I recently had a conversation with a client who confided that she was hesitant to share financial information with her employees because they might think that she was pocketing all the profit. She owns a $30M business with a Net Operating Profit of around 10%. She feared that if the employees saw the P&L statements with all that Net Operating Profit, they may think she was getting rich from their efforts. I believe this concern is pretty common among business owners.
The benefits of sharing high-level financial information are numerous. These include helping employees understand the basics of how increasing revenue and reducing costs can have a significant effect on the bottom line, how that profit helps build a healthy company, and how their actions and decisions can make an enormous contribution. The problem is that many employees don’t understand that Net Operating Profit isn’t the same as cash. Many cash outflows don’t even show up on the P&L statement. When sharing financial information with employees, it is essential to provide the context to help them understand the relationship between profit and cash.
By subtracting variable costs, overhead costs, miscellaneous expenses, and some other non-cash items (depreciation, amortization) from the revenue, you arrive at the Net Operating Profit. But that doesn’t tell the whole story, and the parts that are missing are significant. Helping employees understand this is critical.
So, what do they need to understand? They don’t need a financial degree to “get it.” But perhaps a simple explanation will help. Following is an incomplete list of some of the items that “suck cash” but are not always reflected in Net Operating Profit:
- Interest – Interest does appear on the P&L statement, but the deduction comes after Net Operating Profit
- Taxes – if the company is a C Corporation, taxes are paid on the Net Operating Profit less interest. If the owner then pockets any leftover cash, they also pay personal income taxes on that amount (this is the origin of the term “double taxation”).
- Principal payments – The company must repay any debt using profit. For instance, if the owner bought the business and the previous owner (or a bank) financed the purchase, profit is used to make those payments. Maybe money was borrowed to purchase a building or to upgrade/expand the facilities. Often, credit is used to buy expensive equipment. Sometimes, expense items or travel expenses are charged to credit cards, and a balance carries over into a future period. None of these principal payments appear on the P&L statement, but they all require cash, which comes from profits.
- Capital expenditures – Large expenditures may be purchased with cash but are “capitalized,” which means that the cost deductions on the P&L statement appear over months/years as “depreciation.” Examples include new facilities, facility upgrades/expansion, machinery, equipment, computers, vehicles, software costs, etc.
- Accruals – Many companies build up reserves to pay large expected or unexpected expenses. For example, if a company pays annual bonuses, cash is saved throughout the year to have it on hand to pay them. Another example might be a significant yearly expense, like a licensing fee. These expenses eventually show up on the P&L statement but do not appear on the monthly/quarterly P&L statements as the cash is accrued throughout the year.
- Research & development – Many companies invest considerable money to develop products or services that may not generate revenue for months, years, or ever. Engineering, material, consulting, training, and marketing costs can run into millions of dollars before a single product gets sold. While some, even most, of these costs may be reflected in “overhead” on the P&L, there may be significant portions that aren’t, such as equipment purchases, prototype builds, or tooling. These costs usually get capitalized but are paid for with cash.
- Working capital – All companies need to have the cash to cover time gaps between expense and revenue. Perhaps material or labor has to be paid one month to build products that get paid for some time in the future, especially for companies with an inventory of products ready to ship when an order comes in. Working capital is usually some percentage of revenue. As a company grows, a more significant reserve of working capital is required.
As I said, this list is incomplete but illustrative. Employees are smart. While most of them may not completely understand the inner workings of P&L statements, balance sheets, and cash flow statements and how they interact with each other, they can understand that there are considerable expenses that require cash outside of current operating expenses.
The benefit of helping employees understand how they can help grow revenue, reduce operating expenses, and prevent/delay high costs, such as maintaining equipment, driving safely, working more efficiently, etc., is significant. Seeing the high-level financial information helps achieve this. In addition, educating them on how profits help grow the company should alleviate the concern that they will think the owner is pocketing millions of dollars.
Everyone wants to work for a successful company. And, everyone also understands that the owner deserves compensation for the blood, sweat, tears, and risk needed to start, grow, and manage a successful business. “Profit” isn’t a dirty word, and it doesn’t all just flow into the owner’s personal bank account – it is crucial in allowing the company to make the investments needed to operate effectively and grow.