Thursday, November 1, 2007

Your Month is not over Until You Have Accurate Financial Statements

Do any of these statements sound familiar:

- "I don't understand why some months I make a 15% net income and other months I lose 7%. I can't trust what my financial statements say."

- "Our profit is low this month because we bought a lot of inventory that we haven't sold yet."

- "Our profit is low because we paid for the next twelve months of insurance this month."

- "Our profit is higher than normal because we invoiced our customers for work we haven't actually done yet."

Owners and managers of small and medium-sized businesses often make these and other similar remarks, implying that the company's financial statements are wrong. The consequences of not having accurate monthly financial statements can be devastating. We have seen situations where millions of dollars, hundreds of jobs, and entire companies were lost because of inaccurate financial statements.

For the purposes of this brief discussion, financial statements refer to the income statement, balance sheet, statement of cash flows, and any other industry-specific report (like a Work-In-Progress report in the construction industry) that helps the company identify its successes and opportunities for improvement. While ensuring these statements are accurate may cost a little more than the company is currently spending on its accounting functions, the cost is usually well worth the expense.

Accounting personnel usually perform non-revenue generating activities, which can cause some business owners heartburn. If their activities are set-up to effectively and efficiently create accurate monthly financial statements on time each month, the accounting staff is truly an invaluable asset to the company. Our experience shows that neglecting this aspect of a business will cost an entrepreneur much more in the long run than the relatively low cost associated with producing accurate internally-prepared financial statements each month. We will discuss one of the causes for and several benefits derived from accurate financial statements.

We are not suggesting you shouldn't watch your bank account. We are, however, suggesting that start-up businesses typically rely on the balance in their bank account as the critical measurement of their performance. As a company grows and becomes more complex, this is a very ineffective way to measure the company's real performance. Yet all too often growing firms struggle to break this habit and the philosophies associated with it.

In over 90% of the businesses with which we have worked, one of the main causes of inaccurate financial statements is the utilization of cash-basis reporting principles. In essence, cash-based accounting puts cash coming into the business and cash going out of the business into the same accounting period, regardless of if they are related to one another. For example, if in the month of December I buy furniture to re-sell but I don't receive any cash from sales of furniture in the same month, then my cash-based financial statements would tell me that I lost a lot of money in December. But did I really? Sure my cash was negatively impacted, but I still have valuable assets that I will likely sell the next month. Cash-basis financial statements do not portray the performance of the firm.

Conversely, accrual-based financials strive to match revenues to related expenses, and vice-versa. This means we shouldn't show the expense of purchasing the furniture for re-sell until the period in which we actually sell it. The results are financial reports that explain exactly how the firm is performing. Interestingly, accrual-based financial statements will solve each one of the statements in the introductory paragraph.

Accurate monthly financial statements create additional benefits. Your internal accuracy will empower your CPA to be more effective in tax return preparation, calculation of penalty-free quarterly estimated tax payments, and other tax-planning activities. You will become one of their favorite clients, and you know how willing you are to go above-and-beyond for your favorite customers. Your credibility as a viable business will skyrocket with bankers, bonding companies, professional licensing boards, and other outside professionals who may be critical to your ongoing success. When the time comes to value your business, accurate financial statements will ensure the valuation is complete. We have seen companies receive valuations far below their actual worth because their financial statements did not show the true picture of their business.

If you get nothing else from this article, please make sure you remember this - if you take care of this part of your business, you will reap short and long-term rewards. You will have better information from which to base your leadership and strategy. You will satisfy outside professionals that you manage all aspects of your business. We have found that organizations that do not have accurate financial information can quickly lose their competitive advantage. If you refuse to allow your month to end until you have accurate financial statements, you will empower your firm to maximize profitability, cash flow, and value as well as capitalize on future business opportunities.