How many times have you looked in the top of the raku kiln to see if the glaze is bubbling yet? It seems to take forever! I know…. I have lost bangs and part of an eyebrow with my impatience!
If you are familiar with an Income Statement, (aka Profit and Loss Statement, P&L, Statement of Earnings), then you have had the same feeling! You have worked and created and sold your work and, now, you are wanting to know if there is income yet? If you are not familiar with the Income Statement, then let’s dive in.
In the last post, we talked about the Balance Sheet and how it was a “selfie” of your business at one point in time. It told you the cash, accounts receivables, and inventory you had (or your Assets). And, that “selfie” told you the amount of money you owed the bank, your credit cards, your vendors (or your Liabilities) with the remaining amount being the part of the business that was your Equity.
So where does the Income Statement fit in? It is the results of the heart of the business. If you are in business to support yourself with your art, then you are creating and you are selling. There is a cost to creating and there is income related to the sales of your creations.
One formula that is always true in the income statement and one you can count on staying the same is:
Let’s dive into Expenses first!
There are two types of behaviors for expenses: Fixed and Variable. In my world, I remember the Fixed expenses as those checks I write for the things that still cost me if I never produced another piece of art. The electricity for the lights while I sit and brainstorm in my studio and do nothing. The rent I pay for that studio where I am continuing to do nothing but brainstorming or taking that creative nap. So, think of the fixed expenses as the costs you will incur before you start creating. The very basic costs that you would have at any business no matter what product you were creating. There would probably even be some other utilities and salaries for which you could be responsible as you sits and thinks.
The second type of behavior: Variable. Okay, stay with me here because I want to break this down again. There is a semi-variable and a true variable. That is really getting into the grit of the matter yet it bears talking about for a few sentences. Once you start creating, you will need supplies – the wedging table, the wheel, the pug mill, the needle tool, the sponge, …..things that you will use on many different projects and will not be able to tell how much it costs for each project. These are semi-variables….Costs you incur after you quit thinking about it and prepare your place for work. Once you have bought these items, you replace them as they wear out. Let’s pause and see if it helps to explain what the true variable is, in contrast. When I fire up my electric kiln, I know exactly what it will cost to fire that kiln and I can divide that cost by the number of pieces in the kiln to get a round number of the cost to fire each piece to bisque. That is a true variable cost. I would never have incurred that cost if I had not created the piece and I can specifically identify the cost of the kiln firing to a specific piece. Hope that helps! If not, just remember there are fixed costs and variable costs……My intent for the detail was to provide a working vocabulary to you in a new language.
So why do we care about the behavior categories? It matters when you are making a plan for income. If you can figure out what the fixed and variable costs are, you know how much you have to sell to cover the cost of your creations, lights, rent, and your salary, to name a few. But is that all there is? NO! Now we have to get to introduce a couple more concepts.
Gross Margin and Operating Margin!
First let’s discuss Gross Margin. In an Income Statement, Sales are the first thing up. This category includes all the cash (we are assuming a cash basis) that you received for the sales you had.
Next is the Cost of Sales. These are all the costs related to the pieces you sold. They would be variable costs….Costs you would not have incurred unless you were creating to sell for a profit. So, for example, the cost of running the kiln, the cost of the clay, the cost of the glaze, the cost of the labor (usually estimated) to make the piece would be included in here. All of these costs are added up and put into cost of sales because they can specifically be identified as costs that were incurred to make the art you just sold.
Now we have the first subtotal in the Income Statement or Gross Margin. This tells you how much you are making on creating your art. This tells you what is left to apply towards the costs of running the shop, the gallery, the equipment, the salaries, the marketing, the postage, and on and on. If you do not have anything left over at this point, you did not charge enough for your art.
Next concept is Operating Margin. All those fixed costs we talked about earlier and some variable and semi-variable costs get grouped as Operating Costs. These include your utilities, your rent, your marketing, postage, supplies, printer toner, sponges, clay tools, meals you ate while working, travel costs to teach others your special talents, etc. These types of costs would not be included in Cost of Sales, (aka the cost of making the art that sold).
The Operating Margin is what is left over after you have considered all the things you paid for that were not specifically related to making the art you sold. We identified some of them in the previous paragraph. If you didn’t have a positive Gross Margin, then Operating Margin looks even worse. If you had a positive Gross Margin, yet after deducting the Operating Costs, you have a negative Operating Margin, then one of two things need to happen. You either need to consider if you can sell your art for more or check that your costs for making the art or running the studio are the best costs for which you can negotiate.
The next set of expenses is interest and taxes. These are part of running a business yet they have a different character to them. For line items in an Income Statement, you could lay two Income Statements from two differently structured businesses side by side and do some comparisons through the Operating Margin. Usually, these are done on a percentage of Sales basis, yet they would be comparable. As to how you finance your business and whether you are a Schedule C or a Corporation would make the interest you pay and the taxes you pay different, respectively. In comparing the operations of similar business, we would not compare those items as they are personal to each business situation. See an example below:
That is a basic primer on the income statement. It has a formula which never changes!
There are other terms we defined also:Next, we will jump into the Cash Flow Statement, the best statement of all! When you understand the Cash Flow Statement, you are talking the artful accounting language of money! And there is more excitement after that!
In the world of money, which is of interest when we need it, there are three reports that result from the process of gathering all the receipts, numbers, checks, cash, electronic images, paper, paper, paper….. They are the Balance Sheet, Income Statement (or Statement of Profit and Loss), and Cash Flow Statement. I mention the end results first as that is how I feel we create. We see the results in our mind’s eye and then we create it. We may even go so far as to sketch it and put it on a board to use as our guidance so that we can prepare the path there.
Let’s talk about the Balance Sheet. First, think of it as a selfie of your business at a moment in time. Because, like a selfie, in the next second, something changes, and getting that exact selfie moment back is next to impossible because checks are written, deposits are made, supplies are used, payroll is paid, etc.
This formula never changes! Much like you need three things for a glaze recipe – flux, silica, and alumina…..you need the following three things for a balance sheet recipe BUT a glaze recipe can have varied amounts of each to achieve different results. NOT so in accounting…thus is it easier to remember!
Assets = Liabilities + Equity
There are two popular formats for the balance sheet. See the following for two simple examples:
Balance sheets should always balance. If not, don’t call it a balance sheet. If printed and it doesn’t balance, use it in your next raku firing. Remember, the formula never changes!
Next, this is something that never changes either:
Assets – Liabilities = positive (negative) Equity
Hey, what is an “assets”! Okay, these are things you own in your business. And “liabilities”! These are things you owe others in your business. They may be even attached to an asset the business owns, but the things the business owes to others get listed under liabilities. And “equity”! That is the result of the assets less the liabilities. (P.S. a successful business has positive equity.)
Now about the balancing part. This report results from a system used to track money created in Italy during the Renaissance. It was called the double-entry accounting system and is still known as that today. All the “ins” had to equal the “outs”.
So, let’s say you sell a vase. The vase goes out of your business. In return, you plan to get something back – cash. By recording the specifics of the sale of the vase and the receipt of cash, the “ins” would equal the “outs” and the books would balance. A balance sheet can be created. If the report didn’t balance, something had been missed. By the way, don’t fret, we have come a long way and computer programs automatically do this behind the scenes. It is just nice to understand the concepts of the intention of the accounting program, so when it prints a balance sheet that doesn’t balance, and I have seen it done, you can have a reference point from which to start the questions.
Since Balance Sheets are the selfie, you can compare selfies and see how your business is doing. Much like looking at a picture of yourself five years ago and today. Notice any difference? Well, you will learn to notice the differences in the balance sheet selfies as we continue this process.
Let’s read a Balance sheet after we transact some simple business.
Let’s invest $500 cash into our company. Our first balance sheet before we did anything would look like this:
During the next month, let’s buy a kiln and put it on a credit card. Kiln costs $300, paid $100 cash and the rest ($200) went to a credit card. If a Balance Sheet were created right after we bought the kiln, it would look like this and we could put the prior month on there to compare (the most current month is in the first column).
What can we read from the above? Well, the story I see is that Total Assets increased from $500 to $700. Does that mean we were better off? No, you have to finish the second formula of Assets less Liabilities equals Equity to see…….
There was $500 in cash in December with no liabilities. So the company had a positive equity balance of $500. The next month the company bought a kiln to add to their assets and they paid $100 in cash and charged $200 to a credit card. While the things they own or the assets went from $500 to $700, they now owe money to others or have liabilities of $200. So their equity remained at $500. Just because Total Assets went up didn’t mean that the business was better off. We have to look at both the Assets and the Liabilities to obtain a clear understanding of equity.
When talking to financial types of our human race about your balance sheet, you will want to talk in these terms. At the end of the day, they will look at the equity and look at trends over periods of time. Is your equity growing or decreasing? How is that happening? What are the ways your balance sheet can change that will tell you how your business is doing! We will get into that later. Too much of this new stuff at one time can cause you to have a brain freeze!
This is a very simplified look at a balance sheet and assumes we have not incurred any expenses, like rent, payroll, utilities or have made any sales. In other words, there is not an income statement to report yet. I will cover the income statement in the next blog and the effect on the balance sheet and how they work together.
As for today’s blog, remember the following:
Assets = Liabilities + Equity
Assets – Liabilities = Equity
Assets are things you own in your business
Liabilities are things you owe in your business
Equity is the result of subtracting your liabilities from your assets.
Positive Equity is preferable to Negative Equity.
Can it be that there is a connection between art and accounting? Some would say these two words, if used together, would be an oxymoron – that combination of contradictory words. We can recall a time when creative accounting resulted in some rather large companies getting into rather big trouble, but is it really an oxymoron?
Upon consulting the Webster online dictionary, Art is defined as a skill acquired by experience, study or observation. Accounting is defined as a system of recording and summarizing business and financial transactions and analyzing, verifying, and reporting the results. Right there, I want to stop and say this is nonsense to go down this path. I simply want to stress that there is nothing about accounting that should be offsetting or intimidating, much like that definition just was. In my thirty five year career in accounting, all I have experienced, as an accountant, is a set of specific words and specific formulas that are applied with skills acquired by experience, study and observation. Wait! Wasn’t that the definition of art we mentioned above? Oxymoron? Maybe not…..
Where are we going with this? I want to bring you into the world of accounting and make it simple and usable. I have had conversations with many potters who get frustrated because it seems tough to keep up with bookkeeping and accounting…..too many words, too many systems, too many concepts, too many details, too many rules, just “too many” everything. They wait to the last minute, they hope they are making money, they give the shoebox of receipts and bank statements to someone else, and they hope they don’t have to ever see it again. I, even with my training, can completely identify with this. So, beginning with this brief blog and future blogs, I will define the big picture, highlight some specific formulas, and describe the analysis and use of the results that can save you time, help you determine if you are in a hobby (no profit) or a business (profit), and identify areas where you can gain confidence that you are running a business plus helping you to maximize the ability to get all the tax benefits available to you, a business owner, because you understand the basics of accounting.
What this blog will not discuss is taxes. That is for your tax software or your tax accountant. Understanding how to create good records in a timely manner places you in the position of getting the most for your deductions and your tax accountant may charge you less because there were fewer questions. You might even find you know more than your tax accountant! All of these are powerful opportunities for you!
In addition, if you want to borrow money or present your business to a financial institution, you will have the confidence of understanding the documents representing your business and how they fit together. Speaking to financial people in their language can really help in these situations. As you shake hands after that successful financial meeting, you will feel as elated as you did when, after mixing that complex glaze recipe and upon pulling it out of the cooled down kiln, the glaze results were exactly what you were expected. Yes! Get this! Accounting concepts, unlike glaze results, are consistent. You use the same basic concepts and you get the same types of results. Learn it once and you are good to go!
Accounting is both a system and a language. Let’s take the language……we walk into a room and we hear “credit, debit, liabilities, gross profit, cash flow, balance sheet, reconciliation”….and….. we walk out, because, really, who talks like that. Upon entering the next door, we hear these words……bat, wheel, slip, score, throw, rib, slab, mold…..you and I know immediately what these are and we sit down and join the conversation. An unaware person would think maybe we were talking about baseball and wondering where the wheel fits in. To my point, each has its own language. So, we will get comfortable with some new words.
Let’s take the system….there are many ways to create books and records for that data you are accumulating. Spreadsheets, bookkeeping software, shoeboxes, and Big Chief Tables and Number Two Pencils. The first question we will ask ourselves is….What is it I want to know about my business? Those questions will help define the system we will want to use and how much detail we will want to put in because the information we get out of the system is only as good as the information we put in.