Do you shudder at the thought of your financial statements?
If so, you’re not alone. Most agency owners feel lost and intimidated when it comes to dealing with finances, so they often get procrastinated or ignored.
But like it or not, your creative agency cannot be successful unless you have a basic understanding of accounting concepts, so you can understand what’s going on and make intelligent business decisions.
When you have a solid grasp of the basics, you will be able to look at your financial statements and immediately know how your business is doing.
The 8 accounting terms every agency owner should know
Luckily for you as an agency owner, the accounting concepts you need to be familiar with only leverage two key pieces of information: money you’ve made and expenses you’ve paid.
To feel confident working with your financials, you should be familiar with the following terminology:
- Gross Revenue: Represents the total amount of sales that you have made. This metric can be also referred to as sales, gross receipts, or income.
- Cost of Goods/Cost of Sale: The expenses directly related to delivering the service you have sold, such as the project management or creative tools you use. This incremental cost should increase the more revenue you generate.
- Gross Profit: Your leftover profit after all expenses are accounted for, calculated by gross revenue minus the cost of goods sold.
- Gross Margin: The % of your revenue generated that is profit, calculated by gross profit divided by gross revenue.
- Expenses: The cost of business operations (also referred to as operational expenses or general administrative expenses). Examples include payroll, health benefits, and utilities. The more you minimize these expenses the easier you’ll achieve economies of scale.
- Operating Profit (EBITA): To assess how effectively the agency is generating earnings from core operations, calculate gross profit minus expenses. EBITA stands for Earnings Before Interest, Taxes, and Appreciation.
- Other Income & Expenses: Income and expenses not directly related to daily operations of the business. Income could include interest income, royalties, and commissions, and expenses could include taxes, depreciation, and amortization.
- Net Profit Margin: To measure your agency’s overall profitability, calculate the net profit divided by gross revenue.
As you can see, these key concepts don’t require knowledge of complicated accounting calculations. When you understand how to manipulate your earnings and expenses, you can better understand your agency’s financial situation.
Concepts that every successful agency must-know
If you want to take your knowledge to the next level, there are some additional accounting terms that, if understood, make it even easier for an agency owner to assess the business’s current financial health.
- Chart of Accounts: To ensure the accuracy of financial reporting, this structured framework lists the categories of transactions within the accounting system.
- Pass-through Costs: Especially important for media-based agencies purchasing ads on behalf of the client, this term refers to the expenses incurred by the agency but ultimately passed on to another party or customer. Examples include reimbursable expenses, outsourced service costs, utility charges in commercial leases, and taxes/regulatory fees collected on behalf of governmental authorities.
- Agency Gross Revenue: Income minus pass-through costs gives a better understanding of true earnings from core operations.
- Accruals vs. Cash: There are two distinctions of monetary transactions: based on invoices or bank-based transactions. Most agencies are cash-basis filers, recognizing expenses on the date they are physically paid. Accrual-basis filers recognize expenses on the date the original invoice is incurred.
- Ledger: A detailed list of transactions for accurate reporting purposes.
With so many moving parts and transactions within your agency, it’s essential to understand the full multitude of your revenue vs. expenses. Otherwise, you’re at risk of overspending, misinterpreting taxes owed, or hindering cash flow.
Understanding your agency’s financial statements
While having an understanding of these key concepts is important, the most critical part of your accounting process is benchmarking your financial statements.
When generating a financial statement, it is crucial to benchmark your percentages of income month over month and year over year to ensure you’re moving in the right direction.
Use the following thresholds to guide your decision-making and nip problems in the bud to prevent stagnancy or losses:
- The Cost of Sale should remain between 30-40% of revenue.
- Gross Profit should remain between 70 and 55% of revenue.
- Admin & HR Payroll should remain <10% of revenue.
- Office Expenses should remain <3% of revenue.
- G&A should remain at 5% of revenue.
- Sales & Marketing should remain between 8 and 12% of revenue.
- Operational Income and Profit should remain between 25 and 50% of revenue.
- Other Expenses should remain at 3-5% of revenue.
- Net Profit should remain between 20-45% of revenue.
When you compare these metrics month over month and year over year, you can isolate decisions or actions that are contributing to the overall success of the agency, make informed adjustments, and steer your creative agency toward sustainable growth and profitability.
Harness the Power of Numbers to leverage Financial Growth
There’s no doubt about it - you need a basic understanding of accounting principles to manage your finances effectively. But by familiarizing yourself with these key terminologies and concepts, and using benchmarks to interpret your financial statements, you can gain a better understanding of your agency's financial health and make informed business decisions.
Don't let financial statements intimidate you—embrace them as a powerful tool for managing and growing your creative agency.
