There are so many trivial things that can drag back your crucial business activity in the first few stages of entrepreneurship that it’s best to keep them at a minimum. Some of the sillier ones are…
- Designing your first business card.
- How to write and format a business plan.
- Thinking up a cool company name and logo.
- Understanding accounting.
Now that last one isn’t trivial, admittedly, but it’s a huge subject that you don’t really need to understand inside-out to start a business. In fact, understanding it inside out isn’t possible or relevant, because once you’re past the very basics, every business’s needs are different, so their founders will need to learn something different.
In short, once you’re past the basics of “buy for one, sell for two, buy more for one, repeat”, you should be more focused on the business than the accounting.
So what we’re going to do is start with the very basics, starting by converting value-capture into a profit and loss statement, or income statement.
- Value creation is everything you’ve sold (in a certain time-frame) equals your revenue or sales line.
- Your cost of sales is the variable cost of creating that value, quite probably the inventory you will need to buy to sell the same again tomorrow.
- Value capture, or gross value capture to invent a new technical term, is the profit we have left after taking our variable cost of sales from our sales. If we divide that profit by the sales, that’s our gross margin. The higher the better.
Revenue – Cost of Sales => Gross Profit
- Our fixed or operating costs are the things we need to pay to do business, like rent and salaries. Once we strip those out of our gross profit we have our operating profit, and dividing that by sales tells us our operating margin. We could think of that as operating value capture.
Gross Profit – Operating Costs => Operating Profit.
- And if we take our interest repayments and tax out of that, and still have profit left, that’s our net profit. Divide that by sales and we know our net margin.
Operating Profit – Interest and Tax => Net Profit
- If we divide our annual net profit by the cost of setting up and investing in our business, we also know our return on investment, which is worth knowing, because it will tell us if we should be investing more money in it or not.
Net Profit / Capital => Return on Investment
We haven’t got to the “Machine” part of the Value Capture Machine yet, but we will soon, and when we get there, you’ll understand why having this analysis is so important.
What a machine does is repeat itself, but what the operator of a Value Capture Machine (that’s you) should do is make sure that each time the machine repeats a task, it tries to do the task better. This is what our income statement can do.
It measures how much value we are creating, how much of it we are capturing, and how we could improve on either of those, where we could improve either to create more value or capture more value or both.
That’s a long set of questions, but your first income statement is an important step in understanding how your business will capture value, which can lead you to the next step on The Road To Payback.