Do you have confidence in your financials? Naturally, you should be able to answer "Yes", absolutely and without a doubt. The reality for many businesses, however, is that things aren't always as they seem. Inaccuracies in financial reporting can occur for any number of reasons -- human error, blatant dishonesty, and accidental misinterpretation of the numbers are just three of the many reasons your financial records could be out of order.
When it comes to accounting, there are two foundational financial statements that have their tales to tell: balance sheets and income statements. Each one has its own role in your company's story, and they work together to create the bigger picture.
Here's a quick look at each of these financial statements and the cautionary tales they can reveal:
The Balance Sheet
What You Should Look for:
When you look at a balance sheet, you should be looking for balances that don't make sense. The balance sheet is a moment-in-time view of your business. You get a quick snapshot of what's going on in your company's world. The following are some tell-tale signs you might identify if your numbers are out of balance:
- Negative Balances.You might see negative balances on an asset. What does that tell you? Did you sell an asset and take it off the books but forget to reverse the depreciation?
- Misapplied Payments. If you received payment from a client and misapplied it to the wrong account, your balance sheets will be out of whack. You'll likely show a negative balance on one customer's account while you show that the person who paid you still owes you money.
- Rising Debt-to-Credit Ratios. If you have several large "other expenses" on the balance sheets, you may notice a downward trend of revenue, sometimes over several years. This can lead to a rising debt-to-credit ratio, as your monetary funds are being improperly allocated. On the other hand, this could simply signify the business is struggling. In this case, the financial statements may not be wrong, but they would certainly signal red flags that need to be paid attention to. In either case, you need to know why these trends exist so you can analyze the root causes and take appropriate action.
- Opening Balance Equity. Opening balance equity, or OBE, is a red flag. OBEs usually occur when there was some number that nobody knew what to do with. There is no such account called "opening balance equity", which means any entry by this name is a misallocated entry. When the debits and credits don't equal, you're left with a random, unnamed number. Although OBEs may help you reconcile your books, they're not solving the mysteries that derive from these unknown numbers. In truth, you should never have "left over" numbers. Every entry needs a home. Opening Balance Equity entries signal the possibility of greater issues.
Other Balance Sheet Red Flags
At GrowthForce, we recommend that our clients review their Age to Accounts Receivable Report. This report will help you understand if your bookkeeper truly knows what he or she is doing when it comes to your numbers. Do you have customer balances and negative amounts that are equal to each other? This is a sign that your bookkeeper doesn't know how to use QuickBooks.
If you have an OBE, you may have a problem. In this case, this usually means the funds were applied to the customer but not the invoice. This situation often lends itself to accountants who have to clean up after bookkeepers.
Another place of opportunity often arises with undeposited funds. In short, QuickBooks allows you to deposit funds into your general account. You enter the deposits on the main deposit screen. This money is held in an undeposited funds section of your account, accumulating all deposited checks, until you print a deposit slip and move the funds from this holding place into the actual bank account.
Often times, bookkeepers enter the deposits into the main deposit screen, head to the bank, then never complete the transaction via QuickBooks. This causes money to stay in undeposited funds, and this section grows and grows until someone like a CPA comes in and asks why all this money is unaccounted for.
The Income Statement
What You Should Look for:
The income statement presents a summary of income and expenses and shows you how profitable the business has been over a period of time. It is more like a movie reflecting income and expenses over a month, quarter or year, whereas the Balance Sheet represents a moment in time.
Once you understand the accounting method suitable for your business, it should be clear when looking at the Income statement, the accuracy of those numbers.
Income Statement Red Flags:
- Big Profit / Small Cash Flow - One way to get a good view is to look at the Income statement along with the cash flow statement to be sure the profit you’re seeing is supported by the cash coming in. Big profits on an income statement while small on the cash flow statement may indicate a red flag in earnings.
- Decreasing Non-operating income which is easy to identify because it’s stated separately from operating income on the income statement. Analyze the relative proportion of operating income to non-operating income year-over-year. If it’s decreasing, you may need to refocus your efforts into revenue sources that won’t disappear. *(Inuit suggests to Look for These 5 Warning Signs in Your Financial Statements and points out non-operating income as a red flag on an income statement.)
- Unpredictability - When you move from your income statement to income KPIs like Gross Profit (for example), an uneven income trend line with wild swings will look like shark's teeth -- the lines go up and down from month to month in a jagged fashion with no real rhyme or reason. This unpredictability can signify problems with the business, or, at a minimum, issues with the bookkeeping staff.
Without true trends, you're looking at inventory balances and gross profit margins that don't reflect reality, which means you don't really have a grasp on the money coming in or going out of your business.
Your Financial Statements: What Should You Ask Yourself?
When looking at your Financial Statements, it is important to consider accounting methods - understand the differences between Cash Basis vs Accrual Basis methods of accounting:
- Cash basis accounting is based on your company’s cash activity. It tracks when cash comes in and when it goes out. You can think of cash basis accounting similarly to your checkbook register – at the end of the month, you balance everything to see how much cash you have in the bank. Cash basis won’t give you complete insight on how your business is actually performing.
- Accrual basis accounting applies the matching principle - matching revenue with expenses in the time period in which the revenue was earned and the expenses actually occurred. This is more complex than cash basis accounting but provides a significantly better view of what is going on in your company. Accrual basis allows for a more accurate trend analysis of how your business is doing rather than fluctuations that occur with cash basis accounting.
Cash basis and accrual basis are only a piece of the picture and it’s really important to look at both to understand what is actually going on with your company.
Accrual gives a better view of your profitability. You can see a trend analysis because you recognize revenue and expenditures in the period in which the revenue was earned and the expenses occurred. You can see a forecast of your monthly burn rate for operating expenses and get an idea of what you need your gross profit to be in order to cover these expenses.
Cash basis accounting can show larger fluctuations because one month might be really profitable and the next is not because of the timing of receipts and money going out. That doesn’t usually reflect the true profits on a job or project. If you want to see how well your overall operations are, accrual basis will give you a better view.
If you're not confident in your financial statements, every aspect of your business can be impacted. From sales to service teams to management, everyone who has a stake in your business can be affected by the numbers on your financial statements. If they're inaccurate, or if you're not completely confident in the information they're providing, you could be missing out on opportunities.
Here are some other things to consider:
- Do you have enough confidence in your financials to pay bonuses based on those numbers? That's the litmus test. If you waver on this answer, chances are, you need to investigate your financials further.
- Are your financial statements showing true economic results? If there are curious patterns or trends that don't make much sense, you're probably not seeing an actual picture of reality.
- Can you say, without reservation, that you stand behind your bookkeeper's work? Even if you don't have your hands in the day-to-day finance function, you need to understand cash in and cash out. In other words, what's going on with your money? Are your accounts receivable being allocated to the places they're supposed to go? Are your balance sheets and income statements clearly reflecting the economic state of your business? If you're unsure, it's time to investigate.
Now that you've read this, how confident are you that your financial statements are accurate? If you're not sure about your answer, it's probably time to call on a team of experts who can help you organize the data and report correct numbers. At GrowthForce, this is one of our specialties. We offer accounting solutions that go far beyond simple bookkeeping. Take a look at how we can help you analyze performance and increase profitability today!