Outsourced CFO Journal: Financial Statements

Good bookkeeping will save your business thousands of dollars each year. This isn’t just something accountants, financial advisors, and bookkeepers tell potential clients. This isn’t a philosophical idea with nothing to back it up. This is a statement that many entrepreneurs and small business owners have come to learn through harsh lessons. This lesson is usually only learned after something bad happens such as a tax audit, lawsuit, or discovery of an expense you overpaid by thousands of dollars.

Here are just a few reasons why it is important to keep your books in good order:

  • Maximize your Tax Deductions – You have to document expenses to claim them when you file your taxes. Misplaced or overlooked receipts prevent you from being able to claim expenses as write-offs. There are often thousands of dollars small business owners miss each year (resulting in over-payment of taxes by thousands of dollars) because of messy or lazy accounting practices.
  • Causes Costly Mistakes – Misstating profits or expenses due to bad bookkeeping can be disastrous. Overestimating your profits when filing taxes needlessly increases your taxes owed, while underestimating them can lead to fines. Miscategorizing assets (for instance, long-term assets that depreciate over time) and expenses can lead to your paying more in taxes than you need to.
  • Pushes Out Your Cash Conversion Cycle – Remember our first story about JM & Company Windows and their cash conversion cycle issues? Without accurate records, you won’t be able to keep straight who owes you what–which means it will take you longer to send invoices and collect payment. You’ll go without those funds for even longer. Or you may overlook sending an invoice at all, and never receive payment.
  • Limits Your Financing Options – No matter what options you are looking at to secure financing, you most likely will need to provide some financial information. If your data is not accurate or up to date, your options will dwindle. Small business owners who need a loan–particularly in an emergency–may find themselves in a similar situation without accurate, up-to-date financial records.

Those are just a few of the ways that bad records can cost a small business owner real dollars. The problem with most of these issues is the small business owner doesn’t even know it is costing them money. Most business owners will go years, or maybe even decades, never knowing that they wasted thousands of dollars because of bad bookkeeping.

I saved the best reason for last. Without the books being in order, a small business owner can’t review their financial statements. And without a proper review of the financial statements, a small business owner can’t accurately assess where their money is going and where there are possible savings. Good bookkeeping enables good decision making.

While sitting down over coffee with a new business owner this past summer, she told me the story of purchasing her business. The most she explained, the more amazing the story was in highlighting the importance of good bookkeeping.

Stacey Mitchell Institute
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 salespeople for 2 years after her first son was born. 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. While this was not a direct client of hers, she knew it well by reputation. The school turned out a fair number of students and had a solid reputation. The competition was not overly intense in the area and it seemed to have a constant feed of students.

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. Stacey and Ms. Parker agreed to a meet. Ms. Parker said that the school had always struggled financially despite enrollment numbers that were generally strong. Ms. Parker was a former stylist and as such, spent much 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 income statement that listed by month the operating 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.

Stacey knew from her discussion with Ms. Parker and from doing research on their website 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 ran a couple of program start times each year and 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 became even more interested in the business, however, wondered what she was missing. Stacey set up a second meeting with Annie Parker. At this meeting, Stacey floated the idea of possibly purchasing the business but was 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. 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, this was a false impression. 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 actually much 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 an “earn 0ut” 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 went to work on the operations and marketing side of the business. She was a natural with all of her local contacts. Enrollment remained strong and slightly increased. However, there was a matter of the accounting records. Stacey was smart enough to know the records were 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 of Annie’s records, it in fact 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 detailed out an accounting system for how to deal with cash receipts, accounts receivable, and payments. They put systems in place so all of these would be naturally recorded by the staff.

Next, they went to work on improving profit. While Stacey’s efforts had been somewhat successful in increasing attendance, there was still improvement 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.

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. With the average ticket price being just $18, that represented 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 host 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 Google AdWords credits. Stacey found a local company who built a website using WordPress for her and another hosting service to cut the fee to $99/year. While Stacey continued using Google AdWords, the savings was huge. 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.

After the first year, Stacey admitted none of this would have been possible without her financial advisor. The accurate records were instrumental in making the changes that needed to be made. The Stacey Mitchell Institute has now been going strong for 5 years. With continued business refinement and increased enrollment, Stacey now easily takes home a 6-figure income each year. She still uses her financial advisor, who now helps in all areas of her organization: redefining her marketing, accessing the teacher pay structure, etc. The cornerstone of this relationship is their monthly financial review meeting. While Stacey is not well versed in finance, she does now understand the key drivers for her business.

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.

It amazes me how many business owners make critical decisions without having an accurate view of their business. I have seen many small business owners’ financial statements. Most are, for lack of a better word, a mess! Many will have their accountant or bookkeeper clean them up once a year. However, not much can be done when you only review “clean” financial statements once a year. On top of that, these numbers are often outdated and irrelevant.

None of the best practices discussed throughout this paper are possible without having a solid base. That solid base includes having good financial records in order.

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 her recordkeeping was a mess.

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