The Library for Owners
©copyright 1999-2017, The Retail Owners Institute®
by Patricia M. Johnson, CMC and Richard F. Outcalt, CMC
Retail business owners are conditioned from day one to "have a profit" and "improve the bottom line". Yet, sadly, most owners aren’t sure exactly why. What IS profit? Where does it go? Why is it important?
Too many myths surround these good questions.
The first thing to learn is that most retail businesses are on the accrual accounting system and, therefore, profit is not the same as cash.
Your profits—instead of going directly into your pocket—are more likely to help you grow your business by paying off debt, investing in store essentials and expanding your inventory.
Using The I. M Surviving (?!) Company as an example, let’s look at how profit is reinvested in your business. You’ll see how profit or loss affects your overall financial picture.
To manage your profit effectively, start by examining your income statement, or profit and loss (P & L) statement. This statement reports the financial accomplishments of your store over a period of time, usually a year. It includes gross sales, related expenses and resulting net profit (or loss) for a selected period of time, as shown in the chart below.
I. M. Surviving(?!) Co. Income Statement
For the Period 1/1/XX - 12/31/XX
As you know, the last line of your income statement will show either a profit or loss. In this example, The Surviving Co. ended up with $8,000 net profit – but not necessarily $8,000 in cash!
What’s really important is where this net profit has gone and how it affects the rest of this store’s financial picture.
The financial strength of your store is not represented by sales nor even profit, but by the composition of your balance sheet.
The balance sheet is a “snapshot” of the financial condition of your store at a particular point in time, usually the end of your fiscal year. It lists what the company owns (assets), what the company owes (liabilities) and the difference between the two, which is the net worth (or equity) of the company.
The balance sheet’s structure is simple. Assets represent the total amount of money you’ve invested in your business (cash, inventory, fixtures, etc.). Liabilities are outstanding debts (bills, loans). Equity is simply the difference between total assets and total liabilities. Think of equity as money not owed to anyone—the owner’s share.
It works the same way as your house. For instance, if your house is worth $300,000 (asset), and your mortgage (debt) is $200,000, your equity is $100,000 ($300,000 minus $200,000.)
Below is an example of The Surviving’s balance sheet for the end of last month.
I. M. Surviving(?!) Co. Balance Sheet
Now, let’s look at how the income statement and the balance sheet work together. Returning to the income statement, we see that The Surviving Co. has a net profit of $8,000. If you think the owners can write an $8,000 check from this ”profit” and take their families on nice vacations, you’re wrong. That $8,000 is an accounting illusion, existing only on paper. So, where does it go?
Imagine a pipe running from net profit on the income statement to a bucket called “retained earnings” on the balance sheet. Your store’s retained earnings are part of the equity section of the balance sheet—this is where that $8,000 net profit (“bottom line”) goes. Retained earnings adds profits to or subtracts losses from the balance sheet.
Remember—your balance sheet must always balance. Therefore, other numbers must change, too. This cause-effect-cause-effect system dramatically affects the overall financial strength of a business. For instance, assets may have increased $8,000, so that’s really where the profit is!
In review, when a business turns a profit, it shows up on the balance sheet as an increase in equity, called retained earnings. A loss would have the opposite effect—reducing retained earnings and equity.
The essence of management lies in how you balance your balance sheet. Again, a balance sheet will always balance—it does so by definition. But how you balance it is up to you. How you “use” your net profit is a vital owner decision.
The Survivings had an $8,000 profit that increased retained earnings (equity) by exactly $8,000. For The Survivings, the balance sheet now balances because the store owner bought more inventory ($2,000), invested in furniture ($4,000) and paid off a short-term notes payable ($2,000). Therefore, the balance sheet balances by a $6,000 increase in assets, and a $2,000 decrease in liabilities.
Let’s look at Surviving’s balance sheet (below).
Notice how the two balance sheets compare. Retained earnings increased from $2,000 to $10,000; the assets increased $6,000, the debts decreased $2,000—and, again, the balance sheet balances.
Why do you need profit? To gain financial strength. So you, rather than the banks, suppliers and other creditors, can actually own at least half of the assets in your business.
Knowing and controlling your bottom line makes for a financially stronger business—one you can bet your bottom dollar on.
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