Financial Management for Entrepreneurs By Robert Low For most entrepreneurs, financial management is hardly the most enjoyable aspect of running a business. Most find tasks like promoting their business or planning for expansion more stimulating than tracking sales or producing financial projections. But while financial management skills may not be the reason entrepreneurs enter business or initially succeed in building their businesses, those skills are critical for continued success. Every business is required to file taxes and most prepare regular financial statements. But financial management encompasses more than just these basic accounting functions. In fact, those tasks are primarily designed to meet the needs of people outside your business – the IRS and outside investors. Things like planning, internal controls, and cost accounting help you run your business and actually add to, and don’t just add up, your bottom line. Types of Accounting There are three main types of accounting done by for-profit businesses: financial, tax, and management (or cost). Financial accounting is based on Generally Accepted Accounting Principles (GAAP) and is used to prepare standard financial statements. These are an income statement, balance sheet, and statement of cash flows. All publicly owned companies are required to issue regular financial statements and most private companies do so voluntarily. If you have outside investors or lenders, they will almost certainly insist on regular statements, usually with the further requirement that they be audited or reviewed by a CPA firm (more on this below). Pick up a textbook on accounting or take an introductory class and it will almost certainly be about financial accounting. One principle of financial accounting is that statements usually are prepared on an accrual basis. This means that income and expenses are counted when work is done or goods are used rather than when cash changes hands. For example, if someone pays a deposit to rent your facility to host a function a month from now, financial reporting requires you to defer recording the revenue until the event has taken place. Similarly, if someone provides a service to you and gives you 30 days to pay, you still record the expense immediately. The use of accrual accounting creates an important distinction between profit and cash flow. Companies reporting profits, particularly rapidly growing ones, can run out of cash while other companies can generate substantial cash while reporting only modest profits or even losses. In addition to the examples above, things that generate differences between cash flow and profit include: - purchases of equipment (cash is paid up front but the expense gets spread out over several years using a depreciation method) - carrying inventory (cash paid up front but expense only recorded as goods get sold); - adding or repaying debt (affects cash but is neither revenue nor expense) - deferred compensation (expense recorded when work is performed no matter when payment is due). Both profit and cash flow are important concepts. Profit attempts to show what truly is earned each period and keeps irregular transactions like a large capital purchase from distorting the financial picture. But cash is the lifeblood of a business so tracking profit alone is not enough. In addition, while financial accounting can be subject to a great deal of judgment, cash flow is always objectively measured and easily understood by non-accountants. If your accountant or bookkeeper is only providing you with financial statements, insist as well on a report of cash flow. When doing forecasting, project both profit and cash flow. Tax accounting has its own set of rules laid down by the IRS. The differences from GAAP are not so substantial that a separate accounting system is needed, but you will need to make sure you are tracking certain pieces of information. For example, meals are only partially deductible and if you lease equipment you’ll find tax and GAAP rules differ. Also, while high profits might impress investors they also mean higher taxes. Because your choice of accounting methods as well as the timing of transactions can impact your bottom line you may have some strategic decisions to make about trading off profits and taxes. You should consult a CPA for advice on how to minimize your taxes as well as any tax-specific record keeping requirements. Management Accounting Many numbers helpful in running a business either don’t appear in financial statements or don’t get reported on a timely basis. For example, statistics such as the number of customers, average revenue per customer, employee turnover, and revenue by time of day or day of the week won’t show up in statements. Because standard financial statements are generally prepared no more frequently than monthly and often aren’t ready until at least a week after period end, the information can be stale. Keeping daily tabs on things like cash flow and revenues can provide a fresher picture. Finally, financial statements are frequently highly aggregated. For example, a bowling alley may have food sales, video games, and equipment sales as well as lane rentals. Yet, there is no GAAP requirement to report anything other than total revenue. To draw an analogy with baseball, GAAP reporting resembles measures like batting averages and earned run averages. Those statistics have specific rules that objectively define how they are calculated. This standardization allows for objective comparisons across teams, leagues, and seasons. However, a baseball manager will want more specialized information such as how a batter does against a specific pitcher or where he tends to hit. Though box scores may be very efficient in summarizing information, a manager needs more. Similarly, a business owner needs more than just financial statements. Management accounting is the discipline dedicated to capturing the internal, operating information needed by managers. Unlike GAAP or tax reporting, there are no rules. Data can be detailed or aggregated, reported on whatever time period is desired, and can include non- financial measures. In other words, it can contain whatever is considered relevant and be formatted as desired. However, while business owners may be instinctively in tune with the need for such information, accountants and bookkeepers may be so focused on GAAP reporting that they overlook management accounting. You may need to specifically request such information. You may also find that if you track certain key data, like daily receipts and headcount, that you’ll develop an instinctive feel for what your bottom line is well before financial statements are available. Who the Players Are Your internal accounting and financial management is likely to be done by people with titles such as bookkeeper, accountant, controller, comptroller, or chief financial officer (CFO). Though titles vary from company to company, bookkeepers and accountants usually do the mechanical work of daily transactions and compiling basic financial statements. Controllers oversee accounting but have broader, operating, responsibilities including interpreting financial information, controlling expenses and cash flow, planning, systems, and internal controls. Interestingly, the term “comptroller”, which derives from the French word for counting, has generally been replaced by “controller” as the role played by these financial managers has expanded. CFOs have the added responsibilities of general administration, treasury, and financing. Smaller companies, perhaps less than $5-$10 million, likely won’t need a CFO and under $2 million may get by with just a bookkeeper. Increasingly common is the use of contract, part-time Controllers and CFOs to fill these needs. Certified Public Accountants (CPAs) work externally and specialize in two key areas: taxes and auditing. Audits consist of an examination of a company’s financial statements and internal controls and results in a written opinion from the CPA firm as to whether the statements conform to GAAP. As mentioned earlier, an audit is required of public companies. Private companies may be required to have an audit by outside investors or bankers or may elect to have one in anticipation of future merger or financing activity, to ease establishing credit with vendors, or just to get an independent appraisal of accounting practices and procedures. Choosing what CPA services to use can be confusing. Only CPAs can certify financial statements but if your investors don’t require a full-blown audit, consider having your CPA provide a review instead. This process also examines your processes and statements but relies on a smaller volume of information and results in an opinion on whether the auditor is “aware of any material modifications that should be made.” You can also save money but using smaller, local firms rather than a “Big 4” firm. Don’t be afraid to negotiate price and ask if you can save money by doing certain work in-house. Be aware, too, that though CPAs may offer a range of software implementation, payroll, and consulting services, the CPA designation does not assure experience or training in these other areas. Systems & Controls Good record keeping is critical to keeping control over your business. Most accounting transactions are directly generated by routine, every day activities such as paying bills and collecting money. Two key elements are having efficient accounting systems for data entry and retrieval and a sound system of controls to ensure accuracy. Solid accounting software is no longer expensive or hard to use. Packages under $300 like Intuit’s QuickBooks or Peachtree Accounting are great for getting started and can suffice for surprisingly large businesses including those with basic point-of-sale needs. Implementations of mid-range solutions, such as Great Plains, MAS-90, Solomon, and others may easily cost $15,000-$60,000 or more and should only be selected if the number of system users or the complexity of transactions outstrips what low-end packages provide. Many of these vendors also have third-party modules specifically tailored to different industries so inquire about these. If buying a mid-range solution, you will almost certainly need to work through a value-added reseller (VAR). Implementation and training may be more important, and costly, than the software itself, so pay particular attention to the skills of the VAR and be sure to budget adequately for the implementation. Strong internal controls, basically a set of checks and balances, are essential for accurate processing. Though theft and fraud are concerns, errors and omissions in everyday processing usually present a greater problem. Some basic concepts include: - Separation of duties. Just having at least two different people involved in a transaction greatly improves control. For example, don’t allow the same person who writes checks to sign them. - Reconciliations. When you have independent sources of information you can compare your accounting system to, do so. This includes essential tasks like reconciling bank statements as comparing vendor statements to your own records, and balancing daily cash register receipts to the cash drawer. - Physical control. Prevent access to assets by locking up cash and unused checks, labeling equipment, and keeping inventory in storerooms. - Control numbers and logs. If documents like purchase orders, and sales orders are pre- numbered and recorded any gaps in the sequence or inability to match them to invoices can identify problems. Strong controls don’t have to be a burden. In fact, good checks and balances ensure accuracy and eliminate the need for constant policing. Also, if systems start providing inaccurate information, employees develop their own side systems as double-checks, a costly duplication of effort, or stop using the system altogether. Forecasts & Budgets Though smaller companies may not need formal budgets, they should always maintain some type of forecast. The forecast should go out at least 12 months, by month, complete with an income statement, balance sheet, and cash flow. If cash is tight, a week by week cash forecast going out one quarter should be prepared. Developing a forecast accomplishes several basic objectives: - It predicts future profits and cash flow, identifying risks of potential shortfalls or showing whether sufficient cash flow exists to support expansion plans - You can test outcomes for a variety of scenarios doing what-if analyses - It communicates expectations to investors and employees - By laying out milestones, concrete goals are set and progress can be measured - The process itself requires managers to go through the numbers which can be a valuable learning experience Forecasting will always be somewhat imprecise but that should not stop you from continuing to do them. Update plans if they become out of date and attempt to learn the reasons expectations weren’t met. Also, use the forecasting exercise as a time to come up for air from the demands of day-to-day management and think strategically. Not maintaining a forecast is like trying to steer a car without headlights so stay in control by running the numbers. Conclusion Strong financial management is more than just accounting and can have a real payback. Timely and accurate information, efficient processes, and solid planning not only help measure but contribute to the bottom line. Financial management may not be the most interesting part of running a business but understanding it can ensure you stay firmly in control.