoint, a lender standpoint, those kinds of things.

All right. We’re just about to the getting to the Q& A section. but I do want to just raise a couple of things on your P& L that I would like to make sure that you all are thinking about on the revenue side. I think it’s important to make sure you’ve got a breakdown between recurring and project revenue.

You don’t need to have a category for every service that you offer necessarily. You might want that, but, but the bottom line one is you need to be able to tell the difference between your recurring and your project revenue because understanding that mix for most agencies is going to be important to your decision making process for the kinds of things that you’re doing.

And if you see that project revenue is climbing up. And recurring is going down. That tells you, geez, you know, I either need to focus more on recurring or maybe the market is speaking to me more that they want project, right? So you need to understand that split in particular, but there may be others that you want as well.

But that’s where I would start. If I was just building a P&L for an agency today from scratch, just have recurring and project as the two main categories. Again, we talked about labor costs. Make sure that you’re accurately tracking that and blocking it together. Understand what your sales and marketing costs are.

Have that in a separate grouping within your chart of accounts. that’s a term we haven’t talked about yet, but your chart of accounts basically is just your expense categories and your revenue categories. You want to make sure that you can easily spot what you’re spending on sales and marketing, whether that’s sponsorships, CRMs, Email programs.

If you have a marketing person on on staff, whatever it is, you want to make sure that you’re tracking that. And then finally, G&A or overhead costs. Those are those are the four main things I would be looking at if I were creating a P&L for an agency from scratch today. But again, you want to then dig deeper based on the specific questions that we’ve talked about.

Let’s see just a couple of parting thoughts here and then I will get to the Q and A. So if you have questions, you are here live. Make sure that you’re submitting them through the Q and A function and I will try to get through as many of them as I can. I see again that some have already started to come in, so we’ll get to that in just a moment.

Don’t overcomplicate your financial reporting. Keep it simple. If you’re not going to use the data, don’t collect it. This is really true for all of your reporting as an agency. I see all sorts of stuff, time tracking in particular. This is a huge problem where I see agencies put together these really detailed categories and subcategories for how employees spend their time, but then they never actually use that data.

If you’re not going to use the data on your financial reports, you shouldn’t be bothering to collect it. So work with your professionals. and trust your professionals to put together the kinds of reports that you need. Make sure they understand what you need from a management perspective. They’ll help you make sure that you understand what they need for preparing taxes or doing other things, whatever filings they may have, and you need to trust them.

You need to trust them from the beginning. You need to, in other words, hire people that you trust. If you tell me that you do not trust your accountant or your bookkeeper, get a new one. Because you need to put your, your trust in them to advise you properly to help you put these things together. They need to know what you’re trying to achieve, but they need to help you get there and you need to trust that they are in a position to do the things that you need to minimize your tax burden, to maximize your profitability.

They should be there to help you and good ones will absolutely, they’re worth their weight in gold if you find the right one for your business that understands what you’re trying to accomplish. And then finally, I would say, make sure you’re focused on yourself. I, I often say it, it’s valuable to be selfish as an agency owner.

You don’t take on all of the risk and stress of being an owner unless you’re getting what you want from it. And in terms of financial results, that means how much money you’re putting in your pocket, whether you call that compensation, your pay for the work that you’re doing, or you call it profits and draws and dividends or what, I don’t care what you call it, are you putting the money in your pocket that you deserve for the risk and the work that you’re putting in?

And if you are, then you’re setting yourself up for success. If you’re not, you’re setting yourself up for misery. So make sure that you’re using these financial reporting, these financial structures to drive towards getting you what you need, what you want from the business. Is it selfish? Yes, but it’s an important kind of selfish because the selfish that helps the business grow and if the business grows because you’re getting what you need from it, Then it’s going to help all of your employees.

It’s going to help all of your clients. If you are struggling, if you are not getting what you need from it, if you’re not getting what you want from it, you are not going to be able to invest yourself into the business in the same way. And so the results will be worse for everyone. So, yes, it’s selfish, but it still pays off for everyone around you.

So, absolutely something that you need to make sure you’re doing. Focus on yourself. So, that will wind up the prepared portion of this presentation. I tried to pack in as much as I could here, in today’s session. Hopefully, I’ve given you a pretty good overview of some of the key things to be looking at, thinking about in terms of agency finances.

I know that you all may have other questions. Some of them may be very specific to your business. I’ll try to jump in here in a minute and start answering some of the general questions. but if you are watching this on replay or you’re watching it live and you want to talk through any of these things with me, feel free to drop me an email, or we can set up a free consultation.

there’s a button on the website for that, whatever, however I can be most useful to you in understanding your agency’s finances and putting yourself in a position for success. I want to be doing that. So. With that, we will now shift over to the Q& A function for people who are here live. If you’re watching on replay, this will conclude the replay.

Thank you all for watching. Again, drop me an email at chip@smallagencygrowth. com. If you have any further questions or join the community on Slack, we’d love to have you there as well. And again, that is absolutely free. So I’m going to grab a sip of water and we will jump into the Q& A for live participants.