New Venture Lab: Equipping Christian Entrepreneurs

Question

From the : Over past 10 years, Our service company revenue & long term liabilities have increased while retained earnings, equity, and net profit have decreased. Any observations and/or counsel?

Answer

While it is somewhat difficult to answer the question without additional information, the most likely scenario is that your Expenses are rising faster than your Revenue and -- as an owner -- you continue to take out the same salary as well as most or all of the Net Income and the shortfall is being made up by taking on more Liabilities.

To illustrate the point, here is an example of a summarized Income Statement and Balance Sheet of a ficticious company that experiences what one would normally expect to see:

• Direct Expenses that decrease slightly as a percentage of Revenue with increases in Revenue due to scale economies and the learning curve
• Indirect Expenses that decrease slightly as a percentage of Revenue with increases in Revenue due to operating leverage
• Net Income stays in the company to finance working capital and growth needs
• Liabilities increase along with the increase in Revenue (typical Working Capital requirements that tend to increase with size)
• Total Net Worth (Owner's Equity and Retained Earnings) increases over time

To further illustrate the point, here is an example of a summarized Income Statement and Balance Sheet of a ficticious company that experiences a situation similar to what you describe:

• Direct Expenses that increase slightly as a percentage of Revenue with increases in Revenue (the opposite of what one would expect)
• Indirect Expenses that increase slightly as a percentage of Revenue with increases in Revenue (again, the opposite of what one would expect)
• Net Income is taken out of the company to finance the owner's lifestyle needs
• Liabilities increase along with the increase in Revenue as well as the reduced profitability and the lack of earnings left in the company
• Total Net Worth (Owner's Equity and Retained Earnings) decreases over time

It was suggested on the LinkedIn discussion thread to build a financial model to ascertain the issue.  I would suggest starting with a simple model as illustrated above as a starting point.