The Income Statement and The Balance Sheet
By Mike Carlton
Accounting was not my favorite subject in school. In fact, I still don’t understand the concept of double-entry bookkeeping. It always seemed to me to be like twice as much work as necessary.
But, I did learn the role of the Income Statement. And the role of the Balance Sheet. And their basic purpose in any business. Yet it was many years before I understood their fundamental, and interconnected, relevance to anyone leading an advertising agency. Relevance that goes way beyond accounting.
Looks Can Deceive
On the surface it all looks fairly simple. The Income Statement shows how much the business made and how much it spent. With the difference being profit (or loss). And of course, taking in more than you spend is usually a good thing.
The Balance Sheet shows how much the business has and what it owes. With the difference being, according to accounting, what the firm is worth. And of course having more than you owe is usually a good thing, too.
Agencies are Different
Yet while it appears to be fairly simple, it isn’t. Accounting 101 – at least the class I was in - was not designed to accommodate some of the characteristics of the agency business. Characteristics that need to be examined in order to put these financial documents in their proper context.
The linkage between the profit an agency makes and what it is worth is much more complicated. And not only are the Income Statement and Balance Sheet interrelated with each other, but also linked tightly with the agency’s short and long-range vision and business plan.
Understanding how the two work together and connect with the agency’s vision and business plan can make leading the organization easier, more rewarding, more fun and more successful.
Stuff that was not taught in Accounting 101.
Let’s Start with the Balance Sheet
Agencies provide intellectual services. Services in which they seldom have ownership rights. The ownership of agency work almost always resides with the clients. And furthermore, agency work is almost always custom for each client, and therefore has no value to anyone other than that specific client.
Thus agencies don’t have the kind of marketable assets that most other businesses have. There are no hard assets like inventory, machinery, patents, and copyrights. Agency assets are in people. Talented people. Not things.
This creates an entirely different dynamic. One that unfortunately is not always grasped by accountants.
Leo Burnett Said It Best
In commenting on the value of his groundbreaking agency he is reputed to have said, “The assets of this agency go down the elevator each night.”
And if the clients also have the freedom to leave on short notice (a right that most clients have) they are not legally anchored to the agency either. From a strict Accounting 101 standpoint about all an agency really owns is its cash, furniture, office equipment, etc. Not worth much. Nor very exciting.
But wait. Those things have almost nothing to do with the value of an agency.
The most important assets of an agency are its talented people, its brand perception and its reputation. That is what attracts and retains clients. That is what attracts and retains talent. And that is what generates continuing income. That is where the real value of an agency is found.
Yet the traditional Balance Sheet has no way to account for these soft assets.
Now Let’s Look at the Income Statement
To make a simple example, let’s just include Gross Income and Operating Expense and the difference between them in our discussion. The historic target for agencies is to hold Operating Expense at 80% or less of Gross Income. Thus yielding a 20% Operating Profit. Typically an agency that can continually produce that kind of Operating Profit is doing quite well.
This looks simple enough. And it is when there is external ownership. Or if the agency acts as if there is. The Operating Expense includes rewards for the talent. Including leadership talent. And the Operating Profit covers rewards for the owners.
But things can get complicated. Frequently bonuses for leadership and craft talent are paid out of Operating Profit. So are contributions to retirement funds.
And when the agency is owner-managed the rewards for being owner and the rewards for being manager can become intertwined. Frequently this is driven by what makes the most sense for tax purposes. Both for the company and for the individual.
As a result, a very well run owner-managed agency may show an Operating Profit of less than 20%. Sometimes close to zero. This of course obscures the true profit potential of the business. Sometimes the same descriptions can have quite different meanings. Causing the Income Statement to be potentially misleading. And making comparisons with agency norms difficult.
Why is All This Important?
For anyone leading an agency there are two eternal questions. First, “What are my short-term goals?” And second, “What are my long-term goals?”
The challenge in answering them is that they are usually interdependent. And, can in fact, be in perpetual conflict. That’s because maximizing short-term rewards can conflict with maximizing long-term rewards. And vice-versa.
The Yin and the Yang
Long-term growth usually requires investment. The more money you take out in the short-term, the less money there is to invest in long-term growth. The flip side of that is the more you invest in long-term growth the less money available for short-term rewards. Nothing very complicated in this concept.
But, selecting the appropriate trade-off between short and long-term interests, and managing toward that outcome is not easy. And in fact in many agencies the yin and the yang just happens by accident.
That is not good. The relationship between short-term rewards and long-term rewards should be a proactive choice. This is essentially finding the desired balance between agency profits now and agency value later. A balance that should be built into the agency’s business plan.
And unfortunately, it is not uncommon for agency leaders who maximize short-term rewards to be disappointed later with the long-term rewards.
So, What Is an Agency Worth?
There are countless different formulas for estimating the market value for an agency. Some are quite complex. And some are quite expensive. And at best they only provide an informed appraisal. Nothing more. They do not assure that a buyer will show up with cash in hand. Buyers, whether internal or external, can only come from the marketplace. And they come when they want to come.
This of course leads to the old truism. That ultimately any business, including agencies, is only worth what someone else is willing to pay for it.
And what someone else is willing to pay is often based more on feel and emotion than it is on fact. This is just the way any free market works. Otherwise why is the stock market, which is so carefully studied, analyzed, formulized and computerized, so volatile?
Emotion usually trumps logic.
Typical Value Benchmarks
Having said that, most buyers of agencies (either folks from inside the firm or from outside) primarily focus on the anticipated future income stream as the first step in establishing an agency’s value.
And remember this is anticipated income. It is certainly not assured. Usually this forecast is based on recent Gross Income figures tempered by the reasonable expectation of continuing to achieve at least that level in the future.
And the expectation of reasonable profits in the future, too.
However, that is just the beginning. There are lots of other factors. Often taking into account the desirability of the clients, the likelihood of those clients staying, special capabilities or characteristics of the agency, the strength of secondary leadership and craft talent within the agency as well as geographic considerations.
Anything that will enhance the future income generating capabilities of the agency.
Is Bigger Better?
Obviously, the more Gross Income the greater the valuation usually is of the agency. Thus, there is a strong argument for continued growth.
But that begs the question of the quality of that growth. Growth for the sake of growth may not be the best way to enhance the agency’s market value. Indiscriminate growth may, in fact, make the agency less attractive to buyers.
And growth usually drives down profits. At least in the short-term. This is because expansion usually requires investment before it can generate income.
The Rule of 30
Here’s where the interconnection between profits and agency worth comes into play. There is an old axiom that says that a reasonable expectation for a mature, well run agency should be for the combined percentages of profit and growth to total 30.
What this means is that a well run agency that has a real operating profit of 20% can probably be expected to have a growth rate (adjusted for inflation) of about 10%. For a total of 30.
Conversely, an agency with a faster growth rate, say 25%, might be doing quite well if it only earned a real profit of 5%. Again, a total of 30.
This rule also states that it is probably unrealistic to expect any agency to consistently sustain a rapid growth rate and a high real profit simultaneously. But like all rules of this kind exceptions to it are not unknown.
The Soft Factors
Let’s move beyond the hard numbers. Agencies are in a trendy business. Hot agencies can command better clients, firmer pricing, greater income, be more attractive to talent, and grow faster. This not only enhances their market valuation but also makes it easier to earn a strong profit.
But hotness doesn’t just happen. It is usually the result of some calculated and skillful marketing.
And surprisingly while agencies are highly skilled at marketing their clients’ products many don’t do so well in marketing their own brand. Their business development programs can be tightly focused on tactical selling with very little strategic marketing.
As one very successful agency leader said, “With a strong tactical selling new business program you make the phone calls. With a strong strategic marketing new business program you just answer the phone.”
Quite a difference.
This suggests that a continued investment in strategic marketing can have an important long-term impact on the agency’s market value. And in fact, aggressive marketing, as differentiated from aggressive selling, is probably one of the best kept success secrets of hot agencies.
What This All Means
Thirty some years ago Fram oil filters launched a memorable ad campaign. Its signature line was, “You can pay me now, or you can pay me later.” That line is metaphoric for the decision every agency owner-manager must make.
You can take big rewards now. Or you can take big rewards later. But you probably can’t have both.
If you maximize your rewards now your future rewards will likely be minimized. And the flip-side of that is that if you take less out now you can probably get greater rewards in the future.
It is a choice. And it is as simple as that.
Making Your Choice
Every agency leader has a decision to make in synchronizing agency profits (the Income Statement) with agency value (the Balance Sheet). Here are some thoughts that might be helpful in finding the right equilibrium for your agency.
1. What Do You Want?
The first step is to determine what you, and your partners, want to achieve. How do short-term rewards and long-term rewards fit into your individual and collective life plans?
This is not hard to do. Yet, surprisingly, many agency leaders never proactively mesh their agency plans with their life plans. Nor do they set expectations for profits or agency valuation. And, of course, without profit and valuation goals there are no benchmarks to measure performance against.
But failing to do this is an almost sure guarantee for disillusionment as time passes.
2. Create a Pro Forma
Lay out a plan for both agency profits and growth (incorporating a factor for inflation) for the next five to ten years. Looking at the numbers generated in this pro forma should help put the agency’s business plan into context as well as help clarify the totality of the agency’s focus.
Remember the rule of 30 when you are doing this. It will help you keep the forecasts reasonable. And nobody will ever be unhappy if the agency’s actual performance exceeds 30.
3. Don’t Neglect the Soft Values
Establish a long-range plan for marketing your agency. This is different from tactical sales calls. This means painstakingly building your agency’s brand with a single-minded continuing focus and intensity. A process that is much like what you probably recommend to your clients.
A hot agency is worth more. It can mean the difference between a good valuation and a great one. And becoming hot is usually the result of carefully planned and implemented strategic marketing.
4. Live the Plan
If the plan becomes imbedded within the agency’s culture there is a far greater chance that it will be achieved. This is particularly important if you anticipate eventually selling the agency internally.
The more that potential future buyers are able to internalize the agency’s long-range business plans, the better. It can give them greater confidence in the agency’s future and solidify their commitment to it.
The Income Statement and Balance Sheet as Tools
In my long ago accounting class, the Income Statement and the Balance Sheet were presented as if they just kind of happened after all the work of the business was done. They were reactive documents reflecting a view through the rear view mirror. A passive after-the-fact sort of reporting. Kind of dull.
In today’s agency environment they can be much more.
When future expectations for the Income Statement and Balance Sheet are tightly linked with the agency’s business plan they can become assertive, active tools in the accomplishment of both agency goals and the life goals of the principles. Dull reports become living management tools.
With the Income Statement and Balance Sheet as tools, rather than just accounting reports, leading an agency can be more successful, more enjoyable, more rewarding and more fun.
Not a bad combination.