Using Financial Analysis to Make Better Business Decisions

By Gene Holland, Interim Director of SBTDC Raleigh and Joel Harper, Director of SBTDC Chapel Hill

Do You Understand Your Business’s Financial Picture?

In our roles as Counselors and Center Directors with the SBTDC, we are frequently called upon to help clients make better business decisions based on their company’s financial statements. Unless the client has already been assisted by a CPA in financial reporting and tax return preparation, any financial records are often sloppy at best and sometimes nonexistent. While it is unrealistic to expect a small business owner to have skills that approach those of a trained accountant, it is crucial that they understand the basics of financial accounting and adopt a scalable bookkeeping platform early. Otherwise, the owner will never fully understand the company’s financial position, nor will they be able to communicate this information effectively and efficiently to other parties of interest.

Larger corporations devote entire departments to accounting and finance, in addition to hiring outside CPA firms to assist with audits and tax preparation. While it is understandable that a small company or sole proprietor, especially at or shortly after launch, often lacks the resources to dedicate a person or department to these roles, it becomes even more crucial that the owner understands his/her company’s financial fundamentals. As former owners ourselves of very successful small businesses, we cannot imagine attempting to operate daily and make strategic decisions without the ability and means to understand our company’s financial positions. Obviously, we are convinced that this lack of knowledge or awareness is a widespread problem, so what are some solutions?

Accounting Fundamentals Training

One way to help prepare the small business owner to understand the financial management processes is for that person to dedicate a little time to some training on accounting fundamentals. This can be achieved through formal classes at a nearby community college or online training modules, such as those offered by the Corporate Finance Institute, which generally receive good reviews. 

Any business owner should have some understanding of the following accounting concepts:

• Debits/Credits and Double Entry Methodology
• Accrual vs. Cash Methods
• Purpose and Structure of the Income Statement/Profit & Loss Statement
• Purpose and Structure of the Balance Sheet
• Purpose and Structure of the Statement of Cash Flows
• The Relationship between the Income Statement and the Balance Sheet
• What Each Financial Statement Tells its Audience

A cursory understanding of the above principles not only equips the owner to assess the company’s financial position, but it also provides the tools by which he or she can communicate effectively with financial partners. 

Adopting a Scalable Bookkeeping Platform

In addition to developing an understanding of financial accounting, the small business owner would be wise to adopt a simple, affordable, and scalable bookkeeping platform at or soon after launching. Examples of such platforms include Quickbooks, Xero, Wave, and Freshbooks, and there are others. Many budget platforms don’t offer the ability to track inventory or run reports, so do your homework before purchasing. Most are web-based platforms; however, Quickbooks still offers a desktop version, which might be preferable if there is no need to run the books on more than one machine in one location. 

An attractive attribute of these platforms is that most are easily scalable. As your business grows in volume and in complexity, most of these software modules allow some expansion within each level, and when the company outgrows that solution, these providers offer more robust platforms to which one can easily migrate. The point is that although the “cigar box and legal pad” method of bookkeeping might suffice for your child’s lemonade stand, a serious small business owner should care enough about the venture to invest in a functional accounting platform. You will thank yourself later, as will your CPA, banker, or SBTDC Counselor!

The Two-Step System to Managerial Accounting

Once you adopt a system, the statements that it produces contain pertinent information. This information by design is best suited for reporting to the IRS. However, these same platforms often are not very robust nor easy to navigate when a small business owner wishes to make management decisions. This is where managerial accounting steps in, and we have developed a two-part system to assist small business owners in this endeavor. 

Step One

The first step is to transform the often-clunky Profit and Loss Statement (P&L, Income Statement, IS, etc.) into a form that is easier to read and understand. Generally, the P&L that your system generates lists the operating expenses either alphabetically or by random account number. This doesn’t help much when the business owner wishes to assess spending related to occupancy, as those accounts, such as rent, utilities, and the like are spread throughout the statement. This is the primary reason for the process. To solve this problem, we take 3-4 years’ worth of P&Ls and recast them into a simple spreadsheet, rounding to the thousands, lumping related line items into their respective buckets, calculating key percentages, and aligning the years side-by-side so that we and the business owner can evaluate and analyze. From here we look at trends and outliers. This process almost always reveals issues of which the business owner is unaware, and it spurs questions from us as counselors to help the client improve their operations. It is quite simple, and extremely effective. 

Step Two

The second step is a bit more complicated, but nonetheless important. We use a credit analysis spreadsheet to do some further analysis, as the P&L tells only about half the story. This spreadsheet allows us to see on one tab up to 4 years of condensed P&Ls, Balance Sheets, and some helpful ratios and other calculations. On the other tab, it automatically generates a Statement of Cash Flows and a measurement of Permanent Working Capital. Although this second step is usually a bit too complicated for the business owner to undertake on their own, it is something that we as SBTDC counselors can do. However, the output is quite simple and easy to follow with a little guidance. This step is very useful, especially for operating companies that might have Balance Sheet accounts such as Inventory, Accounts Receivable, Accounts Payable, and/or Accruals. It is crucial because cash can easily hide or leak in this operating cycle, and the P&L alone will never reveal the issue. We both have had clients come to us who appear profitable but always seem low on cash; it is usually found here!

Invest in the Financial Foundation of Your Business

It is understandable that many small business entrepreneurs view the daily accounting and periodical analysis functions as necessary evils and boring tasks, and it is very easy to put off those unpleasant items on your long to-do list. However, it is a painless undertaking to invest some time in developing your own skills in that area and some capital in implementing a scalable accounting platform. After all, you, as the heart and soul of your small business, should want to be able to understand the financial strength of your company in real time so that you are equipped to react to market influences and make sound business decisions. Think of this as the financial foundation of your business upon which you can build using your sales, marketing, and operations skills. The accounting/bookkeeping function is just one of the tools in the box of the small business owner, and he or she should have some proficiency in its use.