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Does Your Agency Have Lots of Cash But No Profit? You’re Likely Measuring Profitability Wrong.

See if this sounds familiar: your agency’s bank account is flush with cash, but your accountant tells you at the end of the year that you haven’t made any profits. Something doesn’t add up. “But we’ve had so much business this year!” you think. Not only that, but when you looked at your sales and profit each month, you were in the green. What happened?

Believe it or not, there are a few scenarios that may cause your agency to be cash-rich but unprofitable. First, though, let’s review the warning signs that you’re having profitability problems. If your agency isn’t profitable, that likely means one or more of the following:

  • Your gross margin is wildly inconsistent. This just doesn’t happen in well-run, profitable agencies
  • You’re focusing on your gross billings instead of your gross profit (also referred to as net revenue or AGI)
  • You aren’t paying attention to important profitability indicators like staff cost and overhead ratios (as a function of gross Profit, not gross Billings).

Operating issues are another likely scenario. In this case, unprofitability can result from:

  • over-servicing your clients
  • pricing your engagements improperly
  • having too many senior resources or too much overhead cost for the size of your business

Although these scenarios are technically possible, they aren’t necessarily the most common ones. The most likely culprit of your unprofitability? Cash accounting.

Why Does Cash Accounting Lead to Profitability Problems?

The reality is, a lot of agency owners and their accountants aren’t familiar with the best practices of agency accounting. Unlike lots of industries, agencies are really lucky when it comes to billing their clients because they can bill in advance of doing the work — and most do. This is ideal for optimizing cash flow, but it also adds a layer of complexity to accounting for agencies. Unfortunately for agency owners, most bookkeepers or entry level in-house solutions they hire aren’t familiar with best practices for agency accounting. 

What are the most likely reasons why your agency has cash, but isn’t profitable? Here are the four most common causes.

1. You’re Relying on Your Bank account Balance As an Indicator of How Well Your Agency is Doing

First off, cash is not profit. This is true for almost all businesses, but especially businesses that bill in advance. So if you are measuring your agency’s profitability off of your cash balance, just know that it is very likely not even a “good enough” indicator of profit. All it tells you is how much money is in your bank account. It does not provide an indication of who else owes you money, who you owe money to, and most importantly, what work you have been paid for that you still need to deliver.

Agencies that bill ahead will find it a blessing and a curse. Receiving payments early is great. But without the proper accounting for pre-bills, you could very easily assume your business is much more profitable than it really is.

2. You’re Focusing on Gross Billing Instead of Gross Profit

In lots of industries, it is really common to focus on gross billing when determining profitability.  If your agency handled very few third-party project-related expenses, this probably wouldn’t be that misleading, either. But the reality is that most agencies do handle a lot of third party costs on behalf of clients. More and more, the mark-up on these costs is proportionately not that material, unless you buy a lot of media for clients — or you are in the event or production business where it is still very common to mark up out-of-pocket expenses.

Gross profit, which is your gross billing minus your project-related expenses, is really the number that agency owners need to focus on. This is the amount you “keep.” The amount should be equal to your fees + your mark-up on out-of-pocket expenses. Most importantly, it’s also the money that you have to pay your employees and pay your overhead expenses. If you aren’t focusing on your gross profit number to evaluate your financial performance, then you could very well be making decisions that aren’t good for your business.

For example, imagine you win a new client and part of your mandate is to buy their social media. You expect to buy $2 million in media per year and you expect $300,000 in fees to do so.  Up until then, your agency’s gross billings were $5 million a year, and your gross profit was $4.2 million. With this new client, your gross billing will grow to $7.3 million. 

On paper, it looks like your agency has grown by 46%. However, what really matters is how much your gross profit has grown. In this example, your gross profit grew by 7% ($4.2 million + $300,000 = $4.5 million). This is a really significant difference.  If your agency is investing against your top line growth, you can see how easy it could be to overinvest.  This is one of the biggest reasons we see agencies who have cash be unprofitable.

3. You’re Relying on Cash Accounting Even Though Your Agency Pre-bills A Lot of Your Work

We would never suggest you don’t keep billing your clients before you do the work. This is an enviable position to be in. If that is your situation, keep billing as early as you can.

However, if you are in this position, you need to make sure you have a system to track what money is yours (an asset) and what money was paid to you in advance of delivering work that is still owed (a liability). This is what accountants refer to as “accrual accounting.” When you invoice your client in advance, it’s actually a liability, not revenue. Why is it a liability? Because you still have to do the work. If the client cancels a project before the work begins, you would be liable to reimburse your client for the amount paid in advance.

How do you know if you are doing cash accounting in your agency?  Most likely, your gross profit number is highly variable. In an agency or firm, this isn’t reasonable. If your headcount doesn’t fluctuate much month over month, your gross profit would not change much month over month. The same number of resources are going to produce about the same amount of revenue each month. If you are adding resources over time, you want to see your gross profit consistently increase month over month. If you don’t, it’s a really strong indicator that you aren’t increasing your revenue with each additional resource.

If you regularly invoice your clients in advance, you need to work with an accountant who holds off on recording the revenue until you actually do the work — not before — and who can tell you how much of the cash in your bank doesn’t belong to you. This is known as “accrual accounting,” and it’s the only way your financial statements will give you an accurate picture of how profitable your business is.

4. You’re Not Relying on Your Financial Statements to Make Decisions

The sum of all the decisions you make about your business shows up in your financial statements, and that makes these documents critical to getting the fullest picture of your profitability. 

So if your agency has sufficient cash but it isn’t profitable, it’s possible you’re relying on misleading indicators, like bank account balance, to inform your decisions about your business.

Profitable agencies achieve the following minimum performance, as reflected in their financial statements:

  • Their gross profit is at least $150,000/annum per full-time equivalent (FTE)
  • All of their staff costs are less than 60% of their total gross profit
  • All of their overhead costs (rent, insurance, meals and entertainment, training and development, etc) are less than 20% of their gross profit

If you rely on cash accounting, it is going to be difficult to understand your agency’s performance at that level. With accrual accounting, you will be able to measure quickly the three performance metrics listed above. And if you find you perform well against the metrics, and you have a healthy cash balance, you can feel comfortable knowing your agency has cash and is profitable.

Using Accrual Accounting to Read Your Profitability Correctly

Matching your revenue with your cost of revenue is one of the most important ways you can ensure that your profitability is accurate. It’s called the matching principle. If you don’t have access to a trained accountant to help you recognize your revenue when it is earned vs. when it is billed, the matching principle can work as a shortcut to ensure that your gross profit is not overstated. In this scenario, when you invoice in advance for out-of-pocket costs, you would “accrue” a corresponding cost of sale entry equal to the amount that you are expecting for out-of-pockets.

For example, if you pre-billed $100,000 for media costs before you received the invoice for the media, and you were expecting to spend $85,000 on media, you should “accrue” a cost of sale for $85,000. That way, your financial statements will show gross profit on the media of $15,000 instead of $100,000 until you actually receive the $85,000 in costs from the media supplier.  When the actual costs come in from your media supplier, you would then reverse your accrual for those costs, and enter them to cost of sale.

Determining Profitability Often Requires a Trained Eye

If you read the billing mistakes mentioned above and broke out into a cold sweat, relax. Many agencies and their accountants make these mistakes.

While these are common errors, they’re also potentially very costly ones. If you really want to optimize your agency’s performance and feel confident in the financial statements you are making decisions from, you probably need more than a bookkeeping solution. You need a business partner with agency experience.