Financial Statement Review

Stacey Mitchell put herself through business school by working as a hair stylist. It took 6 years, but she made it through. After receiving her degree, she took a sales job with a supplier of cosmetology and esthetics products. She loved the job and found great success. However, as she and her husband settled down and started a family, the constant travel weighed heavy on her. Despite this, she kept up with the job and was one of the top sales reps. As a sales rep, she would from time to time learn about interesting opportunities. Most were salons that were either going out of business or coming up for sale. One day she caught wind of a rumor about the Palace Beauty School. The school was going out of business. The school turned out a fair number of students and had a solid reputation. The competition was not overly intense and didn’t seem to have an issue with enrollment.

Upon hearing this news, Stacey spoke to some of her contacts that might know more information. While most didn’t know much about the business behind the school, she did eventually get an introduction to the current owner, Annie Parker. Ms. Parker said that the school had always struggled financially despite generally strong enrollment. Ms. Parker was a former stylist and spent most of her time teaching and working with other instructors. Stacey mentioned that she might be interested in purchasing the beauty school but would like to look over the financial records first. Ms. Parker seemed hesitant but finally agreed to provide them.

It was after dinner that night that the records arrived in Stacey’s email. After putting their son to sleep, she sat down with her husband to comb through the two-page monthly income statement for the previous eighteen months. While Stacey and her husband were not well versed in financial statements, they could immediately tell things were a mess.

From her discussion with Ms. Parker and research on their website, Stacy was aware that a typical program would take between 600 hours on the low end (esthetics) to 1,500 hours on the longer end (cosmetology). The courses cost anywhere between $5,000 and $12,500. Programs seemed to be well attended, at least based on what Stacey had researched. The school was accredited by The National Accrediting Commission of Career Arts & Sciences and was approved with the Department of Education to offer full Financial Assistance to those who qualify. Payments were received in two chunks – the first being received prior to starting the class and the second due 30 days after classes started.

In reviewing the books, Stacey believed the business was profitable. Expenses, while sporadically recorded, were less than overall revenues. Stacey was interested in the business, however, wondered what she was missing. A second meeting with Annie Parker was set. At this meeting, Stacey floated the idea of possibly purchasing the business,  but was still afraid she was missing something in the financials. How could the numbers look so good but the business was getting ready to close?

Ms. Parker said she had a confession to make. About 12 months ago she was audited by the IRS. Initially, she was not worried because the business had a part-time bookkeeper. Ms. Parker was under the impression that the books were in good shape. However, the IRS ended up finding many deductions that were taken in the wrong period. Similarly, the business had not been recognizing revenue correctly and as a result, profit for the year under audit was higher than previously reported. The Company had underpaid their taxes and now owed tens of thousands of dollars in taxes and fines. Further, since the bookkeeper had been fired, Annie had taken on the task of doing books on her own. If there was one thing she understood from this experience, it was the need to make timely estimated payments of taxes. She was now making such payments quarterly based on their books, however, these payments were draining her cash reserves. She was now at a point where closing the business seemed like the most viable alternative.

Sensing an opportunity to realize a dream of running her own business Stacey and her husband came up with a plan. They worked with a financial professional they knew to help broker the deal. They would purchase the assets of the business and assume the lease for next to nothing. Outside of a small down payment of just a few thousand dollars and having to take personal liability for the lease for the next 3 years, there was relatively little risk. They would also pay Ms. Parker a percentage on sales for the next 30 months. Each quarter, they would pay her 4% of sales, however, only if they were profitable based on GAAP reporting.

Ms. Parker agreed to this arrangement almost immediately. Stacey would work on the operations and marketing side of the business. Enrollment remained strong. However, there was the matter of the bookkeeping. Stacey was smart enough to the accounting was not accurate. She structured a deal around this fact. However, she didn’t know where to begin. She gave a call to her financial professional and they met to discuss a strategy. Stacey and her advisor decided to reconstruct the past 12 months of records so they could get a more accurate assessment of where things stood.

To say this was an eye-opening experience would be an understatement. Despite the business appearing to be profitable from her initial view, it was just barely profitable. What Stacey’s advisor found was that there were several expenses being paid by Ms. Parker personally. These expenses were never counted in the Company’s records which made the profitability look higher than it was. As a result, Ms. Parker was paying tax estimates on profits that didn’t exist. Further, she didn’t have accurate records to make business decisions.
Upon discovering this, Stacey and her advisor put a plan in place.

First, they created a system to handle cash receipts, accounts receivable, and payments. They put systems in place so all of these would be automated.

Next, they went to work on improving profit. While Stacey’s efforts had been somewhat successful in increasing attendance, there was still improvements to be made. Upon review of the detailed income statement, there were several line items that presented opportunities. For instance, trash pick-up was being done way too often. By cutting down the frequency, the Company instantly saved $3,000 each year.

In the school’s salon, credit cards accounted for 80% of receipts. The school’s merchant provider was charging a low rate of 1.95% but also $0.15 on each swipe for a total merchant fee of close to 2.78%. The school was able to negotiate with a new provider for a flat rate of 2.49%. While that might not seem like much, it was close to $3,500 savings per year. The new merchant provider also included a point-of-sale system which allowed the school to scrap their current one; this saved an additional $2,400 per year.

Stacey also discovered that the internet hosting for their website was charging over $600 per month. This was supposed to include a “marketing” package of one blog per month as well as $200 in digital ad credits. Stacey found a local company who built a new website and another hosting service to cut the fee to $99/year. She saved $4,700 per year.

Stacey and her financial advisor had found over $20,000 a year in annual savings. Not to mention, they had pin-pointed Ms. Parker’s financial issues. By the time they were done cutting expenses and growing enrollment, Stacey had purchased a business that netted over $90,000 a year, not including her salary, for pennies on the dollar.

Accurate Books are a Big Deal
Small business owners are tasked with making business defining decisions on a regular basis. All these decisions will have a financial impact on the business. Even if the decision is how to implement a new customer service plan, it will have an impact on the bottom line.

One common goal among all small business owners is to build a valuable business. As indicated in the story, it’s impossible to know what value your business has if your records are a mess. Ms. Parker, while most likely a good teacher, was a bad business owner. She left hundreds of thousands of dollars on the table because of bad accounting.