Accounting for Technology: Gross Margins and Financial Statements.

Many of my most recent young and highly talented software and service clients have unbelievable knowledge and depth into their technological field.  However, I find like many other young companies, these professionals lack the Finance & Accounting knowledge in order to best represent their company financials and financial stability to creditors, banks, venture capitalists, or other key stakeholders.  It has led me to rethink how I consult companies and how I train their management teams to look at their own performance.  Three key metrics or financial terms I would like to talk about today include gross margins, Profit & Loss (P&L) Statements, and the Balance Sheet.

Gross margins, which can also be referred to as gross profit margins, by definition is a company’s total sales revenue minus its cost of goods sold (COGS), divided by the total sales revenue, expressed as a percentage.  The gross margin represents the percent of total sales revenue that the company retains after incurring the direct costs associated with producing the goods and services sold by a company.  Obviously, the higher gross margin percentage the more a company retains on each dollar of sales.

For example, if Company XYZ were said to have a Gross Profit Margin of 25%, it would retain $0.25 from each dollar of revenue generated. Strong gross margins vary between companies and industries depending on the service or product being provided.  However, keep in mind gross profit margins do not translate directly into net profit.  The gross margins are generally put towards capital expenditures and operating expenditures, including general and administrative expenses.

One of the first analyzes I put forth with my clients always relates to profit margins and knowing what your COGS are in comparison to your net sales (or earnings capacity for new company’s).  In close to ten years of industry experience around the Hosting Industry I find many new companies and founders tend to overlook Accounting and Finance principles.  Two very important concepts assets and liabilities and net profit can be found on two separate financial statements that should always be viewed by senior management.  They are the P&L, or statement of net income, and the balance sheet.

The balance sheet is a financial statement that summarizes a company’s assets, liabilities and shareholder’s equity at a specific point in time.  It is the best depiction of what a company owns versus what it owes.  In translation to the hosting industry this can be viewed as leasing a server from a reseller versus leasing space in a data center and purchasing servers.  In most US GAAP scenarios the expense of purchasing new server and co-locating it would be pushed to the balance sheet and depreciated over the useful life, typically three to five years.  On a month-to-month operating lease, that same server [as an example] costs $500 at your local reseller is shown on the Statement of Net Income or P&L (profit & loss statement).  If the cost of that server to purchase is $5,000 and the useful life three years, the P&L would receive approximately $140 a month in depreciation expense versus $500/mo for data processing and data center expenses.  Granted additional upfront costs and other fees apply; further analysis is required to understand which model, operating leases or ownership, works best for you.  Keep in mind separate business models and key management philosophies can determine whether purchasing assets or leasing them is best, not just in terms of upfront capital costs, but also from a maintenance and support perspective.

The P&L statement  summarizes the revenues, costs and expenses incurred by your company during a specified period of time. Generally speaking profit centers and corporations report quarterly whereas cost centers look at monthly P&L’s.  This statement shows the ability of a company to generate profit by increasing revenues and reducing costs.  A good measure of company growth is not always looking at the bottom line and seeing the fluctuation of profits but rather the increase in sales.

Doug C. is a Financial Analyst for a top 20 Fortune 500 Financial Services company and owner of YIPFolio Financial & Management Consulting Services. He specializes in Financial & Accounting services including balance sheet, P&L, fixed assets, and capital funding. He has spent several years in the Hosting and Technology industry while consulting management and senior management on all aspects from raising capital to managing daily cash flow. Doug received his BS in Finance from Fairfield University and resides in the Greater New York City area.