Financial Statements: A Necessary Evil

Do any of these statements sound familiar?

“I don’t understand why some months I make a 15 percent net income and other months I lose 7 percent. I can’t trust my financial statements.”

“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 12 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 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.

Financial statements refer to the income statement, balance sheet, statement of cash flows, and any other industry-specific report 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.

A Necessary Evil
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 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.

Watching the Bank Account
A small business typically relies on the balance in the bank account as a critical measurement of 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.

Accrual vs. Cash
In more than 90 percent 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 one I buy plants to resell but I don’t receive any cash from sales of plants in the same month, then my cash-based financial statements would tell me that I lost a lot of money that month. But did I really? My cash was negatively impacted, but I still have valuable assets 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 plants for re-sell until the period in which we actually sell them. The results are financial reports that explain exactly how the firm is performing. 
 
Additional Benefits 
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 improve with bankers. 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 businesses.

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 help you manage all aspects of your business. 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.

The author is founder and CEO of CFOwise.com, a CFO firm for start-up, emerging and small- to medium-sized businesses.