Management Reporting and Understanding Financials The Balance Sheet While the income statement is the scorecard for business performance, the balance sheet is the storehouse of the owner’s accumulated investment. It tracks what is owned (assets) and who is owed (liabilities) which include third parties and the owner. Management needs to ensure that the balance sheet properly reflects the underlying value in the business and when necessary adjust these values with offsetting impacts to the income statement. An analysis of the underlying quality of the elements of the balance sheet is usually the basis of vendor and bank credit decisions. Monthly reporting should include a detailed balance sheet with comparison to prior month and prior year. This will help to identify major changes and potential areas of concern. A more detailed approach to reviewing activity is to request a detailed trail balance, which is readily available through most operating systems. Assets are what is owned by the company. These include items that can be easily converted to cash (Current assets) and those that are more permanent in nature (Fixed assets). The primary difference is in how these are consumed in the business. Current assets are usually offset against current liabilities (i.e. using cash to reduce accounts payable), another current asset (i.e. decrease accounts receivable and increase cash), or consumed in the business (i.e. inventory reduction included as part of COGS in the income statement). Major current asset categories include: - Cash and investments: This is the most liquid type of asset that a company can hold. It is important to ensure proper controls over access and monthly reconciliation to bank supplied records. Investments should be managed to ensure availability in line with cash flow forecasts. - Accounts receivable(AR): The primary type of AR is from operations. At times, businesses will have another account set up for non-operating entries (i.e. advances to employees, amounts due to owners, amounts due from sale of vehicles, etc.). These should be kept separately. Key items that should be reviewed by the management team include all past due items with emphasis on those over 90 days past due and the top ten balances (which usually cover 70% of the overall account balance). To provide a conservative valuation of this asset class, companies usually carry a reserve or contra asset account called “allowance for bad debts”. This account is usually adjusted at least annually based upon some evaluation of the quality of the items carried within the AR balance (i.e. aging, collection experience, historical bad debts, etc.) - Inventory: There are two main types of inventory, work in progress (WIP) and stock. WIP is the accumulation of expenditures on a project prior to the project coming to completion and being invoiced. This may include product purchases, labor, and other types of expenditures. Given the nature project nature of furniture dealers, this is the most common type of inventory. All WIP inventory should be directly associated with a customer project. A top ten list of WIP by project should provide management the tools necessary to ensure reasonableness of this asset class. Stock inventory is usually used for items that are bought for later resale without an underlying order (i.e. a chair stocking program, OFUSA stock). It is a healthy practice to not include items that are not readily saleable in inventory (i.e. mis-ordered product, showroom furniture, damaged product, used product, etc.). Inventory account also may have an associated reserve (contra) account, similar to accounts receivable. - Pre-paid expenses: This includes items that are paid in advance and consumed over several accounting periods (i.e. insurance premiums). - Vendor deposits: These are advance payments to vendors which are in essence a loan receivable. The quality of the asset is directly associated with the credit worthiness of the particular vendor. These balances are usually reduced upon receipt of goods that will eventually be cleared through cost of goods sold or may increase some other asset class (i.e. fixed assets). Fixed assets have a useful life of over 1 year that are consumed by the business in generating it’s revenue. For accounting purposes, their value must be carried for and expensed over this useful life. Useful lives are vary by asset class and some other determining factors. The method for capturing the use of the asset is through a process of depreciation (capturing the “used” value to the monthly income statement). This depreciation is accumulated in a contra account which when offset with the particular fixed asset provides a “net asset value”. Typical fixed assets include vehicles, leasehold improvements, and furniture and fixtures. A periodic reasonableness check of this category is necessary to ensure that items such as inventory or expenses are not inadvertently recorded. A thorough review of the asset accounts should be done at least annually. This may identify items that no longer carry their recorded value. These items should be expensed through the income statement or adjusted along with the reserve account to properly reflect the associated asset class. Liabilities are what is owed by a business. These are classified as either current (usually due within one year) and long term (due beyond one year). It is important to have all amounts owed by the company recorded to properly reflect the business’s financial condition. Current liabilities are short term in nature that usually arise from normal operating activities. These include: - Accounts payable: Amounts due to vendors. These can be aged much like the accounts receivable. While it is important to not pay too early to preserve cash, paying late can have a detrimental impact on the business. - Customer deposits: These are amounts pre-paid by customers. They remain a liability until the actual revenue is earned through delivery of an agreed upon product or milestone that is usually documented through the invoicing process. If a project is not delivered, the amounts must be returned to the customer. - Accrued salaries and commissions: These are amounts earned by employees that are not yet paid. This is mainly due to timing of when financial statements are created vs actual payment. - Current debt: Amounts due within 12 months to financial or other lending institutions. These amounts are classified in this manner to match with the most likely source of funding (current assets). - Taxes payable Long term liabilities are usually due beyond the current year. These may include: - Notes payable to financial institutions or others - Deferred payments Equity includes the net accumulated value that the owner holds in the business. In some cases, the net value is negative indicating accumulated losses beyond amounts contributed. Probable accounts include: - Paid in capital: This is the owners direct investment into the business. This is sometimes called common stock or a similar heading. - Retained earnings current year: This is the accumulated income/lose for the current year. It should tie to the year to date income statement’s net income. This account rolls to the retained earnings prior years account at the beginning of a new year and is zeroed out. - Retained earnings prior years: This is an accumulation of earnings from the inception of the business offset by any distribution of earnings to the owners. Key reporting and analysis for the balance sheet includes: - Detailed balance sheet accounts with comparison to prior month and same month prior year - Detailed reporting trail balance from the system which shows changes to each account during the period - Cash account reconciliation to ensure confirmation to bank reported balances and identify discrepancies - Detailed AR aging report from the system which shows invoice items by customer and allow identification of potential issues - Top 10 AR balances. This usually equates to about 70% of the total outstanding and gives the management team a quick overview of the status of collections. - Top 10 WIP balances by project. This should equate to about 70% of the total WIP as projects generally turn within 30 – 60 days. Significant balances that remain in this account may be signs of other issues in the business. - Stock inventory reconciliation. This aids in the identification of assets that may be recorded at non-realizable values. It also brings light to potential issues that may have created the unwanted stock. - Top 10 vendor deposits. This should cover a significant portion of all deposits and provide insight how vendors view our credit worthiness. These amounts limit available funds that can be deployed elsewhere in the company. - AP aging report. - Commissions report We are hopeful that this segment provided insights into a dealership balance sheet. While there are many variations to the types of accounts included in a balance sheet, the general format and content will be similar. Should you have comments or wish to discuss this topic further, please send me an email Dan.Zona@Haworth.com. Upcoming segments will provide a look at cash flow forecasting and planning/budgeting. Thanks gain for logging on and more importantly for your business partnering with Haworth!
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