Financial Statements for Service Vs. Merchandise
Service businesses and companies that sell merchandise employ distinctly different business models. Service businesses sell intangibles, or the results of a performed action, whereas product businesses purchase and sell physical inventory. This fundamental distinction in operations causes a range of differences in balance sheets, income statements and cash-flow statements, as well as in the financial metrics derived from them. Understanding the differences that can arise between product and service businesses can help you to develop financial statements consistent with others in your category.
Product companies' balance sheets include inventory as a large percentage of the assets category. As a result, they tend to have less cash on hand than service businesses, since their capital is tied up in relatively illiquid assets. Service businesses' assets are more likely to be weighted toward accounts receivable. Even if a service business's receivables have a similar absolute value to a product business, the absence of inventory will make the receivables a greater proportion of assets. The liabilities section for sellers of merchandise is likely to include a greater proportion of accounts payable to suppliers for raw materials or finished-goods inventory. For service companies, liabilities are likely to be weighted toward accounts payable for subcontractors and other complementary service providers. The owners' equity section is not likely to differ too greatly between the two. As a product business, focus on maintaining a healthy mix between inventory on hand and free cash on the balance sheet. If you are a service provider, keep a close eye on your accounts receivable to ensure your assets do not become inflated by bad debt.
Income is likely to be similar on the income statement for both product and service businesses, but expenses are likely to differ. Product companies include the cost of goods sold as a major component of income-statement expenses, whereas service companies may not list cost of goods sold at all. Service businesses are likely to list a much higher expense for consumable materials used to provide services, including things such as paint, nails, film, fuel or paper. As a product business, focus on managing your cost of goods sold to boost profitability over time, while keeping an eye on the quality of incoming goods and materials. As a service business, focus on waste reduction on the front line to boost your net income on the income statement.
The "investing" and "financing" portions of the cash-flow statement can be fairly similar between the two, but the difference in asset composition introduces change in the "operations" section. Whereas product businesses list cash paid out for inventory in this section, service businesses focus on cash paid for consumables and one-time expenses incurred as part of delivering services.
The differences in the makeup of financial statements leads to different valuations when analyzing financial ratios. Any ratios dependent on assets are likely to be significantly different between product and service companies. The inventory turnover ratio, for example, can be irrelevant and impossible to calculate from a service business's financial statements, since no inventory is involved in operations. Service businesses are likely to have higher values for liquidity ratios, such as the quick, current and cash ratios, since they have less cash tied up in inventory. The same holds true for return on assets, which can be diluted by large stocks of inventory on hand. As a product business, pay special attention to inventory-based ratios to display operational efficiency. As a service business, focus on cost control through efficient process design and waste management to boost operational performance ratios.