Improve Your Financial Literacy
– – Episode Highlights – –
Dave: As a former music school owner, I always felt like I didn’t fully understand what to take from my financials, and I’m hoping today we can shed some clarity on what value financial statements have for school owners.
Jeff: Yeah. Hoping we can we can put something together that would be really helpful to folks.
Dave: So what are some things that a music school owner should be looking for when they either receive their monthly financials or run a P&L? What’s some helpful information that can be obtained from looking at financials?
Jeff: Sure. So your financial statement is divided into a couple of statements. The most common one that we want to spend time on is the income statement. That’s going to tell you how much money came in in the form of your revenue and where did it go. For me, I think understanding how much of your revenue is going into certain buckets is really helpful by both understanding the current health of your business and then making decisions about how to change or evolve in the future based on what you see.
Generally speaking, when we analyze our schools or schools that we’re looking to acquire, we look at revenue and then expenses in a couple of different buckets. I think getting your bookkeeper to help you organize your P&L in this way can be really beneficial.
The big buckets of expenses that we see are direct lesson expenses, which are mostly teacher costs, but are sometimes things like if you sell retail, the cost of those retail goods. All of the variable expenses or the cost of goods sold should be that first bucket that we look at.
You’re basically separating expenses in fixed and variable. Your variable expenses go up top, above a line called gross profit. Down below that you have your fixed expenses.
When you measure your variable expenses as a percentage of your revenue, you understand how much of every dollar you bring and you’re keeping. That tells you how much money you have left over to cover your fixed expenses, like your rent, like your admin staff—some of the things that we’ll get into in a second.
So if you have give a hundred hypothetical dollars of revenue and 50 of those dollars are going to pay your variable expenses, your teachers, your cost of your retail goods, you know that now what I have leftover is those 50 hypothetical dollars. But I also know that if my revenue goes from 100 to 105, that I’m likely to keep about half of that incremental $5 increase in revenue. From there, I can make good assessments about if I’m not currently covering my fixed expenses, how much do I need to grow to get there? How much, you know, if I have a certain income target for the business that I want to achieve, I can do some math around how to get there based on the percentage of the incremental dollar that my business brings in that I’m keeping, which is that gross profit percentage or the percentage that you’re keeping out of the revenue less the variable expenses.
The fixed expenses, you’ll often see 20 or 25 different laid items, which can be a little bit confusing. We think it’s helpful to group them into a couple of big categories. The first is your facilities, your rent or facilities spends. The second is your administrative or non-teaching staff expense, and the third is basically all other.
We think that a healthy school is generally gonna spend between 10 to 15% of its revenue on rent. In some great situations, it can be much less than that. If that’s you, then you’re in a really good spot, but 10 to 15% of revenue on rent is a healthy range.
Similarly, for admin expense, you know, we want to see that closer to that 10 or 15% range, given that we’re generally as middle school owners giving away about half of that revenue to the teacher, you know, we only have half left to play with and we want to see a healthy profit margin leftover. So if your rent is higher than 15% and your admin expenses is higher than 15%, we’ve already used up most of the remaining revenue and we haven’t even gotten to other expenses that we’re going to have.
So that’s kind of how we think about analyzing a profit and loss statement is. We try to figure out what the variable expenses of the business are, and what percentage of revenue they make up. That’s going to help us understand how the business is going to evolve as it grows and how much of that incremental revenue will drop to the bottom line and then we want to analyze our fixed expenses for sort of the overall health of the business.
Of course, being fixed expenses, they’re harder to change day-to-day, but that might inform whether we need to make a change to our staffing formula or to consider a relocation if our rent is no longer affordable for the business that we have. Some of those ratios can help give us that information.
Dave: Wow. Yeah. That’s so interesting to separate it that way. So what you’re saying is you’ve got variable expenses and you have fixed. Just to make sure I have it right. Other than your teaching staff would fall under that and if you have a retail component, what you’re spending on your inventory would also be there?
Jeff: That’s exactly right.
Dave: And that’s it, though, for that category. Correct?
Jeff: Generally, yes. You know, what we’re trying to include is things that are directly attributable to the service or physical good that was provided to earn that revenue.
Dave: I found this interesting that the administrative cost and the rent should ideally be 10 to 15% of your expenses?
Dave: Are there any other percentages that you think are important to look at besides those two categories?
Jeff: I mean, ultimately, the one that really matters in this is the one that is the result of the formulas that we gave earlier is what’s your net profit as a percentage of revenue. Right? Hopefully that’s the million dollar question. Right? We hope that’s actually the million bucks at the end of the day.
Jeff: And, yeah, I’m joking, of course. But we’re looking for, you know, a healthy profit margin in the mid to high teens. Sometimes even the low 20s, depending on what market we’re in and what’s possible from a rent and labor cost perspective. But yeah, I think that net profit percentage, you know, ultimately is going to tell you, that’s the ultimate arbiter of the health of the business, but in terms of how to improve it, that’s where the other ratios come in because that’s everything that’s being subtracted off before you get into that profit percentage. And so understanding, you know, what’s in a healthy range and what might be out of whack is how we’re ultimately going to make decisions about our business going forward.
Dave: Yeah, well, that’s great. I think it’s really helpful when you share these percentages because it’s just I think, for the listeners, they can kind of look at what percentage these expenses are consuming of the revenue. And I don’t know if we clarify this, but everything we’re talking about here is in relation to what we’re seeing on a profit and loss statement. Correct?
Dave: Are there any other reports other than a profit and loss statement that you feel an owner should be looking at on some frequency?
Jeff: Yeah. I mean, the balance sheet is the other statement you’re gonna get generally from your financial professional, but it’s generally gonna contain things that you already know: How much money you have in your bank account? How much money you owe to the bank?
Generally speaking, businesses of our size are not going to be recording accounts payable or accounts receivable. It’s really just going to be sort of a statement, sort of a moment in time snapshot of the kind of fixed assets and obligations of the business. I think it’s less relevant for making decisions other than sort of keeping tabs on what’s in the bank and what’s owed, but that’s generally things that are going to be top of mind for most owners.
Dave: Let me think for a second where I want to go. I was like, “Oh, this meeting. This is exciting. Where is this going?” So what are some common mistakes that you see business owners committing on their profit and loss statements or what are some things that owners are doing that’s maybe making life more complicated than it needs to be?
Jeff: Sure. So we’re talking exclusively in the in the realm of financials and accounting here. I think the biggest one is just not prioritizing financial hygiene or sort of the quote and quote cleanliness of your accounting because it really makes it hard for you to get full information out of your accounting. But critically also, you know, a third party like a lender, a landlord, and a potential acquirer, it just makes it harder for somebody outside your business to get a good insight on what the success and value that you’re creating inside your business.
So I think for that reason, I’d recommend going back in if your bookkeeper doesn’t currently separate your fixed and variable expenses and doesn’t have a gross profit line, let’s try to separate our payroll into teaching and non-teaching costs because that will tell us some useful information about what our gross margins are, but at a way more fundamental level just lets pay attention to are we classifying our expenses correctly, you know, if we have one or more lines of business that our family is involved in, are we keeping separate books for those two businesses and making sure that they’re not commingled? Are we being thoughtful about not running personal expenses to the business, because, you know, while that might generate some tax savings, if there are items that are harder to identify after the fact, like personal travel or personal meals, you know, those things can be harder for to convince an external party that those were really not business expenses, whereas something more fundamental like an auto expense? Well, it’s somewhat straightforward that the music school doesn’t need a car. And so, you know, an auto expense is something we commonly see run through business. And that’s fine. We know, we understand that that’s not necessary and we can adjust for that.
But again, some of those subtler things like when putting the personal groceries on your Costco run for the business, you know, that can make things really murky. You know, not just reduce the usefulness of your financials to an external party, but make them less useful for you in making business decisions because you’re basically going to look at your P&L and say, “Oh, well, I know that my expenses are overstated. So I’m not going to trust this report. And that’s gonna deprive you of useful information.
So I think prioritizing, you know, financial health or hygiene and kind of keeping separate and accurate books that will be useful to an external party because you never really know when that might be needed or necessary would be kind of the biggest set of mistakes that we see and that make it harder for us to ultimately understand the financial story that someone is telling us when we see a really great business, but we get a messy or complicated set of books.
Dave: If a school has two locations, two or more, do you recommend that each location have its separate P&L?
Jeff: We do that, you know, for ourselves. It’s not critical. It can be done, but if in the future you were hoping to sell off one of those locations separately, that’s gonna be a case where you’re gonna want that. But if you give your business as being generally one offering to the community, it’s not critical. Certainly not as high of a priority as many of the things I mentioned, but we do think it’s the best practice.
Dave: Well, and I can also see by having an all under one profit and loss statement, it might be harder to measure the individual health of each location.
Jeff: That’s definitely right.
Dave: All right. Well, Jeff, this has really been super helpful and informative. And I hope for the listeners, it’s helped clarified or cleared up some questions that they’ve had and it certainly has for me.
Jeff: Sure. And hopefully, we kept it short enough that people were able to make it all the way through.