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I visited a friend the other day who runs a well-organized business and keeps a meticulous office. Every desk is tidy, every scrap of paper is in a binder or folder, and everything is labeled and filed alphabetically and by year.
And yet, despite all this organization, he never quite feels in control of his business. Sure, the organization gives him good control over the workflow and processes, but he could not answer the basic business questions he had about cash flow, profitability and pricing. Despite all the binders and folders, he could not get reliable answers out of his accounting system and so could not make good decisions about the future of the company.
I believe all good answers start with good financial statements, so we sat down to take a look at his. Within just a few minutes, we spotted six areas that needed attention. Here’s a quick test to see if these same six areas can help you get better answers to your financial questions – and make better decisions about your company’s future.
- Does your balance sheet have negative accounts?
A balance sheet is set up so that accounts are always positive (with just two exceptions: Depreciation and Owner Distributions). It’s understandable that your bank account should never show up in the negative, but it is less intuitive that debts (credit cards, loans, etc.) should also be a positive value on the balance sheet. All assets, liabilities and equity accounts should be positive numbers. If they’re not, it’s likely that transactions are being booked incorrectly.
- Is it true?
Since it shows bank account balances that should agree with a monthly bank statement, a balance sheet is easy to fact-check. But not all accounts have objective statements, so look closely. Tax Liability accounts are the most common place to find mistakes (and fraud). See if you’re booking taxes and tax payments correctly, then look into loan balances, leases and credit card accounts. (Remember, a negative balance here means that you have over-paid a loan!)
- Does the income statement show negative values?
Like the balance sheet, a properly set up income statement should have all positive values. If values are negative, it probably means you have an expense account in an income section, or vice-versa. That’s fine if it’s on purpose, but otherwise, you’ve got something backwards.
- Are variable costs hiding in the xxpense section?
The most important part of an Income Statement is the Cost of Goods Sold (also called COGS or Cost of Sales), which helps you determine Gross Margin and thus, to set more accurate pricing. This section should capture all variable costs. If you have costs like Wages (of your revenue-producing workers), credit card processing fees, shipping, or sales taxes hiding in your Expenses category, you are not properly capturing your true cost of sales.
- Are payroll expenses properly broken out?
Payroll is the largest expense for most companies, but given the least attention. Unless you allocate labor to specific jobs (or products) calculating profit margins is impossible. Further, if taxes, insurance and benefits are not allocated properly, you are not seeing the full picture. Workers Comp insurance is a particularly big issue. Properly allocating labor by cost code can result in huge WC savings.
- Does your income statement look like your business?
Because accounting is so boring, many business owners don’t realize the flexibility they have to make their income statement suit their management needs. If a company sells three lines of products, it should have three different income accounts on the P&L. Likewise, within expenses, there should be accounts for those items you want to measure and control – but not so many you get lost in the details. For example, “Utilities” is a reasonable expense account, but separate accounts for water, electricity, gas, cable, phone, mobile phones, and data plans is just too much detail. When properly put together, the Income Statement should paint an easy-to-use and reliable picture of daily operations.
Now Look Again and See the Truth
Looking for problems in your financial reports is not the most fun way to spend the day. But it’s one of the most important things a business owner can do. Mistakes in common accounting entries can twist the overall results in ways that will confuse and conceal the answers you need to run your business effectively.
When you can rely on the numbers, you can rely on the decisions you make to take your business forward. Review the books, fix the problems, then look again – knowing you can trust the numbers to tell the truth.
David Worrell is an award-winning entrepreneur and now helps other business owners as a part-time CFO. He is a partner at Fuse Financial Partners in Charlotte, North Carolina, and author of “The Entrepreneur’s Guide to Financial Statements.”