Suggested Financial Practices to Build Your Company

Just a few certain financial practices suggested to follow and why as you build your company…and whether you are thinking about selling or not…

I. Use the accrual accounting method.

For business owners thinking about selling their company and for those not planning to sell anytime soon, there are certain financial practices, such as following generally accepted accounting principles (GAAP) that require using the accrual accounting method that you will want to follow. Doing so makes it so that when you are going through due diligence phase of the acquisition process, it will be easier for the buyer to do the work necessary to verify such things as certain line item costs as a percent of revenue produced, calculating cost of goods sold and creating pro formas projecting future sales and profit. Actually, these are practices you will want to think about even during the embryonic stages of your company. Not only will these things that I will suggest in this article be helpful for potential buyers or investors, but as you are growing your company it will be easier to measure things and to read your business more precisely such as material and supply cost as a percent of revenue. So, my first suggestion is that you use the accrual method of accounting when creating your income statement. What is accrual accounting as opposed to using the cash basis of recording revenue and costs?

Accrual accounting requires companies to record production/revenue and costs needed to deliver that revenue at the time at which revenue and related consumption of resources actually occurred. Accrual accounting also records costs so that the costs to deliver revenue and the producing of the revenue itself are matched up. The costs are recorded when the use of resources are matched up with the timing of the production of that revenue that those costs were needed to deliver. In the cash basis method of accounting, the timing of actual payments from the customer is not important. Accrual accounting method does a better job of showing a manager what the costs are to deliver the revenue produced. Accrual accounting recognizes costs and expenses when they occur rather than when actual cash is exchanged. So, in accrual accounting, revenue is recognized when a transaction has occurred, regardless of when the customer pays. If a service is provided, then revenue is recognized. If the customer has not paid, then a corresponding account receivable is booked, which is eliminated once the company receives payment. Accrual accounting requires that companies match revenue with the expenses incurred to generate that revenue. Accrual accounting is another term for the matching principle.

II. Report all your revenue.

Reporting all of your revenue as accurately to the IRS as you can is something that one should consider a given but, nonetheless, it is something that is important for tax and legal reasons, measuring performance, being able to show all the numbers to a lender in case financing is needed, showing potential investors performance history, being able to do pro-formas with historical data to back it up, etc.
Financial institutions and investors such as private equity groups are not going to rely on unreported revenue. When a company decides to sell, investors/buyers are not going to pay for unreported revenue in the same way that they pay for reported revenue, if they are willing to pay for unreported revenue at all.

III. Get outside expert opinion on your payroll practices and compensation formulas.

Payroll rules and laws can differ from state to state. Owners will want to be compliant and ensure compliance wherever they operate. Sometimes a company’s payroll practices and formulas are thought to be compliant when they are not. This is not all that unusual. Even little deviations from all rules and laws can end up having significant impact on a company. Agencies such as the Dept. of Labor and their Wage and Hour Division are easily triggered to do audits on companies regarding payroll. HR experts/consultants typically can ensure that your company is compliant with payroll rules and laws.

IV. Keep a separate line item on your P&L for each of your lines of business.

Tracking the revenue separately on your income statement makes it easier to track the individual performance in each line of business. Throwing all revenue into one line item sometimes hides poor performance in an individual line of business. A company should be able to track the growth performance and the profit performance (at least the contributory margin) of each line of business. To do so requires that a company track different lines of business separately and also track the costs associated with delivering that particular LOB such as labor, material and supplies and vehicle costs.

V. Be consistent in the use of codes to identify the different lines of business.

Don’t have different codes for the same line of business. In addition to using a different code for different lines of business, use a different code for recurring revenue that you use for one-time services. Make it easy to track each LOB and recurring revenue vs one-time revenue.

VI. Ensure that the cost line items on your P&L are accurately allocated.

Allocating costs to the right line item on your income statement will enable you to measure things such as the cost of materials and supplies in both dollars and as a percentage of revenue and in a way that enables you to see costs per line of business which is another reason to keep a separate line item for the revenue in each LOB. Misallocation of costs to the wrong line item can create a significantly false picture of performance.

VII. Keep track of owner’s/seller’s discretionary earnings.

Simply put, owner’s discretionary earnings are defined as “the amount of money a new owner would be able to take out of the business annually”. Many of these costs are related to the owner such as life insurance, salary, expenses being put through the company that would go away post-sale, etc. These are also sometimes referred to as “add-backs”. Identifying add-backs is one step that is necessary to get to the adjusted EBITDA which has a lot to do with the purchase price offer being considered by a potential buyer. Keep track of add-backs and be able to show what those add-backs are and the validity of them in terms of them going away after a new owner takes over.