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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." Vendors of all sorts tout their products and services as sure-fire ways to grow profits. 

Yet, sadly, many owners are puzzled by questions like these:

What IS profit? 

Where DOES it go? 

WHY is it important? 

 

Alas, these good questions have launched many myths. It's time to get to the bottom of all this!

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 this:

- where has this net profit gone? 

- how does it affect 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. 

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

 

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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. 

For instance, assets may have increased $8,000, so that’s really where the profit is! 

This cause-effect-cause-effect connection dramatically affects the overall financial strength of a business. 

 

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.

 

Let’s look at Surviving’s balance sheet (below).

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.

 

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.

 

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