I consult with dozens of CEO’s from start-up’s to 20 years old small businesses, many of them have the same problems.
- How do I get access to capital? (click here to review)
- What do my financials really mean to me?
- How do I position myself in the market?
- How do I grow my revenue?
One could say that all businesses have more than one of these same problems. True, but small businesses make up the vast majority of the US economy and their issues tend to carry a huge weight on our daily lives. According to surveys 99% of US employers have less than 500 employees. Most of my established businesses have less than 20 employees and generate less than $2,000,000 in annual revenue. As a SCORE Mentor and Chapter Board Member I help my clients deal with these issues every week.
In this article I’ll just discuss Problem #2 – Understanding Financials.
Small business CEO’s are best served by using financial management software right from the very start, for example QuickBooks. By using this type of software either by an employee or through an outside accounting firm, the CEO automatically gets important financial reports, the company’s “Financials”. The first step in “Understanding Financials” is to actually have access to them.
The issue I stress is that a CEO doesn’t need to become a “CPA”, however understanding financials, helps; a) spot trends, b) manage more effectively, and c) grow the business. The focus is to understand enough to analyze and take action. A great deal of “actionable” information can be gained by strategizing how your financial information is initially set-up.
The Income Statement
Understanding the Income Statement or Profit & Loss statement (P&L), is probably the 2nd most important report, after Cash Flow and Cash Forecast reports. I encourage CEO’s to start their business using Accrual Basis accounting vs. Cash Basis. Although the IRS allows small businesses to choose a method, starting with accrual or “modified cash” shows a much better view of a business’s performance. Besides, using something like QuickBooks makes this easy.
The very top of the P&L is Revenue and Cost of Goods (COGS). I suggest the segregating of revenue as much as possible and its associated costs of goods where possible. For example, in a services business track revenue and costs by various types of services, and then further separate out all product sales. Therefore when running reports you can easily see, at least, gross profit by type of service(s) and product(s). The ability to accurately determine costs that is unique to revenue vs. general business overhead is quite important. You want to potentially include directly related costs to “Cost of Goods”, vs. Expenses.
I tell my CEO’s the “best” kind of revenue is “reoccurring”, sell or contract once, enjoy it monthly. When possible find ways to provide on-going, auto renewing, contracted services. In a former business about 65% of my total revenue was “reoccurring”, enough to cover all business expenses except sales and marketing. We’ll talk more about this in a future article on “positioning a business”.
The income statement is somewhat meaningless, unless you also have a budget to compare to. Each line item should have a predetermined budget amount. The budget is normally done annually and the monthly portion is shown on monthly financials, similar with Year to Date (YTD). Comparison to budget, is “actionable” information, why are we over or under, what can we do about it.
The bottom half of the P&L is Expenses. The goal in every business is to continually manage and lower expenses as a percentage of revenue. A dollar saved in expenses is worth more than an extra dollar of revenue. The biggest single expense category in most businesses is payroll costs (salaries, taxes, insurance etc.). As business grow they need to add employees, managing this expense is the single biggest lever available to a CEO. Here’s a tip, unless you are in a really fast growth business, do not “let expenses chase revenue”.
For all practical purposes, CEO’s need to initially understand only a few items on the Balance Sheet (B/S). A Balance Sheet merely shows Assets, Liabilities and Paid In Capital (Owner Equity). Three items are most critical on a B/S: Cash – Asset, Accounts Receivables (A/R) – Asset and Accounts Payable (A/P) – Liability. Cash is exactly what is in your checking or other business accounts at the end of the accounting period. A/R is the total amount owed by customers, and A/P is money you owe vendors for products or services they have already provided billed or unbilled (accrued costs). Keep in mind that whereas cash is easy to understand, A/R and A/P need further analysis, that’s why they are “aged” on a separate report. The longer out on an aging report the A/R and A/P is, the more trouble you are in. Unless you have very unique business requirements, A/R should be kept as current as possible. If you are carrying accounts more than 30-60 days you have issues. In my past business I changed my terms of sale and specified ACH Debit as my standard method of payment, over 80% of my billings were paid in the month billed. One would look at my AR month end report and think we were in trouble, not so, it was all turned to cash.
That are the two biggest factors that affect AR? First, how you “train” your clients. If you allow them to pay in 60 – 90 days they will take advantage of you. If you call them 1 day after the due date they will get the message. Secondly, happy customers are much more likely to pay on-time. You can’t “make them happy”, but you can treat them really well, they’ll probably decide on their own to be happy.
Cash Flow Forecast
You notice that I’m not referencing a Statement of Cash Flow, but a forecast here. Yes, a cash flow statement is a very important tool, but it is “yesterday’s newspaper” by the time your read the report, it is too late to take action. For small company CEO’s, more important is your forecast for future cash requirements, usually in a spreadsheet format. You can easily build the cash forecast from both the statement of cash flow and your budget. It is a whole lot more comfortable for a CEO to have 3-4 months of cash on hand than to continually worry about making payroll.
The bottom line is that it is important that CEO’s of small businesses understand the key elements of their financials. Getting consulting services from SCORE or a business advisor may help you in your efforts. Once a CEO has a sufficient level of financial understanding he/she can focus on other key areas of the business. In future articles I’ll cover the remaining 2 Problems shown above.
You can research our Florida SCORE chapter here: https://pascohernando.score.org/