Making Financial Statements Useful
Q. I run a small business. I pay an accountant to produce financial statements each month, but I have not found them to be very useful. Could I save this expense and just do without financial statements? If I do need them, what can I do to make them useful?
A. If your business has any size or complexity, you absolutely need financial statements. Trying to run a business without good financial statements is like trying to call football plays without knowing the information on the scoreboard (e.g., score, quarter, down, distance needed for a first down, time remaining, etc.). Regardless of your coaching skills, it’s impossible to call plays effectively under such circumstances. Yet, in our experience, far too many small business owners attempt exactly this.
They have financial statements that are, at best, not useful for management decision making. At worst, they are inaccurate. In addition, small business owners often receive their financial statements so late that they are no longer relevant (sometimes months after the end of a reporting period). For entrepreneurs who are counting on their businesses to provide a consistent source of income for them and their families, this is not an acceptable state of affairs.
At a bare minimum, you must get accurate financial statements. This is an absolute requirement. If you aren’t getting accurate financials, you most probably need a new bookkeeper. Beyond this, we suggest six tips for upgrading your financial reporting process.
• For the purposes of management decision making, it’s generally best to use an accrual accounting system rather than a cash system. Accrual systems do a better job of matching expenses to revenue. If you report revenue and the associated expenses in different periods, the result can be wild swings in month-to-month profitability. The company might well show a loss in one month and be extremely profitable the next. This variation in results prevents the owner from understanding true performance. If there are advantages to using cash accounting for taxes, you can still do that while using accrual accounting for management decision-making.
• Separate costs directly associated with delivering your product or service from other expenses (e.g., selling, administrative and overhead costs). This will enable you to calculate a Gross Margin Percentage (equal to the difference between revenue and the costs directly associated with producing the revenue divided by the revenue). Generally, the Gross Margin Percentage should remain relatively stable from period to period. If it fluctuates wildly, this may be a red flag indicating a potential problem.
• In a service business, understanding the profitability of each job/client is critical. Similarly, in a product-based business, it’s important to understand product line profitability. We have often found small businesses that had unprofitable clients or product lines and didn’t know it. When you discover such a discrepancy, it’s generally best to raise price, reduce cost, or stop doing the unprofitable work.
• Revenues and/or costs that are the responsibility of a single manager should be broken out separately. This makes it easier to hold people accountable. For example, we have frequently seen line items such as “People Costs,” that lump all personnel costs together. However, if there are four senior managers each of whom have responsibility for a portion of the people costs, such categories obscure performance. Our rule is that for every line item on a financial statement, there should be one and only one person accountable. Break apart line items where multiple people have responsibility until you reach point accountability.
• Insist on receiving financial statements within two weeks of the end of each month. In most cases, you can do better than this. We’ve seen bookkeepers who deliver financial statements one, two, three months or more after the end of a month. This greatly diminishes the value for management decision making. We’ve often heard bookkeepers say that they can’t deliver financials as quickly as we would like. Don’t accept this. Additional resources may be required. You may need to estimate certain items, but you can usually get good financial statements within two weeks of the end of the month.
• Set a hard close to the end of each month. Worse than not delivering financial statements in a timely manner is making change after change to statements that have already been delivered. Figure out how to get all significant items reported in a timely manner and close the month. Any additional entries go in subsequent months.
Insist that your financial statements are accurate, formatted in a way that is useful for management decision making and that you receive them in a timely manner. If you don’t know how to do this, reach out for help—this is critical. Anything less can limit your ability to make effective decisions and cripple your business.