Dispelling Financial Statement Myths

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January 05, 2006

You may think you know how to use financial statements to manage your business. While you may understand how key performance indicators, percentages and benchmarking can be used when reviewing balance sheets, income statements and cash flows to help manage a business rather than operating it by default, there are many myths about financial statements out there.

Here a few truths behind the misperceptions:

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“Financial statements are just history. I manage my business forward. The banks and tax man can use the financials, but they aren’t much use to me.

Any business owner who thinks like this doesn’t understand the constant loop between financials and the budgeting process. Budgets need to be dynamic, adjusting to changes in goals or results. Planning means understanding how your business will reach these goals.

Your historical financial statements must be the bedrock on which your budget/plan is built. While you can prepare your budget independently from the prior year’s financials, it’s important to bridge the information back, define differences and consistencies and plan accordingly.

It’s also important to understand that budgets are worthless without results to compare them to. Comparing actual result to budgets will tell you where you over-performed or under-performed, where you have opportunities or unexpected superior results. Analyzing this information will help you incorporate the appropriate standard procedures into your business and show you where you need to make repairs.

If you don’t take the time to compare budget plans to monthly financials, you are letting opportunity pass you by.

“I don’t really understand my financials, but they seem to keep the bank happy, so I am okay with them.”

Believe it or not, this statement is too common. Obviously, the banking relationship is a critical one, maybe one on which the life of the business is underpinned. But, why hand financial statements to the banks without understanding how the bank is going to use them? You need to be able to look at your financial statements like a banker.

This is a tall order, so let your accountant help you. Ask “How will the bank view these financials? What are the points that are critical to the bank? What parts of these statements worry the bank (i.e., losses, excessive leveraging, poor current ratio, inappropriate asset investment)?”

Better yet, address these questions in December, not January, as part of your year-end planning process so that you can make necessary changes before it’s too late. For example, your financial statements may indicate that you should reclassify officer loans, pay some payables, run the cash balance up or refinance some debt. Having this information for year-end planning can enhance your banking relationship.

“My accountant-prepared financials indicate I made (or lost) money, but I don’t believe it.”

Not many people say this to their accountants, but we wish they would, so we can help them better understand their situation. As a betting man, I will bet with the odds that your financial statements are right. It is not responsible to allow disconnect between your perception of your business performance and the reality because there is wonderful knowledge in understanding the difference.

First, your financials are based upon certain assumptions or accounting policies, which may be minor in some businesses and huge in others. These may include depreciation calculations, amortization, bad debt recognition, revenue recognition and tax provision computations, etc. You need to understand those policies and be okay with them. Accountants cannot productively discuss your financials without basic agreement on the appropriateness of these policies, or at least framing our conversation in the realities of how these policies are applied.

Second, it’s important to understand that profits don’t always feel like profits. Profitable businesses can and often do have negative cash flow. A vendor screaming for payments or wondering if you can make next week’s payroll doesn’t feel like profit. Similarly, cash flow issues can mask losses. Many businesses are awash in cash even as they fail. Receivables are collected and become cash, inventory is reduced and becomes cash all while the business is literally cannibalizing itself. So, you also need to learn to understand your cash flow statement, not just your profit, and build appropriate plans.

In any case, it’s important for you to ask your accountant questions about your financial statements and how they impact your business. And, if you don’t understand the answer, ask again, persist again until you and the accountant sort out where your perception of the financials collides. This knowledge gives you a true realization of issues so that you can fix them before you have consumed years of hard-earned equity.

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