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ARE YOU MAKING A PROFIT?
Making a profit is the most important--objective of a business. Profit can
be simply defined: Revenues - Expenses = Profit. So, to increase profits
you must raise revenues, lower expenses, or both. This checklist is a
series of questions with comments to help you analyze your profits. This
material is not meant to be a definitive presentation on the subject.
However, it may help you identify areas where further study might be, well,
Analysis of Revenues and Expenses
Since Profit equals Revenues less Expenses, to determine what your profit
is, you must first identify all revenues and expenses for the period under
1. Have you chosen an appropriate period for profit determination? Yes or
No For accounting purposes firms generally use a twelve month period, such
as January 1 to December 31 or July 1 to June 30. The accounting year you
select doesn't have to be a calendar year (January to December); a seasonal
business, for example, might close its year after the end of the season.
The selection depends upon the nature of your business, your personal
preference, or possible tax considerations.
2. Have you determined your total revenues for the accounting period? In
order to answer this question, consider the following questions:
- What is the amount of gross revenue from sales of your goods or services?
- What is the amount of goods returned by your customers and credited?
(Returns and Rejects)
- What is the amount of discounts given to your customers and employees?
- What is the amount of net sales from goods and services? (Net Sales =
Gross Sales - [Returns and Rejects + Discounts])
- What is the amount of income from other sources, such as interest on bank
deposits, dividends from securities, rent on property leased to others?
- What is the amount of total revenue? (Total Revenue = Net Sales + Non-
3. Do you know what your total expenses are?
Expenses are the cost of goods sold and services used in the process of
selling goods or services. Some common expenses for all businesses are:
- Cost of goods sold (Cost of Goods Sold = Beginning Inventory + Purchases
- Wages and salaries (Don't forget to include your own--at the actual rate
you'd have to pay someone else to do your job.)
- Utilities (electricity, gas, telephone, water, etc.)
- Supplies (office, cleaning, and the like)
- Delivery expenses
- Advertising and promotional costs
- Maintenance and upkeep
- Depreciation (Here you need to make sure your depreciation policies are
realistic and that all depreciable items are included.)
- Taxes and licenses
- Bad debts
- Professional assistance (accountant, attorney, etc.)
There are, of course, many other types of expenses, but the point is
that every expense must be recorded and deducted from your revenues before
you know what your profit is. Understanding your expenses is the first
step toward controlling them and increasing your profit.
A financial ratio is an expression of the relationship between two items
selected from the income statement or the balance sheet. Ratio analysis
helps you evaluate the weak and strong points in your financial and
4. Do you know your current ratio?
The current ratio (current assets divided by current debts) is a measure of
the cash or near cash position (liquidity) of the firm. It tells you if
you have enough cash to pay your firm's current creditors. The higher the
ratio, the more liquid the firm's position is and, hence, the higher the
credibility of the firm. Cash, receivables, marketable securities, and
inventory are current assets. Naturally, you need to be realistic in
valuing receivables and inventory for a true picture of your liquidity,
since some debts may be uncollectable and some stock obsolete. Current
liabilities are those which must be paid in one year.
5. Do you know your quick ratio?
Quick assets are current assets minus inventory. The quick ratio (or acid-
test ratio) is found by dividing quick assets by current liabilities. The
purpose, again, is to test the firm's ability to meet its current
obligations. This test doesn't include inventory to make it a stiffer test
of the company's liquidity. It tells you if the business could meet its
current obligations with quickly convertible assets should sales revenues
6. Do you know your total debt to net ratio?
This ratio (the result of total debt divided by net worth then multiplied
by 100) is a measure of how the company can meet its total obligations from
equity. The lower the ratio, the higher the proportion of equity relative
to debt and the better the firm's credit rating will be.
7. Do you know your average collection period?
You find this ratio by dividing accounts receivable by daily credit sales.
(Daily credit sales = annual credit sales divided by 360.) This ratio
tells you the length of time it takes the firm to get its cash after making
a sale on credit. The shorter this period the quicker the cash inflow is.
A longer than normal period may mean over due and uncollectable bills. If
you extend credit for a specific period (say, 30 days), this ratio should
be very close to the same number of days. If it's much longer than the
established period, you may need to alter your credit policies. It's wise
to develop an aging schedule to gauge the trend of collections and identify
slow payers. Slow collections (without adequate financing charges) hurt
your profit, since you could be doing something much more useful with your
money, such as taking advantage of discounts on your own payables.
8. Do you know your ratio of net sales to total assets?
This ratio (net sales divided by total assets) measures the efficiency with
which you are using your assets. A higher than normal ratio indicates that
the firm is able to generate sales from its assets faster (and better) than
the average concern.
9. Do you know your operating profit to net sales ratio?
This ratio (the result of dividing operating profit by net sales and
multiplying by 100) is moat often used to determine the profit position
relative to sales. A higher than normal ratio indicates that your sales
are good, that your expenses are low, or both. Interest income and
interest expense should not be included in calculating this ratio.
10. Do you know your net profit to total assets ratio?
This ratio (found by multiplying by 100 the result of dividing net profit
by total assets) is often called return on investment or ROI. it focuses
on the profitability of the overall operation of the firm. Thus, it allows
management to measure the effects of its policies on the firm's
profitability. The ROI is the single most important measure of a firm's
financial position. You might say it's the bottom line for the bottom
11. Do you know your net profit to net worth ratio?
This ratio is found by dividing net profit by net worth and multiplying the
result by 100. It provides information on the productivity of the
resources the owners have committed to the firm's operations.
All ratios measuring profitability can be computed either before or
after taxes, depending on the purpose of the computations. Ratios have
limitations. Since the information used to derive ratios is itself based
on accounting rules and personal judgments, as well as facts, the ratios
cannot be considered absolute indicators of a firm's financial position.
Ratios are only one means of assessing the performance of the firm and must
be considered in perspective with many other measures. They should be used
as a point of departure for further analysis and not as an end in
Mix Of Profit
The profit and ratio analyses of each major item helps you find out the
strengths and weaknesses in your operations. They can help you make profit
increasing decisions such as to drop a service, product line or to place
particular emphasis behind one or another.
Sufficiency Of Profit
Making a profit is only the first step; making enough profit to survive and
grow is really what business is all about. The following questions are
designed to help you measure the adequacy of the profits your firm is
12. Have you compared your profits with your profit goals?
13. Is it possible your goals are too high or too low?
14. Have you compared your present profits (absolute and ratios)
with the profits made in the last one to three years?
15. Have you compared your profits (absolute and ratios) with profits made
by similar firms in your line? A number of organizations publish financial
ratios for various businesses, among them Dun & Bradstreet, Robert Morris
Associates, the Accounting Corporation of America, NCR Corporation, and the
Bank of America. Your own trade association may also publish such studies.
Remember, these published ratios are only averages. You probably want to
be better than average.
Trend of Profit
16. Have you analyzed the direction your profits have taken?
The preceding analyses, with all their merits, report on a firm only at a
single time in the past. It is not possible to use these isolated moments
to indicate the trend of your firm's performance. To do a trend analysis,
performance indicators (absolute amounts or ratios) should be computed for
several time periods (yearly for several years, for example) and the
results laid out in columns side by side for easy compar-ison. You then
can evaluate your performance, see the direction it's taking, and make
initial forecasts of where it will go.
17. Does your firm sell more than one major profit or provide several
distinct services? If it does, a separate profit and ratio analysis of each
should be made:
- To show the relative contribution by each profit line or service;
- To show the relative burden of expenses by each product or service;
- To show which items are most profitable, which are less so, and which are
losing money; and
- To show which are slow and fast moving.
Good records are essential. Without them a firm doesn't know where it's
been, where it is, or where it's heading. Keeping records that are
accurate, up-to-date, and easy to use is one of the most important
functions of the owner-manager, his or her staff, and his or her outside
counselors (lawyer, accountant, banker).
18. Do you have a general journal and/or special journals, such as one for
cash receipts and disbursements? A general journal is the basic record of
the firm. Every monetary event in the life of the firm is entered in the
general journal or in one of the special journals.
19. Do you prepare a sales report or analysis?
(a) Do you have sales goals by product, department,and accounting period
(month, quarter, year)?
(b) Are your goals reasonable?
(c) Are you meeting your goals?
If you aren't meeting your goals, try to list the likely reasons on a sheet
of paper. Such a study might include areas such as general business
climate, competition, pricing, advertising, sales promotion, credit
policies, and the like. Once you've identified the apparent causes you can
take steps to increase sales (and profits).
Buying and Inventory System
20. Do you have a buying and inventory system?
The buying and inventory systems are two critical areas of a firm's
operation that can effect profitability.
21. Do you keep records on the quality, service, price
and promptness of delivery of your sources of supply?
22. Have you analyzed the advantages and disadvantages of:
(a) Buying from several suppliers,
(b) Buying from a minimum number of suppliers?
23. Have you analyzed the advantages and disadvantages of buying through
cooperatives or other such systems?
24. Do you know:
(a) How long it usually takes to receive each order?
(b) How much inventory cushion should you (usually called safety
stock) have to maintain normal sales while waiting for orders to arrive?
25. Have you ever suffered because you were out of stock?
26. Do you know the optimum order you need for each item you need?
27. Do you (or can you) take advantage of quantity discounts for large-
sized single purchases?
28. Do you know your costs of ordering inventory and carrying inventory?
The more frequently you buy (smaller quantities per order), the higher your
average ordering costs will be, (clerical costs, postage, telephone costs,
etc.) and the lower the average carrying costs (storage, loss through
pilferage, obsolescence, etc.). On the other hand, the larger the quantity
per order, the lower the average ordering cost and the higher the carrying
costs. A balance should be struck so that the minimum cost overall for
ordering and carrying inventory can be achieved.
29. Do you keep records of inventory for each item?
These records should be kept current by making entries whenever items are
added to or removed from inventory. Simple records on 3 x 5 or 5 x 7 cards
can be used with each item being listed on a separate card. Proper records
will show for each item: quantity in stock, quantity on order, date of
order, slow or fast seller, and valuations (which are important for taxes
and your own analyses).
Other Financial Records
Creation of financial records is governed by generally accepted accounting
30. Do you have an accounts payable ledger?
This ledger will show what, whom, and why you owe. Such records should
help you make your payments on schedule. Any expense not paid on time
could adversely affect your credit, but even more importantly such records
should help you take advantage of discounts which can help boost your
31. Do you have an accounts receivable ledger?
This ledger will show who owes money to your firm. It shows how much is
owed, how long it has been outstanding, and why the money is owed. Overdue
accounts could indicate that your credit granting policy needs to be
reviewed and that you may not be getting the cash into the firm quickly
enough to pay your own bills at the optimum time.
32. Do you have a cash receipts journal?
This journal records the cash received by source, day and amount.
33. Do you have a cash payments journal?
This journal will be similar to the cash receipts journal but will show
cash paid out instead of cash received. The two cash journals can be
combined, if convenient.
34. Do you prepare an income (profit and loss or P&L) statement and a
balance sheet? These are statements about the condition of your firm at a
specific time and show the income, expenses, assets, and liabilities of the
firm. They are absolutely essential.
35. Do you prepare a budget?
You could think of a budget as a "record in advance," projecting "future"
inflows and outflows for your business. A budget is usually prepared for
a single year, generally to correspond with the accounting year. It is
then, however, broken down into quarterly and monthly projections. There
are different kinds of budgets: cash, production, sales, etc. A cash
budget, for example, shows the estimate of sales and expenses for a
particular period of time. The cash budget forces the firm to think ahead
by estimating its income and expenses. Once reasonable projections are
made for every important product line or department, the owner-manager sets
sales and expense targets for employees. You must plan to assure a profit.
And you must prepare a budget to plan.
A Guide to Record Retention
Organizing, filing and retaining records can be a burden for the small
business owner. The following checklist is a guide to record retention.
This guide provides a timetable for transferring records from active files
to inactive storage and ultimate destruction.
To maintain up-to-date files, develop a retention schedule that
specifies when certain records are to be destroyed. Be sure your record
retention program contains storage and disposal instructions for multiple
copies, including non-paper media such as film, microfilm, computer disks,
carbon paper and carbon ribbons.
This checklist takes into account the more than 900 federal and state
regulations, State statutes on tax and payroll records vary widely,
however. Check with each tax commissioner in the states you conduct
business for further details. The normal statute of limitations on federal
returns is three years. Under some circumstances it is six years.
The Office of the Federal Register, National Archives and Records
Administration has produced the Guide to Record Retention Requirements in
the Code of Federal Regulations. To obtain a copy, contact the
Superintendent of Documents, U.S. Government Printing Office, Washington,
Classification of Accounts (Sample)
Avoid using too many accounts. Break down sales into enough categories to
show a clear picture of the business. Use different expense accounts
covering frequent or substantial expenditures but avoid minute
distinctions, which will tend to confuse rather than clarify. Use
Miscellaneous Expense for small, unrelated expense items.
100-Cash in Banks
101-Petty Cash Fund
105-Materials and Supplies
122-Accumulated Depreciation -- Buildings (Credit)
123-Tools and Equipment
124-Accumulated Depreciation -- Tools and Equipment (Credit)
126-Accumulated Depreciation -- Automotive Equipment (Credit)
127-Furniture and Fixtures
128-Accumulated Depreciation -- Furniture and Fixtures (Credit)
130-Organization Expenses (to be amortized)
207-Federal Withholding Taxes
208-State Withholding Taxes
220-Long-Term Debt-Mortgages Payable
221-Long-Term Debt-SBA Loan
300-Common Capital Stock
301-Preferred Capital Stock
Sales (Revenue) Accounts (Credits)
500-Salaries and Wages
515-Dues and Contributions
RECORDS RETENTION SCHEDULE
Accident reports/claims (settled cases) 7 years
Accounts payable ledgers and schedules 7 years
Accounts receivable ledgers and schedules 7 years
Audit reports Permanently
Bank reconciliations 2 years
Bank statements 3 years
Capital stock and bond records: ledgers, transfer registers, stubs showing
issues, record of interest coupons, options, etc. Permanently
Cash books Permanently
Charts of accounts Permanently
Checks (canceled-see exception below) 7 years
Checks (canceled) for important payments, i.e. taxes, purchases of
property, special contracts, etc. Checks should be filed with the papers
pertaining to the underlying transaction Permanently
Contracts, mortgages, notes, and leases
(expired) 7 years
(still in effect) Permanently
Correspondence (general) 2 years
Correspondence (legal and important matters only) Permanently
Correspondence (routine) with customers and/or vendors 2 years
Deeds, mortgages, and bills of sale Permanently
Depreciation schedules Permanently
Duplicate deposit slips 2 years
Employment applications 3 years
Expense analyses/expense distribution schedules 7 years
Financial statements (year-end, other optional) Permanently
Garnishments 7 years
General/private ledgers, year-end trial balance Permanently
Insurance policies (expired) 3 years
Insurance records, current accident reports, claims, policies, etc.
Internal audit reports (longer retention periods may be desirable) 3 years
Internal reports (miscellaneous) 3 years
Inventories of products, materials, and supplies 7 years
Invoices (to customers, from vendors) 7 years
Magnetic tape and tab cards 1 year
Minute books of directors, stockholders, bylaws, and charter Permanently
Notes receivable ledgers and schedules 7 years
Option records (expired) 7 years
Patents and related papers Permanently
Payroll records and summaries 7 years
Personnel files (terminated) 7 years
Petty cash vouchers 3 years
Physical inventory tags 3 years
Plant cost ledgers 7 years
Property appraisals by outside appraisers Permanently
Property records, including costs, depreciation reserves, year-end trial
balances, depreciation schedules, blueprints, and plans Permanently
Purchase orders (except purchasing department copy) 1 year
Purchase orders (purchasing department copy) 7 years
Receiving sheets 1 year
Retirement and pension records Permanently
Requisitions 1 year
Sales commission reports 3 years
Sales records 7 years
Scrap and salvage records (inventories, sales, etc.) 7 years
Stenographers' notebooks 1 year
Stock and bond certificates (canceled) 7 years
Stockroom withdrawal forms 1 year
Subsidiary ledgers 7 years
Tax returns and worksheets, revenue agents' reports, and other documents
relating to determination of income tax liability Permanently
Time books/cards 7 years
Trademark registrations and copyrights Permanently
Training manuals Permanently
Union agreements Permanently
Voucher register and schedules 7 years
Vouchers for payments to vendors, employees, etc. (includes allowances and
reimbursements of employees, officers etc., for travel and entertainment
expenses) 7 years
Withholding tax statements 7 years