"The ability to ask the right question is more than half the battle of finding the answer.”
– Thomas J. Watson, former chairman & CEO of IBM
Let’s be honest – accounting is not a topic most people would choose as a conversation starter. But accounting is much more than putting all the debits and credits in their proper places each month. It is the common language management, shareholders, potential investors, and acquirers (among others) use to understand how a business performs financially.Accounting metrics allow for meaningful comparisons across companies and over time. The ability to produce reliable accounting information is an indicator of a well-run business, while the opposite can suggest some problems extend beyond an accounting system snafu.
Without solid accounting practices, you cannot communicate information about your company using this critical common language; that could mean your business is excluded from the conversation. If your accounting system does not provide helpful information timely, you may need to look for a different system.
But often, the real issue is that business owners fail to recognize the importance of maintaining quality accounting information and therefore do not devote sufficient time and resources to supporting the accounting function. In other words, your accounting system may be fine, but you may not appreciate the importance of the information it provides.
In this article, we explain some of the accounting-related issues business owners and management should focus on regularly, as well as how investors and other stakeholders view key accounting metrics when evaluating a business.
What is the purpose of my company’s accounting system?
Perhaps the place to begin is with the question What is the primary purpose of accounting for a small to mid-sized business?
Is it to:
A. Prepare monthly financials (close the books)?
OR
B. Provide useful information that helps a management team to make decisions?
Correct Answer – BOTH. With that in mind, here is a list of questions to ask about your accounting processes and to be ready to answer when a potential investor asks them:
Understanding cash flow
Does your company prepare cash flow statements, both historical and forward-looking?
Cash is king- and the Statement of Cash Flow may be the most important financial statement of all. Many companies have a positive EBITDA but poor cash flow and do not understand why or how to address the problem. If you do not prepare regular cash flow statements and forecasts, you cannot truly understand where your cash goes and whether you will run out of it.
Read more: Cash Flow 101: Tips for Management, Projection, and Long Term Improvement
Managing receivables & inventory
Does your company regularly review its accounts receivable aging schedule, paying close attention to trends in the 60+ days categories?
Receivables that age beyond 60 days usually indicate that the client is dissatisfied in some way or is experiencing economic problems. There may be good reasons a client cannot pay, but you may need to delay or eliminate service if ultimate payment is in doubt.
Trend analyses of AR aging may suggest management is losing focus or control concerning collections and may even be allowing non-paying clients to place new orders.
Does inventory turn quickly enough?
Are there patterns (seasonal or otherwise) that indicate you could adjust inventory levels to be more “lean”? If some items have been on hand for two or three years, should they be written off as obsolete? Almost every company has some “bad” inventory.
For example, it may be necessary to purchase raw materials in large quantities, more than what is needed for a year or longer.
However, raw materials or finished goods on the shelf may be obsolete, and some bad decisions can be buried in inventory. It is better to own up to such problems rather than hope they will cure themselves. Management must be embrace honesty and acknowledge mistakes that were made in good faith.
Margins and metrics
Do margins and other key performance indicators swing wildly from month to month (or not at all)? Do you monitor changes in KPIs regularly, rarely, or never?
Large swings in KPIs indicate that revenues and/or expenses are highly volatile or something is wrong with the accounting process. Having consistent accounting procedures and regular management reporting will help.
The CEO and senior managers should be able to explain the changes in KPIs, as this indicates they have a fundamental grasp of the business.
Read more: 8 Financial KPI's the Board Expects Every CEO to Know
Understanding the Business Accounting Process
These questions focus on a firm’s understanding of its accounting processes. Potential investors will want to address the process and the specific items noted above.
Can you, your CFO, and others responsible for accounting and financial reporting describe your company’s accounting policies?
Are your financial statements based on accrual, cash, GAAP accounting, or a “blend”?
Companies need to apply a set of accounting policies consistently to understand how the business’s financial condition is changing over time. Different accounting methods have their roles, and each can provide valuable information to management and investors.
However, to raise money, a company must provide prospective investors with financial statements prepared according to GAAP, whereas blended statements frequently create problems later in due diligence.
While following GAAP is important to outside investors and lenders, the CEO and management team should first focus on having a set of accounting policies that make economic sense, clearly articulated, and consistently applied.
Read More: Everything You Need to Know About Financial Statement Audits
Who prepares your monthly financials – an internal accounting professional, an outsourced bookkeeper, or someone else? Can anyone describe the month-end closing procedures?
Monthly financials should be prepared regularly by a competent professional – this is critical to the reliability of the output. And, fully closing the books and analyzing the key balance sheet accounts is critical to a proper close.
Managing this process accurately signals that the company is well run and that the management team knows that the numbers reveal how the business is doing.
How long does it take to close each month? Is the close consistent and regular, or are delays fairly common?
Monthly reporting is most valuable when it is timely, with the same practices employed each month. If the statements are late, you could have a problem in the business that you do not know about and will continue to fester until you take corrective action.
Timely financial statements also suggest a sense of management discipline and organization.
Do you typically make many year-end adjustments related to the entire year (e.g., bonus accruals, commission accruals, bad debt provisions, etc.)?
It is imperative to avoid recording such expenses all at once at the end of the year. Otherwise, you end up with 11 unrealistically profitable months and one excessively bad month, violating the principle of maintaining consistent practices (discussed above).
This also interferes with management’s ability to evaluate performance, as profitability is either over- or understated every month.
Has your company attempted to implement a standard costing system to provide information for budgeting, and evaluate and controlling costs?
This allows management to know what a true product costs. Without the insights that standard costing can provide, it may be difficult to honestly evaluate a product’s profitability. A word of caution: it can be a lot of work to maintain a standard costing system, and, like all things, without providing the necessary information, the results are likely to be less than helpful (in other words, “garbage in, garbage out”).
While the word “accounting” may be associated with “boring” in your mind, the language and processes of accounting are vital to your business. Using correct, consistent accounting “grammar” in creating your financial statements results in a clear picture of how your business is doing, providing critical information to your management team and others who want to understand your company.
To discuss whether weaknesses in your accounting processes could be affecting your businesses, contact us.
