Do Your Financials Match Your Business Narrative?

As you’re studying your monthly financials and preparing for year-end reporting, and you find that your financials are not depicting the business narrative you know to be true, it could be a sign of bad accounting. Here are some best practices for reviewing your P&L and determining if there is an opportunity to enhance the accounting practices:

• Revenue – if you’re having a great month and selling a ton of services or inventory, but revenue is not telling the same story, it’s likely revenue is not recorded in the proper period on your financials. For service revenue, the best practice is to record revenue in the period the service is provided, not when invoiced (which invoicing usually occurs well after the service is provided). For revenue from goods sold, the best practice is to record revenue once the item has shipped or good is exchanged. There are other factors that may change the timing of revenue recognition, but in general these principals should be applied and will help your financials mirror what is happening in your operations.

• Cost of services – just like service revenue, the cost of services should be recognized in the period the services are provided, not when the services are paid for. Matching the timing of revenue with the cost of providing that revenue will result in margins that reflect the actual business operations and could lead to better decision making.

• Cost of goods sold – For companies that sell inventory, we often find the main driver for swings in gross margin period over period is due to inaccurate inventory accounting. Best practice is to capitalize all costs incurred to directly obtain and get inventory ready to be sold. For a lot of companies, there are costs that are expensed each period like direct labor or inbound freight that should be sitting in inventory on the balance sheet and expensed when the inventory is sold. Examples of costs that should be capitalized to inventory include direct labor costs, inbound freight and tariff cost, direct materials cost, indirect labor costs, storage costs and manufacturing overhead.

• Payroll – payroll should always be recorded in the period the hours were incurred. If the payroll cycle is every 2 weeks, this will result in a few months of the year having three payroll runs. This can greatly distort the financials and margins if payroll is not properly accrued. Three payroll runs in one month should not define a bad month.

• Insurance costs – if the timing of your premium payments is anything other than monthly, these costs should be capitalized as prepaid expense and amortized over the policy period. Depending on the size of the premium, this could be a significant expense in one period and could distort profit margins in one period over another.

• Subscription costs – if you have any other subscription costs that are paid annually, these should also be capitalized as prepaid and amortized over the policy period.

• Balance Sheet – review your balance sheet and determine if there are any deferred revenues or costs that should be recognized on the P&L.

Another powerful visual that could help you understand your monthly and annual operating performance is looking at your financials or key drivers (like revenue, gross margin, and profit margin) each month on a trailing twelve-month basis. Using this viewpoint will eliminate seasonality in sales or costs and could convey insights around growth and performance on an annual basis.

Being able to decipher financials and knowing whether the results are indicative of a good or bad period or just bad accounting can be a powerful tool. Being able to decipher financials and correct bad accounting practices will help the business owners align their financial story with their business narrative.

Be Prepared for Tough Questions, and Ask Them Yourself

We get asked by clients all the time what we expect to happen over the next 12 to 18 months. The answer is “uncertainty”. However, that does not mean all expectations are in the dark and that a business cannot plan. We are already seeing certain trends in the market that are likely to continue. Most notably, is the scrutiny that businesses are likely to undergo as we are in the midst of a slowdown at a minimum, and more likely a full recession.

Bank underwriting has started to tighten. While deals are still getting done, more in depth due diligence is occurring. We are seeing banks dive one or more levels deeper into:

• How are inventory purchases managed and the right levels to carry determined
• How have lines of credit historically been managed
• Historical fluctuations in margins and underlying causes
• How susceptible the business is to changes in interest rates
• The labor force - turnover and wages
• The health and buying patterns of customers - including analyzing volumes, not just revenue
• Corporate overhead, fixed costs, and breakeven sales
• To what extent a COVID bump and/or bubble has or is likely to occur

While M&A multiples have declined from a broad sense, buyers are still plentiful, and deals are still getting done. There is however heightened scrutiny, especially revisiting the growth prospects for the prospective seller.

Very much in line with our mantra of Living Sale Ready, it is most certainly a best practice to ask these questions of your own business. Do you understand your downside? Have you explored a scenario of slow to no growth for 2023, or possibly even a decline? Does how you make decisions on expansion opportunities, capital investment, or even operating investment like inventory purchasing need to be scrutinized further? One of the best lenses that any business can be viewed through is an outside eye – it exposes flaws, blind spots, and outdated assumptions.

This is very different from the black swan event that was the onset of COVID a couple years ago. That is something almost no business was truly prepared to take on. Times like these are about how a business manages ordinary business cycles, which is exactly what a recession represents.

Ask these questions of yourself and your team. Take the time to model out some what-ifs. Maybe a bank renewal is on the horizon or new financing is needed. You will be much more prepared going into the negotiations and even if that is not a factor. This line of thinking will help you run your business better. In the face of uncertainty, the best course of action is understanding key drivers and alternatives. This allows a business to be proactive instead of reactive as micro and macro-economic forces are at work. Some of the greatest opportunities in business occur in down cycles. Asking tough questions may just be the key to grabbing your share of them.

Why the Budget Matters

Ah, fall… the weather cools off, pumpkin flavors abound, the leaves change (or so I’m told; the cactus here pretty much stay the same), and for many companies, the start of “budget season”. That’s an accounting thing though, right?

Not exactly.

One critical step in ensuring a budget is a success is to have stakeholder buy-in. To do so means the budget process is more than just an accounting exercise. By taking the time to gather stakeholder buy-in and input, management team members will feel more in control of department targets and how to execute on them. Pair this with a consistent month-end review process to follow up with leaders on where variances occurred and, importantly, why they occurred. Are there true cost increases/decreases? Did we miss executing on critical projects? Are there strategic initiatives getting delayed?

All of these discussions can help the leadership team make proactive decisions about how to guide the company forward. These discussions are less about whether there was a budget variance and more about why there was a budget variance. Understanding why leads to key learnings and better decisions moving forward.

Having a good budget plan can also be critical in external party conversations. This is especially true if you expect performance over the coming year(s) to be significantly different than the year before. The budget helps tell the story of where your company is going and how you’re going to go get there. It lends credibility to “the numbers” part of your external story which makes conversations with bankers, investors, and potential buyers much smoother.

Regardless of whether or not there are capital transactions on the horizon, a good budget is a critical tool in the hands of any business leader to understand driving factors of company performance and plan for the future.

So – happy budget season!

The Fed, The S&P 500, and Your Business

Reading the financial news every day can be exhausting, confusing, frightening, or all the above. Making sense of the noise is even more challenging for a CEO. What does it mean to your business?

Interest rates
We read about rising interest rates – that is a broad characterization. The Federal Reserve controls the Federal Funds rate, which put simply is the rate banks charge each other as money moves in the economy. Mortgage rates and treasury rates will follow the federal funds rate directionally, but not in lockstep.

Why It Matters
Rising interest rates hit the American consumer, and this is a consumer driven economy. We have already seen how rising interest rates have hit the housing market hard. It also affects credit card rates, car loans, which can reduce purchasing power when inflation on other goods is already extremely high. How is your customer doing and what is the impact on them?

Your own borrowing will be significantly more costly. For companies with tight margins that rely on lines of credit, cash flow will take a greater hit as these loans are floating rate. Capital intensive businesses will also feel an impact as any new debt added for assets will be more expensive. Do you have cushion to manage this? How are you managing cash flow right now?

M&A activity is being impacted, especially with smaller buyers and some private equity transactions where higher debt costs are leading to lower purchase prices to make the economics of the transaction work. If a sale of your business is on the radar, does this affect your potential buyer?

The Financial Markets
The Dow Jones, S&P 500, bond markets and most asset classes have been on a roller coaster. The markets can be both reactive (knee jerk responses to key headlines such as the most recent higher than expected inflation reports) and predictive (already pricing in sizeable interest rate increases, which will affect corporate earnings, and lower equity valuations).

Why It Matters
The financial markets have a large impact on American confidence. I know one CEO who follows bitcoin incredibly closely and it has a huge impact on his perspective of the environment. Now bitcoin is far more mainstream today, but still a very volatile asset. Perspective and context are key. The markets are constantly moving. What is critical is why the markets are moving. And does that provide any insights for your business. For example, if they are declining because big retailers like Walmart and Amazon are seeing softening demand and rising inventories, that information can help you make your next move. The performance of industry sectors can also provide very helpful information. How are public companies in your space performing? What actions are they taking and what does that tell you?

This could also impact M&A activity, more so for larger strategic buyers if their own stock price is depressed. Large strategics utilize equity capital for growth and often use stock in acquisitions themselves. Multiple strategic buyers that were very aggressive in acquiring in recent years have now shifted to buckling down to prepare for a recession. If your buyer is likely a large strategic, what does this mean for you?

We constantly talk about the numbers behind the numbers. What happens on Wall Street affects Main Street. You should be watching interest rates, the markets, and broad economic trends. Just be sure to go one to two steps further to really understand their impact on your customers, your vendors, and your business.

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