Financial statements are used in all industries to convey a comprehensive overview of a company’s financial activity and health. They aren’t unique to professional services, but there are some nuanced differences compared to other industries. Some boutique services firm leaders don’t fully understand how to read financial statements and leave it up to their accountant. But this is a mistake. Every leader of a professional services firm should understand the basic mechanics of their financial statements.

The three primary financial statements you’ll encounter are the Profit & Loss Statement (also called the Income Statement), the Balance Sheet, and the Statement of Cash Flows. The sections below summarize each artifact including any considerations that are unique to services firms.

Profit & Loss Statement

The Profit & Loss (“P&L”) Statement (or the “Income Statement”) conveys the firm’s revenue, costs, and profit over a period of time. Most companies evaluate their P&L on a monthly, quarterly, and annual basis. Also, it is common to evaluate each period against the same period from the prior year (i.e. the fourth quarter this year compared to the fourth quarter last year). Below is a simplified sample P&L followed by an explanation of some key concepts.

The services revenue is obviously all revenue earned during the reporting period. But what about the cost of services sold and gross profit? Many boutique professional services firms do not accurately capture the costs of services sold and thus do not know their gross profit ($35,000 in our sample above) nor their gross margin (35%). The cost of services sold should include all costs incurred that are directly related to delivering services to customers. The vast majority of this expense will come from the salaries and overhead costs of your delivery personnel (both employees and contractors).

The reason you want an accurate gross profit and gross margin is because these speak to the profit potential of the business. Gross profit shows you how profitable your company could be if it didn’t have operating expenses, such as sales and marketing costs. It essentially represents the maximum profit potential of the company during the reporting period.

Operating expenses include all costs related to general operation, administration, marketing, sales, and research and development. (Often, there are no R&D expenses in pure services firms.) By subtracting the total operating expenses from the gross profit, we get the operating income (and operating margin) of the firm. The operating income is the firm’s profit before considering expenses such as income tax or depreciation. Most of the time with services firms, EBITDA (earnings before interest, taxes, depreciation, and amortization) will equal the operating income. This is because it is rare for firms to have non-operating income or expenses (i.e. selling an asset such as a computer would generate non-operating income).

Balance Sheet

Whereas the P&L shows financial performance over a period of time, the balance sheet shows the company’s assets, liabilities, and equity at a specific moment in time.

The reason firm leaders should be comfortable with the balance sheet is that it indicates the future viability of the firm. By evaluating the balance sheet, you can get an understanding of the capital structure of the company. For example, the balance sheet will indicate the company’s cash on hand and any long-term debt. It will also show the types of stock that have been issued.

There are a number of important financial ratios that are calculated from the balance sheet. For example, the debt-to-equity (D/E) ratio is calculated by dividing the firm’s total liabilities by its shareholder equity. The D/E articulates the degree to which the company is financing its operations via debt. Another useful ratio is the current ratio, which shows the firm’s near-term liquidity. The current ratio is calculated by dividing the firm’s current assets by its current liabilities. It shows the company’s ability to pay the liabilities that are due within the next 12 months. The higher the current ratio, the stronger the company’s ability to pay off its near-term obligations. A current ratio that’s less than 1 likely represents pending financial trouble.

Statement of Cash Flows

While the income statement and balance sheet tend to get most of the attention, it is also important to analyze the statement of cash flows. The statement of cash flows does exactly what it sounds like – it summarizes the cash (and cash equivalents) that move in and out of the company. The cash flow statement shows how efficiently the company generates cash to pay its debt obligations and fund its operating expenses.

The statement of cash flows is broken down into the following three sections:

• Cash flow from operations: This section shows how much cash is generated by delivering services to clients. Financial activity related to cash, accounts receivable, and accounts payable will impact this calculation.
• Cash flow from investing: This section primarily captures transactions related to asset or security purchases. It generally shows cash leaving the business to buy new equipment, buildings, or short-term assets such as marketable securities. However, when a company sells an asset, this section would show the sale proceeds entering the business.
• Cash flow from financing: This section captures financing activities such as selling stock or issuing debt (i.e. taking out a loan). Any interest or dividends paid will also be reflected in this section.

Through analysis of the statement of cash flows, you can get a clear picture of how much cash the firm generates and accurately assess the financial prosperity of the company.

Summary

It simply isn’t acceptable for firm leaders to lack familiarity with the three core financial statements. Once you have mastered these reports and their associated ratios and metrics, you’ll be more capable of making better strategic decisions related to growth, hiring, investments, asset allocation, and the like.