Poorly structured financial reports stymie a company’s forward movement, but there exist steps CEOs can take to fix the problem.
In my last blog, I noted some 80 percent of small and medium-sized companies are hamstrung by poor financial reporting. If you are the CEO of a company suffering from this problem, I urge you immediately take the step of convening a very serious meeting with your in-house or outside accountant.
As a CEO, you may not know exactly how to classify revenues. But you do know that understanding how much revenue is coming from each of your product lines is imperative. Convey that objective to your accountant. It may require your in-house accountant work with your outside accountant to restructure the chart of accounts used to code and classify transactions in the financial statements.
Once you’ve gone this far in segregating revenue streams, you will next want to learn the gross profit associated with each of those streams. This will help determine which revenue streams should be given additional effort and capital to make them even more robust, or if entirely new streams should be launched.
In addition, you must discuss with your accountants the proper classifications of expenditures. This decision will help determine what direct costs are associated with generating each revenue stream, and what overhead costs exit.
Once you as CEO understand what you are hearing from your internal and external accountants, you will better understand where all this time and effort is headed. It is headed toward creating a vastly improved reporting system, with the objective of using it to make better-informed decisions.
I’ve seen some CEOs react with shock when presented with never-before-segregated revenue streams and their associated costs. “Oh my God!” they exclaim. “ I’ve got to eliminate some SKUs, some product lines. They’re just not profitable to continue selling.” Or, they may respond, “The margins on some of these SKUs are just so low that I will have to increase my prices.”
Now you can look into each stream, examine the number of items comprising each of those streams, and decide which SKUs don’t justify any additional sales effort.
What’s more, if you know you have a good product the marketplace clearly wants, you can make a better decision on adjusting its price.
It all comes down to better informed reporting. As CEO, you can now devote your energies to building profitable sales growth, and sleep better each night knowing your numbers make sense.
If you’d like to sleep better at night, get in touch. I offer a 100 percent guarantee on my work. I take on only clients I can help. Call me and let’s talk about your business. My phone number is 630-269-7646.
Misclassified expenses and un-segregated revenue streams result in poor financial reports that can halt a company’s progress in its tracks
It’s hard to make informed decisions about a company’s future based on poorly- structured financial reports. Yet many small to mid-sized companies rely on reports beset with serious problems. No wonder these firms aren’t growing.
One common problem with financial reports is that the reporting system is capturing a variety of product or service revenue streams in one account. Without those streams being segregated, the CEO doesn’t know what areas of the business are doing the best and worst jobs of generating critical revenues.
Another all-too-frequent issue is misclassification of expense categories into overhead, rather than cost of goods sold. As a result, companies get a read on gross profit and gross margin that is simply not accurate.
For example, if a company wants to launch a new marketing program, officers will attempt to determine how many additional sales the program will have to generate to justify its cost. If they don’t have an accurate read on gross margin, they will make a decision based on skewed sales numbers. That could result in the marketing program being over or under-funded.
These financial reporting issues are very prevalent, and are present in four out of every five companies I counsel. The problems exist for two reasons.
First, company officials don’t know how to distinguish between direct costs to produce sales and those line items that should go into the category called “overhead.” Second, despite their desire to place all transactions in the right categories, the companies do a poor job of coding, or classifying, transactions.
Unless the company addresses these reporting issues, the CEO will face the same problems month in and month out.
He or she must take a stance and rectify the reporting problems. If the CEO is smart, he’s going to say, “We have a direct cost of generating these sales dollars in overhead. They should be in cost of goods sold.”
The result of poor financial reporting is wasted time. The company wastes time pulling financial statements together, and again wastes time being forced to pull information out of the accounting system into a format that can be used. Precious hours and days that could be used to concentrate on building profitable sales growth go down the drain. In this case, wasted time truly is wasted money.
In the preceding paragraphs, I’ve discussed the surprising prevalence of poor financial reporting, and the negative outcomes that result. In my next blog, I will address steps chief executive officers can take to meet the problem head on.
For those not inclined to be organized, the idea of doing your own accounting beyond balancing your checkbook may make you a little queasy. However, you’ve managed to keep your lunch this far, and guess what? You’re almost done! Over the past three weeks, we’ve discussed balance sheets, income statements, and cash flow statements; today, we will be discussing the linchpin that allows the financial statements to communicate in a clear and logical manner… the chart of accounts.
Week 4: Do You Have the Right Chart of Accounts?
Well if you don’t, then you should, and hopefully after this, you will. Your business life has the chance to become incredibly more coherent once you implement the right one. In layman’s terms, a chart of accounts (COA) is just that — a chart, made by you, listing each of your General Ledger account names that describe the nature of the account; all your financial transactions get recorded by coding the transaction following the COA . SmallBusiness.com refers to it as “an accounting term that describes a list of common ways money is used by a business so that its owners and managers can organize revenues, costs, and assets into categories.” It is, for any business, an invaluable tool. Remember, the coherency of financial statements is all in the coding.
Below is a basic format for setting up the COA.
|Income Tax Expense||900-999||9000-9999|
The 3-digit coding can accommodate two product lines; if you have more than two, use 4-digit coding which considerably expands the coding universe. Please note that service lines may be substituted for product lines.
Direct Costs may be defined as costs directly associated with the cost to manufacture, warehouse, distribute, deliver, or to consult, for a “line of business”. Direct Costs exclude selling, general and administrative expenses. These are Operating Expenses, or Overhead.
A chart of accounts is made to be adaptable to each business’ unique needs, so go ahead and tailor it! This is a system made to make your life and the running of your business easier, not to add more stress. Keep it simple. That is the best way to keep it focused, and keeping yourself focused means that you allow yourself more time to explore opportunities that will grow your business profitably by having coherent financial statements.
The most important elements of informative financial statements are 1) a well-defined Chart of Accounts and 2) an insightful classification (positioning) of totals in the financial statements.
Let’s take a look at how these elements are applied to a great Income Statement.
Sales: Each major product and/or service line should have its own account so sales for each are displayed on the face of the statement.
Direct Costs (COGS, COS): Direct costs are those that vary with the volume of sales and would not be incurred if sales did not occur. Examples are labor (and related payroll taxes), materials, subcontractors, royalty or licensing fees, and sales commissions. Codes for Direct Costs should correlate with the codes for product (or service) lines in Sales.
Gross Profit $ and Gross Margin %: With Sales and Direct Costs by product line, you can calculate the Gross Margin % by product line. This tells you at a glance which lines are profitable and which are drains. Also, accurate Gross Margin percentages can be used to make informed business decisions (see Issue #5—Using Breakeven for Decision Making).
Overhead (relatively fixed operating expenses): All operating expenses that are not classified as Direct Costs should be coded into clearly-defined Overhead accounts.
Income (Loss) From Operations: This number is Gross Profit minus Overhead. In investment and valuation circles, this number is called EBITDA—earnings before interest, taxes, depreciation, and amortization. It also represents Cash Flow from Operations. Businesses are most often valued at a multiple of EBITDA.
Other Income (Expenses): This is where all non-operating and non-cash items should be coded and classified, including interest income, interest expense, income taxes, depreciation, amortization, gain (loss) on sale of assets, and any other income/expense that is of a non-operating nature.
Net Income (Loss): Your bottom line is where all the chickens come home to roost. Are you healthy?
Financial reports are a lens through which you assess your present position and set your future course. You can refine that lens by taking your financial reports from good to great.
The Wisdom of Henry Hazlitt (1894-1993)
A hoodlum breaks the window of a baker’s shop. Onlookers decide that the vandalism has a bright side: a glazier will make $250 repairing the window.
Hazlitt disagrees. The glazier’s gain is money that the baker was planning to spend on a new suit. The onlookers did not take into account that a tailor lost a $250 sale and the baker lost a suit. No new employment was added—the scenario is a net loss.
– from Economics in One Lesson