Knowing how to read a financial statement and a few other basics of accounting is vital in an eCommerce business. Without basic knowledge of accounting, you may think you’re raking in the cash when you’re actually in the red.

We’re covering everything from the basics of reading an income statement to the ins and outs of your store revenue.

Subscribe:  iTunes | Stitcher

(Wth your host Andrew Youderian of eCommerceFuel.com and Bill D’Alessandro of RebelCEO.com)

Andrew: Welcome to the eCommerceFuel Podcast, the show dedicated to helping high six and seven figure entrepreneurs build amazing online companies and incredible lives. I’m your host and fellow eCommerce entrepreneur Andrew Youderian.

Hey guys, it’s Andrew here and welcome to the eCommerceFuel Podcast, thanks so much for tuning in today. Today on the show, extremely gripping topic we’ve been wanting to cover for a long time. The absolute bare minimum you need to know about accounting. And joining me, an ex-finance guy who is the perfect man to geek out about this. Bill, I’m sorry we don’t have whiskey this time to chat but hopefully you’ll still stick around until the end of the episode.

Bill: I really should have put that in my contract, shouldn’t I have?

Andrew: Top shelf, $400 a bottle whiskey otherwise I’m not coming back to the show.

Bill: That’s right, I need whiskey or we’ll not record this stuff. I won’t hang out with you if we don’t have any whiskey.

Andrew: To keep things interesting without the whiskey and also, let’s be honest, accounting unless you’re Bill may not be the world’s sexiest topic, we’ve inserted a couple fun little secondary scenes shall we say throughout the episode. You’ll have to listen real carefully to hear them but yeah, just keep your ears perked for those. And Bill, should we get into it?

Bill: Yeah, we should get into it. We should call this episode “Front Lines Accounting.”

The Function of Your Income Statement

Andrew: “Front Lines Accounting,” I love it, I love it.

So Bill there’s really three crucial financial statements that you need to know. The income statement, the balance sheet and the cash flow statement. And we’re going to tackle each of those individually and we’ll go ahead and start with the income statement. So Bill, how do you describe the income statement in a nutshell? What is its function and how do you look at it?

Bill: The easy way to think about an income statement really is, this is the amount of money that your business made over a certain period. Most income statements you’ll see are kind of yearly or monthly. And you in theory could do a daily income statement but I don’t think it would be very instructive.

So most people will do monthly, will do an income statement and it will show a total for the year and then broken down by month. At the top you’ll see revenue and then you will subtract from revenue your cost of goods sold, which is basically the amount of money it cost you to make that revenue.

Then you’ll have a gross margin, and that’s basically the amount of money you have after selling your stuff, the amount of money you have available to use to pay overhead. And then you’ll have a section called expenses or sometimes you’ll see it called SGNA or selling general and administrative expenses and those are all the overhead expenses of your business, salaries, rent, your subscription to the eCommerce Fuel private members forum, all sorts of things like that go in the SGNA expenses section and then at the bottom you have a number called net income, also or hopefully known as profit and not loss.

Andrew: Yeah and it’s kind of important to clarify that revenue is equal to sales, revenue is at the very top. It’s not how much you make, it’s just the gross amount of money you collect from your customers before you pay any expenses. Sometimes you might hear that called top line, like if someone says “What’s your top line?” they’re talking about revenue, and revenue does not mean profit.

A lot of times people will interchange these, they’ll be like “Oh, hey, I’m making X” and you really need to clarify because there’s an enormous difference between revenue and profit and sometimes they just get thrown around interchangeably.

Revenue Versus Profit

Bill: Yeah in fact, oftentimes people ask me, they’re like oh, how big is your business? I’ll tell anybody who wants to listen how much revenue I do. The real sensitive number is how much money do you make, that’s the profit number.

But I think a lot of people don’t realize that revenue is not take home, and so sometimes you have mis-perception you don’t want to throw out a big revenue number because then people will think you’re crushing it and making lots of money and that could be awkward for you and your friends.

Similarly if you’re, I have seen this too many times, people puffing their chests up and trying to impress folks will quote a revenue number and their business could be not profitable. So I’m typically not that impressed by revenue numbers.

Variable Costs Versus Fixed Expense

Andrew: I think one important thing to understand and a mistake people make a lot of times is putting their variable costs and their fixed costs in the wrong spot. So you’ve got your revenue at the top, minus your costs of goods sold, so the costs to fulfill an individual order, that gives you your gross profit. And then gross profit minus all your overhead gives you your net income.

And you always want to try to put any variables costs, so costs that are really only associated with fulfilling a specific order, the cost of the product, the cost of perhaps the packaging, things like that, you want to lump that into your gross profit.

But you never want to put things like your overhead, your rent, your fixed salary, unless your team members are on some kind of commission that you can tie into a variable cost of doing business, you always want that to be below the line.

So a lot of times people will refer to, “is this an above the line expense,” meaning is it a variable cost? Or is it a below the line, meaning it’s a fixed expense.

Bill: And the variable expenses obviously increase and the reason you care about that is your gross profit margin, you can say for every incremental order I do this is the amount of profit that I make.

So as your business gets bigger and bigger and bigger in theory your net income kind of moves closer to your gross profit margin. Of course it never gets there because your fixed costs do get bigger, like you need to move into a bigger space so your rent goes up, or you need to hire more people.

I would love to see a business who had a net margin equal to their gross margin but that doesn’t ever happen. But as you get bigger you should expect your net margin to move towards your gross margin.

Andrew: Perfect, I think that’s about it. Any final thoughts before we move onto the balance sheet?

Defining Accrual Accounting

Bill: The income statement I think is the most famous financial statement, that’s the one people think, they’re like okay, this is how much money this business made. Well the thing to remember on an income statement, and I don’t want to get into too much accounting right now on this podcast, but the income statement is subject to what’s called accrual accounting.

Meaning, let’s make it simple and say if you pay your rent once a year, let’s say you owe $12,000 in rent and you pay it once a year. Your income statement, you’re supposed to make the timing of revenue and expenses match when they were actually received or incurred.

So instead of putting $12,000 of rent on your income statement in January and none for the rest of the year the proper way to account for that under accrual based accounting is to put $1,000 of rent on your income statement for every month.

So that gives you a more accurate picture because you used 1/12 of that rent payment essentially in each month. So it gives you a more accurate picture of a complete picture of how the business operated during the period by using accrual accounting.

However, it can be misleading because if you’re writing a check for $12,000 in January and then you’re not actually writing those $1,000 checks every month you need to understand that the other 12 months are going to be much more cash positive than January will be and we’ll talk about what statement you should use to track that later in the podcast.

Andrew: Yeah. And accrual accounting, the nice thing about it is it’s more accurate, it gives you a better sense month-to-month, year-to-year especially month-to-month, how the business is tracking. The difficult thing about it is it’s harder, it’s more work. Cash based accounting is much easier and there’s some kind of different rules about how the size of your business and some other things that determine whether you should be on cash based or accrual based, but it’s probably a little bit beyond the scope