If you owed another business money, would you put that down as revenue?
You wouldn’t. Obviously.
And yet, that’s basically what happens when you take a deposit or a prepayment, and declare it as revenue for that month.
If your business stopped straight after taking that deposit, that company would want that money back.
Your business hasn’t stopped (phew) but they want their work. You owe them work. So at the moment, that revenue is more like a debt.
A strange type of debt I admit, but work with me. The point is it isn’t money you’ve earned yet.
The same thing happens with retainers. Even if you offer a use-it-or-lose-it retainer, I bet that sometimes clients have a quiet month and you roll it over or adjust the amount. And even if you are strict, imagine this when you have scaled and aren’t the one keeping every client happy. It’s going to happen and it’s the same problem.
That revenue from the first month is now something you owe someone. They’ve paid you, but they haven’t got the value yet.
Your monthly analysis is built on bad data
For simplicity’s sake, let’s say you get the deposit one month and deliver the project the next month. When you look at the revenue line for the next month, it’s going to be zero. Now you have one month with what is essentially a debt in the revenue line, and the next month: no revenue at all, a load of costs, and you make a loss.
If you take both months together, you get the true picture: the revenue and costs land in the same place, and you can see what you actually made.
Mentally, we’re all capable of looking at two months and analysing what went down.
No one is just looking at one of those months and saying, this month was amazing, this month was terrible.
And yet, when you put this in a real-world example, that’s exactly what you are doing.
But that mental analysis gets harder when you add more projects over more months with more billing points. And you will absolutely lose track. You will not know if that number in your revenue line is money you’ve earned or work you owe.
Things get particularly murky when you’re growing. Newer, bigger projects come in and inject cash into the system, which masks the fact that older projects aren’t as profitable.
And because you’re now having to deliver more with a team, your costs aren’t as flexible. You can no longer just do it yourself over the weekend. Every bit of work causes more cost to happen.
This means the margins on your lower rate work dip even further, but that dip is covered by the initial billing from the new higher rate project that just appeared.
Then you get towards the end of that project and the leakages start to appear (overruns, scope creep - those final invoices are rarely as profitable as the first ones you did).
A few months later, the new project’s profit isn’t as high. The old project is running along at close to break even. And potentially another even bigger project comes in and masks everything for a while longer.
It’s very easy to grow in revenue and stand still or go backwards in profitability and somehow not notice it.
You know what’s really cool? Accrual accounting
The solution to this is called accrual accounting. Put simply, it involves only declaring revenue when you’ve done the work that earns that revenue. If you want to examine the business month by month, then you have to have each month provide a true reflection of the business’s performance.
One way to achieve this would be to only bill when you do the work, billing each month for the work done that month. However, this stops us being able to deploy tactics around cash flow like deposits and being flexible with when we bill. And there’s really no need to lose the ability to do those things just to see our business clearly.
The way to approach it is to adjust your revenue line each month.
Accrual accounting stops cash masking performance. The date you raise an invoice and the date it gets paid are ignored. The amount of the invoice is all we’re interested in, and we only put it in our revenue line when the work that invoice is for gets done.
That means your deposit is not revenue. There won’t be anything on your revenue line that you haven’t done.
And because the money you earn from a project and the money you pay out in costs all happen in the same period now, you can take any project you want and see if it made money that month.
The January deposit shows up in February, where it belongs.
This gives you the monthly snapshot. You can see what you actually earned and what it cost you.