Financial management

In Professional Practice Hannah Moss showed the students the arithmetic of utilization, multipliers and overhead, and the danger that a profitable firm can run out of cash. In the fifth week of the graduate seminar she goes further. Each student will build the financial statements of their imagined firm and a month-by-month cash-flow forecast for its first eighteen months, and then defend them to a banker. The banker is Elena Sokolova, who manages loans to professional firms and small businesses and has lent to several architecture practices. She tells the class that she has seen more good design firms fail for lack of cash than for lack of talent, and that she judges founders less by their portfolios than by whether they understand their own numbers.

Three financial statements

Moss introduces the three statements every firm prepares, usually with an accountant, at least once a year and preferably every month.

• The income statement, or profit and loss, shows revenue and expenses over a period and the profit or loss that results. For an architecture firm, revenue is the fees earned; the largest expenses are salaries and benefits, followed by consultants, rent, software, insurance and marketing.
• The balance sheet shows what the firm owns and owes at a moment in time. Its assets include cash, accounts receivable (fees invoiced but not yet paid), work in progress (fees earned but not yet invoiced) and equipment. Its liabilities include accounts payable to consultants and suppliers, loans and amounts owed to employees and tax authorities. The difference is the owners' equity.
• The cash-flow statement shows how cash moved in and out: from operations, from investment in equipment and from financing such as loans and owners' contributions.

Sokolova says that she reads them in the reverse of the order most founders expect. She looks at the cash-flow statement first, because cash is what keeps the firm alive; then the balance sheet, especially receivables and work in progress, because they show how quickly the firm turns work into cash; and only then the income statement.

Where the money goes

Moss shows the income statement of a typical small firm as a single bar, with each dollar of gross fees divided by where it goes. About 30 cents is passed straight through to consultants and reimbursable expenses, which leaves 70 cents of net revenue. Salaries for project work, salaries for time that is not billable and benefits take most of the rest. Rent, software and hardware, insurance and marketing take smaller shares, and what remains is profit, here 9 cents of each dollar of gross fees, or about 13 cents of each dollar of net revenue.

The profit share is close to what the AIA's 2024 firm survey reported for American firms, about 13% of net revenue on average, with wide variation between firms. Moss stresses that profit is not a luxury. It pays for the partners' risk, for new computers and software, for the training of staff, for bonuses that keep good people, and for the reserve that carries the firm through a slow year. A firm that aims for no profit will eventually find that it has none when it needs it.

Work in progress and receivables

The greatest difference between an architecture firm and many other businesses is the delay between doing the work and receiving the money. A designer works in March. The firm invoices at the end of March for the work completed. The client reviews the invoice in April, approves it in May and pays in late May. The firm has paid the designer's salary twice before it receives the fee for her March work. Work in progress, the work done but not yet invoiced, and receivables, the invoices not yet paid, together represent cash the firm has earned but cannot use.

Sokolova says that the number she watches most closely is days sales outstanding: the average number of days between doing the work and receiving payment. For many architecture firms it is between sixty and ninety days. Every day it can be reduced frees cash. Moss lists the methods, some of which the students met in Professional Practice: invoice promptly at the end of each month, describe the work clearly so that the client approves the invoice without questions, follow up on every invoice after thirty days, ask for retainers on new projects, and include interest and suspension provisions in contracts. She adds one more for small firms: know the client's approval process and the name of the person who approves invoices.

A cash-flow forecast

Moss asks Wren to forecast the cash of Common Room Architects for its first eighteen months. The firm opens with three founders, each paid a modest salary, and adds an employee after six months and another after a year. Its billings grow slowly as it wins its first projects. Clients pay about two months after each invoice. The founders put 75,000 dollars of their savings into the firm, and the firm arranges a line of credit with a limit of 150,000 dollars that it can draw when cash runs short and repay when cash returns.

# Cash flow for a new firm in its first 18 months (Canadian dollars).
payroll = [21_000] * 6 + [31_000] * 6 + [46_000] * 6   # salaries and benefits: 3, then 4, then 5 people
fixed = 8_000                 # rent, software, insurance, accounting each month
start_cash = 75_000           # founders' savings put into the firm
credit_limit = 150_000          # bank line of credit
rate = 0.0745 / 12             # monthly interest on the line
billings = [0, 10, 20, 30, 35, 40, 45, 50, 55, 60, 60, 65, 65, 70, 70, 75, 75, 75]  # thousands invoiced
DELAY = 2                     # clients pay about two months after the invoice
cash, line, peak, peak_month = start_cash, 0.0, 0.0, 0
for m in range(18):
    received = billings[m - DELAY] * 1000 if m >= DELAY else 0
    cash += received - payroll[m] - fixed - line * rate
    if cash < 0:                          # draw on the line of credit
        line += -cash; cash = 0
    elif line > 0:                        # repay the line first
        repay = min(line, cash); line -= repay; cash -= repay
    if line > peak: peak, peak_month = line, m + 1
    if (m + 1) % 3 == 0:
        print(f"month {m + 1:>2}: billed {billings[m]:>3}k  received {received / 1000:>3.0f}k  cash {cash:>8,.0f}  line {line:>8,.0f}")
billed, paid = sum(billings) * 1000, sum(billings[:-DELAY]) * 1000
print(f"invoiced {billed:,.0f}; collected {paid:,.0f}; still owed by clients {billed - paid:,.0f}")
print(f"peak use of the line {peak:,.0f} in month {peak_month} against a limit of {credit_limit:,.0f}")

month  3: billed  20k  received   0k  cash        0  line   12,000
month  6: billed  40k  received  30k  cash        0  line   39,517
month  9: billed  55k  received  45k  cash        0  line   37,302
month 12: billed  65k  received  60k  cash   10,236  line        0
month 15: billed  70k  received  65k  cash   38,236  line        0
month 18: billed  75k  received  75k  cash   91,236  line        0
invoiced 900,000; collected 750,000; still owed by clients 150,000
peak use of the line 43,763 in month 7 against a limit of 150,000

The forecast shows the shape Sokolova calls the J-curve. The founders' cash is gone within three months, because salaries and costs are paid every month while the first invoices take two months to be paid. The firm draws on its line of credit until about month 7, when it owes about 44,000 dollars, and then repays the line as payments catch up with costs. By the end of the eighteen months the firm has invoiced 900,000 dollars, collected 750,000 and has 150,000 still owed by clients, two months of billings that are its working capital. Moss points out that the firm is profitable from early in its first year, yet without the line of credit it could not have paid its people in the spring.

Sokolova asks Wren two questions a banker always asks. What happens if clients pay a month later than you assume? And what happens if your second project starts three months late? Wren reruns the model with each change. If clients pay three months after each invoice instead of two, the peak use of the line nearly doubles, to about 84,000 dollars. If a late second project costs the firm 15,000 dollars of billings a month for three months, the peak rises to about 88,000 dollars. Both stay within the limit, but with far less room to spare, and the two together would take the line to about 128,000 dollars, close to its limit. Sokolova says that a founder who has already asked these questions, and knows the answers, is someone she would lend to.

Budgets and monthly reports

A firm should have an annual budget, prepared before the year begins, that forecasts revenue from signed and likely work, salaries, other costs and profit. Moss recommends building it from the bottom up: list the projects and the fees expected from each month by month, then the staff and their costs, then the other expenses. The budget becomes the yardstick for the monthly report. Each month the principals should see, on one page, the month's and year's revenue against budget, the main expenses, the profit, the cash balance and line of credit, receivables by age, work in progress, backlog and the firm's utilization. Moss says the one-page report takes an hour to prepare once the accounting system is set up, and it is the most important hour of the month.

Paying the founders

New founders often ask how much to pay themselves. Moss suggests three layers. The first is a salary for the work each founder does, set at a level the firm could afford to pay someone else to do the same work; this keeps the firm's costs honest. The second is a distribution of profit in proportion to ownership, paid only when the firm has the cash and has met its reserve. The third is the value of the firm itself, which grows if the firm builds a reputation and a team that can continue without the founders. In the first year Wren's founders take salaries well below what they earned as employees, and Moss tells them to record the difference: it is part of their investment in the firm.

Taxes affect how founders are paid and how a firm is structured. In Canada, a professional corporation that qualifies as a Canadian-controlled private corporation pays a reduced federal rate of tax on its first 500,000 dollars of active business income, and owners can take income as salary or dividends, each taxed differently. These choices depend on the province and the founders' circumstances, and Moss tells the students to set them with an accountant before the firm opens, not at the end of its first year.

The banker's view

Sokolova closes the session by describing what she looks for when a new firm applies for a line of credit or a term loan. She wants to see a business plan with a realistic cash-flow forecast, evidence of signed or nearly signed work, the founders' own money in the firm, personal guarantees from the founders for the first few years, and a clear understanding of receivables. She warns that the line of credit is for timing differences, not for losses: a firm that draws on its line every month and never repays it is not short of cash, it is losing money, and the bank will notice. She also tells the students to talk to their bank before they need money, not after, because a banker who has been kept informed through good months is far more helpful in a bad one.

Exercise 5: your firm's finances

• Prepare a budgeted income statement for your firm's first year.
• Build an eighteen-month cash-flow forecast with a two-month payment delay, and find the peak use of a line of credit.
• Run two stress tests and describe your response to each.
• Design the one-page monthly report you would review with your partners.

Self-check

• Can I read an income statement, a balance sheet and a cash-flow statement?
• Do I understand why work in progress and receivables tie up cash?
• Have I tested my forecast against late payments and late projects?
• Do I know what a banker will ask before lending to my firm?