©copyright 1999-2017, The Retail Owners Institute®

The Myth of the Bottom Line

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? 

Myth of the Bottom Line

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.

Profit Management—The Income Statement

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

Total Sales
$1,000,000
 Cost of Goods Sold
 - 700,000
 Gross Margin
 300,000
 Total Operating Expenses
 - 280,000
 Operating Profit
 20,000
 Other Income (Expenses)
 - 10,000
 Profit (Loss) Before Tax
 10,000
 Income Tax
 - 2,000
 NET PROFIT
 $8,000

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.

Strength Management—The Balance Sheet

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. 

Financial Statement linkage

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

12/31/XX

Assets     Liabilities
 
 Cash  3,000        Trade Accounts Payable
169,000
 Accounts Receivable
 80,000    Short-Term Notes Payable
 69,000
 Inventory  250,000    Accrued Expenses
 40,000
 Total Current Assets
 333,000    Total Current Liabilities
 278,000
 Furniture & Equipment
 34,000    Long-Term Liabilities
 -0-
 Accumulated Dereciation
 (12,000)    Total Liabilities
 278,000
 Net Fixed Assets
 22,000    Equity  
       Capital Stock
 75,000
       Retained Earnings
 2,000
       Total Equity
 77,000
         
 Total Assets
 $355,000    Total Liabilities + Equity
 $355,000


Dispelling the Myth

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!

Keeping A Balance

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).

I. M. Surviving(?!) Co. Balance Sheet

12/31/XX

Assets     Liabilities
 
 Cash  3,000    Trade Accounts Payable
169,000
 Accounts Receivable
 80,000    Short-Term Notes Payable
 67,000
 Inventory  252,000        Accrued Expenses
 40,000
 Total Current Assets
 335,000    Total Current Liabilities
 276,000
 Furniture & Equipment
 38,000    Long-Term Liabilities
 -0-
 Accumulated Dereciation
 (12,000)    Total Liabilities
 276,000
 Net Fixed Assets
 26,000    Equity  
       Capital Stock
 75,000
       Retained Earnings
 10,000
       Total Equity
 85,000
         
 Total Assets
 $361,000    Total Liabilities + Equity
 $361,000

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 Does "The Bottom Line" Matter?

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.

 


©Copyright, The Retail Owners Institute® and Outcalt & Johnson: Retail Strategists, LLC.


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