In the investment world we constantly hear about the importance of “thinking like an owner,” particularly in reference to the short holding periods of most money managers. However, in the small business world, the opposite is often true – business owners who fail to think like capital providers.
If you are a small business owner, the responsibility of running a business likely leaves little time for analysis and contemplation. In fact, I have yet to meet a business owner-operator who wasn’t “stretched thin” to the point of exhaustion.
I get it. But if you really want to make good decisions and increase the value of your operation, I am going to put a few more things on your plate. Trust me, it will be worth it.
For starters, you need to learn how to think like an investor. Even if you do not intend on ever bringing in outside capital, then you at least need to learn to be a good steward of your own capital. This means that you need to review your financial information from the standpoint of an equity investor or lender. To do this you need something most small businesses do not possess – accurate financial statements and supplementary data. This is highly important. Sound financial management within your business will make it easier to sell your business, raise capital, expand, or bring in outside management.
Financial Management for a Typical Small Business
For the sake of argument, let’s define a small business as one with between $1 million and $10 million in sales. In my experience, most businesses of this size will use cash accounting. In fact, the IRS recently increased the threshold for using cash accounting to businesses with up to $25 million in sales.
With cash accounting, you construct a profit-and-loss statement based on payments received from customers and payments made to suppliers. The benefits of cash accounting are obvious with the following example. Let’s suppose that you own a plumbing supply business which is growing at a rate of 10% each year. You offer 30-day terms to your commercial customers, and you must pay your suppliers within 15 days. If you are reporting on an accrual basis – that is, you recognize income at time of sale and recognize expenses when they are incurred – your taxable income is likely to exceed your cash flow from operations. There are at least three reasons for this. First, because you are growing, your receivables will likely increase each year, even if they remain constant as a percentage of sales. This means that your reported sales are higher than the payments you received from customers. Second, because you must pay your suppliers faster than you receive payment from customers, you will have an increase in working capital which will reduce cash flow. And finally, you will likely have to maintain higher inventory balances to support your growing sales. This means that your inventory purchases will exceed your cost of goods sold.
In short, you will pay the IRS on income that you haven’t actually received. In finance parlance, your cash tax rate – i.e., your payments to the IRS as a percentage of operating cash flow – will be relatively high.
Now if you are on a cash reporting basis, you will report taxable income as follows: payments received from customers minus payments made to suppliers (this is somewhat oversimplified but does illustrate our point). For a growing business which sells on terms, taxable income will be significantly lower under cash accounting than under accrual accounting. It’s no wonder that accountants so often recommend reporting on a cash basis.
The Problems with Cash Accounting
So, yes, cash accounting can often lower your tax bill. The problem with cash accounting, however, is that it creates an inaccurate picture of your business. So, whether you’re looking to raise capital, deciding whether to expand, or just trying to better manage your business finances, you will need information which cash accounting does not provide.
With cash accounting, you report a balance sheet which does not show certain current assets and current liabilities, thus creating a distorted picture of the company’s financial position. In addition, because these working capital accounts are “levers” which will increase or decrease operating cash flow, they are essential for managing funding needs and making cash flow forecasts. So, how should we deal with this issue?
There are two ways to deal with the shortcomings of cash accounting. The best way to deal with it – and this is where you are going to be angry at me for increasing your costs and creating more work – is to keep two sets of books. More specifically, you should keep your books on an accrual basis, and then keep a more detailed “funds flow statement” which can be used to create a cash basis tax return. If you really want to have accurate financials, you can use Generally Accepted Accounting Principles (GAAP), which are the accounting rules companies publicly listed in the U.S. use when reporting to their investors. While GAAP accounting certainly isn’t perfect as it requires assumptions and judgements to create certain accruals and reserves, it does a pretty good job of capturing a company’s financial picture. GAAP accounting may be prohibitive for smaller companies, however.
In some cases, you may have supplementary information which allows you to piece together an accurate balance sheet and P&L outside of your accounting system. However, this may be more work than reconciling accrual to cash basis accounting.
Key Performance Indicators (KPIs)
Accurate accounting is important, but it is only part of the picture. The next step is to identify and track a handful of metrics which provide meaningful information on the state of your business. These metrics are called key performance indicators (KPIs).
KPIs will vary by business. They should, however, provide a granular level of detail regarding sales, costs, and operating trends. For example, suppose a restaurant has seen an increase in sales. One question would be whether the sales have come from more customers or from higher spending per customer. So, two KPIs for a restaurant would be (1) number of customers (“seats”) and (2) average spending per customer. Another KPI for many businesses would be the number of five-star reviews on various review sites.
KPIs are best tracked over time and compared to average industry metrics (available from trade associations and data firms). The KPIs can convey information regarding the company’s strengths and the areas in which the company can improve. KPIs can also be used to set goals for the company and as a basis for performance-based compensation.
Ideally, the KPIs should be put into a dashboard for easy presentation. A dashboard puts the KPIs into graphical form which can be easier to interpret than raw numbers. While there are many software programs available to help businesses create performance dashboards, they are relatively easy to create in Microsoft Excel and other spreadsheet programs.
Business owners may not want to reveal all their financial information to their employees. As such, these owners can create two different dashboards – one full set revealed only to management, and another focusing on KPIs shown to the whole team.
Conducting Financial Reviews
Once you have a system in place to create accurate financial information, the next step is to set up periodic financial reviews with your top managers. This is where you pull together information from the financial statements, KPIs, point-of-sale software, and other sources. In medium-to-larger organizations, this task is generally orchestrated by the CFO or VP of Finance. For most smaller companies, however, this will have to be performed by the owner-operator or general manager.
If you are just starting out doing this, it is better to have more rather than less detail. Over time, you will know which variables matter the most to your business. The guideline for the level of detail is as follows: few questions should go unanswered. For example, knowing overall sales trends is not enough – you need to know sales by product or service category. Knowing that inventory has increased raises more questions than answers. Maybe you have a few high price items in inventory which are skewing the numbers, maybe you need to reduce inventory in some slow-moving areas, or maybe it’s time to invest in a more sophisticated inventory management system. While some post-review investigation will be necessary, the financial review should provide adequate information to answer these questions.
The focus for these reviews will be on (a) sales at a granular level, (b) cost of goods sold and gross margin, and (c) operating expenses on a budgeted vs. actual basis.
So, how often should a company conduct these reviews? I’m not sure if there is a good answer for that, but my rule of thumb is as follows. An organization should review KPIs and high-level sales and margin information monthly, a full financial review quarterly, and a high-level planning review yearly.
Yearly Planning
You should conduct a higher-level overview at the beginning of each year. This review is where a business owner can really assess the business from an investor’s standpoint, focusing on two key variables: sustainable free cash flow and return on invested capital (ROIC).
We will discuss these variables in greater depth in subsequent posts. For now, we simply define free cash flow as the amount of cash flow which can be distributed out to owners or reinvested in the business. It is important here to strip out any nonrecurring revenue sources or nonrecurring costs. You want a sense of what the business can produce in a typical year, and you want an earnings figure which can be used to estimate the value of the business.
Return on invested capital (ROIC) looks at operating profits relative to the amount of capital needed to support the business. This is where accurate balance sheet data will come into use. The denominator, invested capital, is the sum of debt and equity capital employed in the business. The numerator is after-tax recurring operating profits, excluding interest expense and the associated tax benefit. ROIC is a measure of the company’s profitability.
For a company to be profitable, its ROIC must exceed the company’s cost of capital. Cost of capital is a nuanced subject which we will address in a separate post, but in short, the company should provide a return which exceeds that of investment alternatives available to the equity holders. If you are confident of earning a 15% return on commercial real estate, for example, then the company should generate this return or greater. If the company falls significantly short of this “hurdle rate”, then you will have some difficult choices to make.
Before making any investments to expand the business, you will want to know how your business performs on these two metrics. If the business is generating significant free cash flow and is earning a healthy ROIC, then expanding into an additional location, hiring more employees, or purchasing additional equipment makes sense. If the business is faltering on these metrics, then you’ll have to take a hard look at your operations before putting your hard-earned money at risk or trying to raise outside capital.
Conclusion
To make sound business decisions, business operators need accurate financial information. Creating accurate financial information involves creating and maintaining a reliable accounting system and tracking supplementary data.
Once you have implemented a reliable system, you will need to periodically review this information at a detailed level. These reviews provide needed guidance for making operating and financial decisions within the business.
At the highest level, you should review financial information from the standpoint of a capital provider (investor). This higher-level review will inform you as to the attractiveness of the business from an investor’s standpoint.
