Trying to run a business without good financial statements is like trying to call football plays without knowing the information on the scoreboard (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. 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 have accurate financial statements. This is an absolute requirement. If you aren’t receiving accurate financials, you most probably need a new bookkeeper. Beyond this, we suggest six tips for upgrading your financial reporting process:
1. The right system. 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.
2. Accurate accounting. Separate costs directly associated with delivering your product or service from other expenses (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 could be a red flag indicating a problem.
3. Line by line. 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 prices or stop doing the unprofitable work.