Why is agency accounting important? Here is how to set up and manage your agency’s books in Xero
Many agency owners think the biggest reason why agencies fail is lack of sales.
This is rarely the case.
The biggest reason why agencies actually go out of business is lack of financial planning and poor cash flow management.
The silver lining is – it is easier to get your agency’s finances in tiptop shape than it is to land a bunch of new clients.
In this post, we’re going to walk you through everything you need to need to know in order to run a financially healthy agency, including:
- Why is accounting important for agencies?
- What are the top benefits for agency owners?
- How to do accounting for your agency
- What are some general agency accounting best practices?
- Should you hire an accountant, bookkeeper or both?
Why is accounting important for agencies?
Accounting is the backbone of your agency. If you neglect your accounting or only worry about it for a couple of weeks a year at tax time, you are setting yourself up for a lot of problems in the future.
What are the top benefits for agency owners?
1. Know your numbers
In order to make smart decisions about your agency’s future, you need to have a firm grasp of your agency’s finances.
If you are six months behind on your bookkeeping or there are a ton of mistakes in your reports, you are not going to have confidence in your numbers. This means you are making decisions off of inaccurate data or going purely on intuition.
A better way is to make decisions based on your data, which means you can understand how much free cash flow you have at any time, how profitable each project is, be able to pay your team on time each month (including yourself). how much you can pay yourself each month
2. Pay yourself a livable wage
Many agency owners either consciously or subconsciously make themselves martyrs for their own businesses. They either don’t pay themselves at all, pay themselves whatever is left over at the end of the month, or a “Ramen Noodles salary.”
As the owner of the agency, you should be compensated fairly for the work you do. This means paying yourself a livable wage in addition to quarterly or annual profit distributions. After all, it is your business and you should be rewarded if the business is growing.
3. Eliminate some of the stress at tax time
When you are on top of your bookkeeping, putting aside money each month for taxes, and paying the right amount in quarterly taxes, the end of the tax year is a lot less stressful. You don’t have to dig through a year’s worth of receipts, deal with compliance issues, or worry about how you are going to pay your ginormous tax bill.
Accounting for your agency
Accounting becomes easier when you build the right financial systems and processes in place. Here are the steps we recommend.
Upgrade from spreadsheets to cloud accounting software
Many agency owners take the DIY approach to accounting and rely on Excel spreadsheets. This is fine if you have a background in accounting, love spreadsheets, and have zero plans to grow your business. However, we’re guessing most agency owners don’t fit into this niche criteria.
The more time you spend on manual accounting and bookkeeping processes, that means the less time you are spending on growing your agency and working with clients.
The first step is to get out of spreadsheets and upgrade to cloud accounting software, such as Xero, Quickbooks Online, or MYOB.
At Bean Ninjas, we’re partial to Xero.
All cloud accounting software is faster, more reliable, partially automated, and less prone to human errors than DIY accounting in spreadsheets. It is also fully secure and encrypted, syncs with your bank and credit card accounts, and integrates with key business software, like Gusto and HubDoc.
Pro Tip: Want a step-by-step checklist for setting up and keeping your Xero account in order? Download our free Xero Toolkit.
Set up your agency accounting tech stack
In addition to your cloud accounting software – like Xero – you also want to make sure all of your other key business operational and financial software is integrated with it. If all of your key tools are synced, it means less administrative work for you and your team.
Your tech stack will expand as your agency grows, especially as you bring on full-time employees. Here is a few software we recommend adding to your accounting tech stack:
- Xero – your cloud accounting software
- Hubdoc – this is an app that makes it easy to manage receipts and expenses, and it comes free with Xero as of March 2020
- Gusto – managing employees and contractors invoices and payroll
Commit to either cash or accrual accounting
There is an age-old debate on which accounting method works best for agencies. The reality is either option can work. The most important factor is how consistent you are with it.
If you really don’t know which method to choose, default to cash-based accounting if you are doing less than $250,000 in annual revenue, and accrual accounting if doing more than $250,000.
Decide which financial metrics to track
When you are first starting out, we recommend tracking the following metrics.
- Revenue – this is the metric that even the most stubborn, non financially savvy agency owner is likely tracking. It is top-line revenue or sales.
- Bank Balance – this is the number that is in your bank account at any given time
- Profit – this is sales minus all of your expenses, which includes your own salary, staff costs, and any operating expenses.
- Aged Receivables – this is a term for any outstanding or unpaid invoices.
- MRR – this stands for monthly recurring revenue.
As you bring on more contractors and full-time employees, we’d also recommend tracking the following:
- Gross Margin – this is total revenue minus cost of goods sold divided by total revenue.
- Project / Client Profitability – this is the value you charged less the costs to fulfill the work.
- Labor Efficiency – this is the gross profit per labour dollar spent
Monitor key financial reports regularly
Once you know which metrics are most important for your agency, it is time to build and review your financial reports on a regular basis (i.e. at least monthly).
Here are the three reports that all agency owners should check.
1. Profit and Loss Statement
Your P&L gives you a snapshot into the health of your business by displaying all revenue and expenses in a given time period.
It is particularly useful to get ahead of potential problems before they turn into full-blown crises.
Here are five warning signs in your P&L:
- Declining profit
- Declining spend in sales and marketing
- Agency owners aren’t paying themselves a salary
- Increase in staff costs as percentage of revenue
- Increases in aged receivables (i.e. unpaid invoices)
2. Balance Sheet
Whereas your P&L can give you a snapshot into how your business is performing in a given month, quarter, or year, a balance sheet can provide the bird’s eye view on your overall investment.
Building an agency – or any business for that matter – is an investment just like investing in the stock market, buying real estate, etc.
A balance sheet paints a picture of all of your assets (what you own) and liabilities (what you owe)
3. Cash Flow Forecast
A cash flow forecast is like your business’s crystal ball. It allows you to map out different scenarios from best, moderate and worst case.
We recommend agencies update their cash flow forecasts once a month.
In order to create your first forecast, you need the following:
- Accurate, up-to-date bookkeeping records
- Your beginning cash flow balance from that time period
- Revenue / cash inflows
- Expenses / cash outflows
Pro Tip: Want a step-by-step guide to building your first cash flow forecast? Check out our detailed guide.
4. Bank Reconciliation Report
Within Xero, you can run a bank reconciliation report. This allows you to spot any inconsistencies between your bank and credit card statements and your Xero account. This is especially important to run at tax time in order to ensure that you are reporting the right numbers, or else you could wind up under or overpaying.
Pro Tip: If anyone on your team has access to your bank accounts, we recommend running a reconciliation report at least once a quarter. This is a way to get in front of any mistakes faster as well as ensure that no one is stealing from the company.
What are some general agency accounting best practices?
Once you have the fundamentals in place, here are some best practices.
Implement Profit First
Having a cash flow management system like profit first helps give you control back over where your cash is going. There is often a disconnect between the accounting reports and what is happening in your bank account – profit first solves this by clearly showing if you are running a business with the right margins.
The usual symptoms of an unprofitable agency are:
- Cash flow shortages
- Your P&L says your have made a profit by there is no cash
- Struggling to hit payroll each month
- Unable to pay yourself a decent salary
- Owing back taxes and/or having to pay fines and penalties
One way to fix this is to use the Profit First Method. The Profit First Framework flips the traditional P&L formula around and we get:
Sales – Profit = Expenses
It is a subtle shift but forces agency owners to prioritize business profit, since you are allocating money into different buckets (i.e. operating expenses, salary, taxes, etc) twice each month.
Pro Tip: Want to learn how to implement Profit First in your agency? Check out our detailed guide.
Send invoices quickly
Every agency owner wants to get paid. However, many agencies send invoices later than they need to. This can result in cash flow problems.
One way to fix this is to create a system – ideally partially automated – around sending invoices and follow-up reminders. This ensures you get paid faster for the great work your agency does.
Provide accurate estimates for new projects
Another way that agencies can get into trouble is underestimating the amount of time or money it is going to take to complete a project.
When you are creating your proposals, you want to make sure to account for the project length, all deliverables, staff costs, and more to ensure you are can deliver the work profitably.
Update your chart of accounts regularly
Your chart of accounts is a categorized list of all of your transactions. It is best to update it weekly – or monthly for smaller agencies – so that you always know where you are spending your money.
With Xero, you can even configure conditional logic and automated rules to automatically categorize many of these transactions. For example, you can create a rule to automatically categorize your monthly Slack fees in “software” category.
Want to improve your cash flow and get more confident with your numbers? Learn how to use Xero effectively for your agency with our free Xero toolkit. This includes our step-by-step guide to getting your Xero file in order, a Cashflow Forecast Template, and a Bookkeeping timetable template to help you stay on top of your finances & get current reporting. Download here.
Maintain tax compliance
The added benefit of keeping your chart of accounts up-to-date is that it helps with tax compliance – especially if you want to deduct a lot of expenses.
In addition to making sure you are reporting accurate revenue numbers, you also want to pay close attention to payroll taxes and compliance if you have any employees.
Many agencies get into trouble because of payroll compliance issues. In fact, the IRS in the U.S. can even garnish your business and even personal assets if you don’t pay payroll taxes and associated fines.
Should you hire an accountant, bookkeeper or both?
As one of the pillars of a financially healthy agency, you can’t afford to skimp on accounting and bookkeeping.
It is one of the reasons that an accountant is typically the first expert hired in an agency, usually for tax purposes.
Despite knowing that you need to hire, it doesn’t make the process of actually finding, hiring, and vetting the right candidates or companies any easier. This is especially true for most agency owners, who don’t have a financial background to lean on.
In this case, the two most important things you can do in the hiring process is to:
- Share lots of information about your agency, goals, and challenges
- Ask lots of questions
If you only give them limited information, you will get basic advice and best practices. However, if you share more details about your growth objectives, a talented accountant can ask questions and provide insights that will help you evaluate if they know their stuff.
Besides gauging their experience and credentials, ask questions to learn about how they like to work. For example, an accountant excitedly talks about the 105 point checklist they use with all of their clients is likely to have a dialed-in process. Since accounting is process-driven and detailed-oriented, you want to hire someone who is methodical and likes to dive into the weeds.
On the flip side, if you talk to another accountant, they describe how every client they work with is different, don’t have a detailed checklist, and “wing” it with all of their clients, you should run the other day.
Pro Tip: Want more interviewing tips? Check out our detailed guide to hiring bookkeepers.
There are many different routes you can take when it comes to hiring, vetting and working with accountants, bookkeepers, vCFOs, etc.
In-house vs. freelance vs. third-party service
There are pros and cons to all approaches. If budget is no concern, hiring an in-house, full-time accountant and bookkeeper duo can be beneficial as you are paying them to work directly for your business. As a full-time employee, they will learn all of the intricacies of your business and can potentially help with more tasks as well such as invoicing, payroll, and HR.
The disadvantages of hiring full-time employees is in associated costs, employee onboarding, and management time.
For starters, you have them a full-time salary and benefits. That’s not cheap. It also takes awhile to get them up-to-speed on your company. This can be anywhere from 30-90+ days. You also have the added time of managing them.
For most agencies doing less than $500,000 in annual revenue, the costs of hiring two full-time finance hires is likely out of their budget. Even agencies making $1M or more might not have enough work to justify a full-time finance employee.
That’s why the freelance and third-party accounting and bookkeeping services can be so valuable. Both options are more cost-effective and included the added expertise and knowledge that comes with working with a variety of different businesses.
A freelance bookkeeper might be a cheaper option. However, you still have to deal with all of the time and effort to hire, vet, and manage them on a day-to-day basis.
Pro Tip: If you are looking for the absolute cheapest option, some agency owners like to have their VA do their bookkeeping in addition to general, administrative tasks. While this can potentially save you money in the short term, this usually ends up resulting in additional headaches and expenses come tax time when you realize your VA made a bunch of mistakes because they aren’t a professionally trained bookkeeper.
For example, if you pay your freelancer hourly, you’ll want to make sure they are being thorough and accurate. However, they are still delivering reports in a timely fashion.
On the other hand, a third-party service, like Bean Ninjas, is a more turn-key solution. Third-party services tend to be monthly subscriptions instead of fixed overhead and costs. You get the benefit of working with a service provider that has dialed-in processes, expertise and relationships in the cloud accounting software you use.
For example, as Xero’s Bookkeeping Partner of the Year in 2019, we specialize in working with agencies and eCommerce businesses, have a team of qualified bookkeepers, know the ins and outs of the Xero platform, and have relationships with people inside Xero we can leverage for support. You’d be hard-pressed to find that with either an in-house employee or a freelancer.
Growing an agency is hard enough. When you ignore your accounting and bookkeeping, it only makes it that much harder.
The best thing you can do is set up solid accounting and bookkeeping systems and processes early on to help give you the quality data needed to make better strategic decisions.
Want to learn more about the top 8 metrics to focus on for growth, how to pay yourself properly, and common mistakes agency owners make with managing finances? Watch our free 50-min video training – Financial Reporting for Agency Owners.
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