Do your financial statements accomplish your business purposes? John Jones owns and operates a successful supply business historically generating about $8 million in annual revenue. However, the supply chain issues arising from COVID-19 put a large dent in 2020/2021 sales due to product availability. After much research, John located a new supply source and is ready to start recapturing revenue lost. However, he will need to place a very large order with the new supplier to secure his place on their customer list. John realizes he will need a working capital loan to have the cash to finance the purchase. John contacts his bank to start the application process. The bank instructs John to begin the process by sending over his latest two years’ financial statements. John never felt the need to pay too much attention to the financial statements of his business during the year, rather just that he had enough cash in the bank each month for operations and payroll and to cover his quarterly estimated tax payments. Naturally, around his fiscal year-end, his results on the income statement did become an important conversation with his tax accountant. But, now that the financial statements are important to John other than for year-end tax purposes, he realizes there are some problems … Sam, the bookkeeper, informs him the last set of financial statements prepared was 6 months ago, because no one was asking for financial statements other than once a year. As the loan application sat incomplete, John was now not sure he could keep his new supplier available.
Most business owners (and most corporate CEOs) are not former accountants. It is therefore understandable that they don’t fully understand all the purposes of financial statements. This article cannot change backgrounds, but as a businessperson, you should at least understand the potential business implications of what your company is producing as financial statements, and perhaps the potential as a business management tool.
The problem aggravating understanding is one of timing. The timing issue is that the financial statements for non-corporate level businesses often take a month or two to complete due to competing tasks taking priority. In these circumstances, the owners learn to manage from other sources of information, such as checking the cash balance online at their bank and just keeping tabs on weekly sales (multiplied by some historical margin percentage) as a rough indicator of operating results. While larger businesses can improve the financial statement completion times through more accounting resources, even a 10- business day lag for financial statements has caused the popularization of CEO dashboard reports coming out of ERP systems to get key operating metrics on an overnight basis. Financial statements are, by definition, a historical view and become under-valued by owners in today’s “manage the moment” environment.
Taken to an extreme, business owners can get to the point of almost ignoring the financial statements, as did John above. If the business never needs a bank loan, sophisticated insurance coverage like business interruption or cyber risk or a new contract with a sophisticated supplier, or never entertains the thought of selling the company, this approach might never have consequences. But, while owner-operators can usually understand the state of their business without historical financial reports, third parties cannot. Historical financial statements are likely to be what those parties use as a basis to make their decisions regarding your company. In our CFO services business, we often get the call when the consequences arrive, and we see it quite often. Just when the business needs the external cash or the additional supplier, the consequences arrive and long-ignored issues surface.
As in John’s case, failing to keep a monthly financial closing process on a timely schedule is often a “tip of the iceberg” scenario since lowering the priority on timeliness usually lowers the visibility to other facets not being considered.
Once John sent over the financial statements that were available, the loan officer pointed out that the cash flow statement was not being produced as part of the package. That led to the further question as to whether the existing financial statements were cash basis or accrual basis. Sam the bookkeeper knew it was standard Quickbooks software that was used to produce the statements, but not the full answer. The loan officer indicated the bank would require accrual-basis financial statements within 90 days of the loan application date and that since John’s cash flows would need to be evaluated to evaluate repayment ability and timing, an historical statement of cash flows would need to accompany a cash flow forecast as a validation. Market research indicates that Quickbooks is found in over 75% of small and medium business entities. It’s useful for most business owners to understand its basic strengths and weaknesses.
While John had built this business from scratch and was rightfully proud that he was able to accomplish that just with his own knowledge and effort, for the first time he appreciated that only a look from outside the company can reveal what an outsider will see. At this point, John realized he had to find some help and gave us a call.
With a brief look at the financial statements available, we explained to John and Sam that the company’s Quickbooks setup was, in fact, reporting Accounts Receivable and Accounts Payable on the balance sheet, so it was configured to report on an accrual basis, at least to the extent it was collecting accrual-basis information. That is the standard Quickbooks format unless the cash basis option is elected in the setup routines. Quickbooks has programming to match cash receipts to sales invoices and cash disbursements to vendor payables. So, for any month-end processing cut-off, unpaid sales invoices are reported as the Accounts Receivable and unpaid vendor invoices as the Accounts Payable. For many businesses, this is the principal cash vs accrual distinction of magnitude, so it might be “materially correct” that the records are being maintained on an accrual basis.
However, if there are fixed assets in the business, it does not automatically calculate and enter depreciation. Of more consequence to manufacturing companies, Quickbooks does not automatically can determine work-in-process inventory and make the corresponding value adjustments on the balance sheet and income statement for accrual basis accounting. For government contracting businesses, Quickbooks does not contain all the necessary schedules of information to comply with contractor reporting regulations. But due to the overwhelming popularity of Quickbooks, many new software businesses have been launched specifically to sit alongside Quickbooks and do the very things Quickbooks does not at an affordable price point.
Fortunately for John’s business, there were not too many extra entries that were required. We prepared a monthly depreciation schedule for Sam to post each month to depreciate fixed assets and we showed him how to calculate an accrual for payroll, rent and business taxes each month as well. While a cash flow statement is a standard output of Quickbooks, it was suppressed from being generated in the initial setup. Because Sam had been posting the daily entries all along, the financials were caught up from December 31 to June 30 rather quickly, the bank was satisfied, and John’s working capital line of credit was closed in enough time to secure the additional purchases with the new supplier.
John’s story was to highlight those financial statements can often be crucial to a business even though an owner learns to manage without them. There will never be an acceptable substitute to the outside world if the situation arises. In this case, with a little bit of fine-tuning, John’s financial statements did accomplish an important business purpose.
Nonetheless, it is often underappreciated what financial statements can do for internally managing the business if these are prepared timely, consistently and with some understanding of how best to use them.
Firstly, while financial statements will always be, by definition, “history”, reviewing that history quickly each period allows transactional mistakes to be spotted and corrected while the transactions are still fresh in mind, and/or before an error in process multiplies in magnitude from one month to several months to a year in impact. If revenue slows, or expenses increase, a timely month over month comparison puts the adverse trend in mathematical spotlight. Combining a “look-back” trend analysis with a monthly comparison to a management budget for revenue goals and operating expenses brings a powerful analysis of what is working well and more importantly, what is not working well. The point to be made if each month is watched, the full year result will never be unexpected.
Secondly, most all software products available do a good job of what they are designed to do. The key is to know what level of sophistication is needed and the type of business that will be using it. In all cases, doing the proper initial setup, with adequate surrounding processes and controls, is as crucial as the software selection itself. Don’t short-change this exercise; whatever time might be shaved off in going live will most always be paid back multiple times down the road. It is this methodical approach upfront that provides the assurance your financial statements (and surrounding financial processes) will indeed accomplish your business purposes.
Nperspective CFOs have lived this subject matter for decades. Whether you are choosing financial software, dealing with problems with your current set-up, or just would like an “outside look” at what you have, we are ready to help.