Importance of Operational Accounting in the Small Businesses

I read an interesting article this week written by John Nessel. John Nessel is the President of Restaurant Resource Group, a Boston-based consultancy providing financial tools and support services to independent restaurants and the hospitality industry. John’s number one red flag to restaurants failure is “Absence of a well organized and implemented accounting system.” He goes on to say “Printed copies of basic financial statements (Profit & Loss and Balance Sheet) are not adequate for this task because they do not verify the accuracy of the numbers presented.”

Luis Luarca of Allectus, a business management advisory, says “As proper and accurate accounting is the life blood of business, accurate and relevant accounting procedures allow for the opportunity to affect all aspects of business efficiently and effectively.” They both agree on some simple yet extremely important indicators of a poorly run business.

1. An overall lack of understanding concerning financial statements and their importance in business decision making

Understanding the technical definitions of items portrayed in financial statements is a long way from understanding what it really means and how an understanding of the meaning can be used to help run the business for efficiently and more profitably. The structure of the financial statements can mask potential risk and hide growing concerns. Not knowing what do don’t know can hurt you.

2. Over reliance on online bank balances to manage cash flow

The statement or online bank balance doesn’t tell the real story. It doesn’t tell what deposits haven’t cleared, what checks have not been cashed or what credit card transactions are not reconciled. More importantly it does not provide a vision into future cash needs. It is a point-in-time view of the health of cash. It can be dramatically different within minutes as transactions clear.

3. Inaccurate posting of financial information

This can run from simple transposition errors, to the more complex allocation error. One of the most overlooked concerns for small businesses is that the chart of accounts does not reflect the way the owner operates their business. A badly thought out chart of accounts can actually hide business problems until they are too late. Because of this, the allocation of expenses may not accurately show their impact on the business.

4. Daily and Weekly financial information is not routinely collected, reviewed and acted upon.

Many business owners are too preoccupied with data input to take the time to routinely apply a logic test to the financial information. Expand the effort to daily or weekly information gathering and little time is left to run the business. Owners should spend the majority to their time reviewing financial information for trends and taking action on those trends to improve the business performance. Instead many spend their time with the low level activity of capturing data.

5. The absence of a well organized and implemented accounting system that includes business specific Chart of Accounting, key performance tracking and repeatable procedures.

This seems to be the last thing any small business owners wants to take on. There are a lot of reasons for this. Tactical operational issues take precedence. There is a lack of understand as to the quantifiable benefits. There is a lack of interest or aptitude. All of these are the very reasons that a small business owner should look outside of their own expertise and time. This is a primary skill, much like tax accounting, that should be outsourced.

These trying economic times have brought to the surface ongoing operational issues that were previously covered by a better economy. Although poor profitability might have still been a problem, cash flow allowed these problems to go unaddressed. Many companies managed this through short term borrowing or lines-of-credit. Once credit was constrained and cash flow became an issue, operational inefficiencies came to light.

A lack of attention to good operational accounting may have masked many of these issues until they became a crisis. Crisis management is never a good answer. For some companies it became the only viable answer. The owner must take back control. To accomplish this there must be an in-depth review of how they currently account for financial activity and what that tells them or doesn’t tell them about the health of their business. This many times requires a third party that can objectively assess the environment exclusive of day-to-day operational bias and business ownership pride.

Social Entrepreneurship

Let me start out with a few definitions from Wikipedia.

Capitalism is an economic system in which the means of production are privately owned and operated for profit. Income in a Capitalist system takes at least two forms, profit on the one hand and wages on the other. There is no consensus on the precise definition of capitalism, nor how the term should be used as an analytical category. There is, however, little controversy that private ownership of the means of production, creation of goods or services for profit in a market, and prices and wages are elements of capitalism

Social capitalism (Socio-capitalism), as a theory or political or philosophical stance, challenges the idea that socialism and capitalism are inherently antagonistic. The essence of social capitalism is that markets work best and output is maximized through sound social management of the macroeconomy. Social capitalism posits that a strong social support network for the poor enhances capital output. By decreasing poverty, capital market participation is enlarged.

Social entrepreneurship is the work of social entrepreneurs. A social entrepreneur recognizes a social problem and uses entrepreneurial principles to organize, create and manage a venture to achieve social change (a social venture). While a business entrepreneur typically measures performance in profit and return, a social entrepreneur focuses on creating social capital. Thus, the main aim of social entrepreneurship is to further social and environmental goals. Social entrepreneurs are most commonly associated with the voluntary and not-for-profit sectors, but this need not preclude making a profit. The terms social entrepreneur and social entrepreneurship were used first in the literature on social change in the 1960s and 1970s

Many people, this people tend to be workers or politicians rather than owners or investors, see capitalism as a system of moving money from the poor to the rich. They believe that the entire ecosystem is disproportionately tilted toward the rich. The poor may benefit to some extent by having jobs but the preponderance of the benefit is given to the rich. I can’t argue this view. Capitalism rewards those with resources, who reinvest them, with greater gains then those without. I could argue that without those who are willing to risk what they have there would be no jobs for those who have little to risk. But only the truly greedy person would accept this as a valid response. After all, one person can only consume so much. The incremental value to their quality of life of spending more on themselves diminishes as assets accumulate. It’s the law of diminishing returns.

Social capitalism says that there is an inherent benefit to the economic enterprise to address social issues. That by building a business around serving the community, the business prospers. True social capitalist suggest that government should regulate the social interaction. I disagree with this mainly on the grounds that politicians are not free of bias. They tend to sponsor bills that promote their own longevity. Fundamentally political parties are just a special form of capitalism. The exchange rate is not calculated in dollars but power and influence. They produce a product, they raise funds, they distribute funds, and they pay wages. They do not fund social programs outside of their specific agendas.

Free of regulation companies and individuals could determine where social investments create the best return. Money would not be spent on programs that look and sound good but do not produce positive change.

There is the caveat to social capitalism and social entrepreneurship; enterprises must be economically driven to be sustainable. If they do not have a good profit structure, they too will become a social casualty. Without a true long term profit driven approach the enterprise will dry up for lack of capital and its social value will go away. The failure of most social entrepreneurs is not that their idea for social change was not valid; it was they lost the concept of perpetuating their enterprise by failing to more aggressively promote economic capitalism.

Transactional versus Transformational: Franchisers Lament Lack of Skills

The British Franchise Association (BFA) claims that the biggest obstacle to growth is finding people with the right skills to run their own outlet. A survey conducted in conjunction with NatWest revealed that a quarter of franchisers are finding it difficult to attract new franchisees because applicants lack the skills and funds to take on the job.

Dr. Michael Davis, who received his PhD in accounting at the University of Massachusetts, wrote a great article entitled “The Ten Lessons for Entrepreneurs”. One of his ten important lessons is that you can’t overestimate the value of good marketing, yet many small business people are woefully unskilled at this vital function. Most small business gets their marketing education at the hands of an aggressive sales person or at a half day seminar. Dr. Davis also extols the virtues of knowing finance and accounting as a primary tool for business decision making. The lack of this skill is a primary reason that many small business are overly optimistic about potential which leads to underfunding and collapse. Both of these skill sets are required to be successful. Small business manager don’t have the time or resources to stay current on finance, accounting, marketing, sales, operations, human resources and business practices.

One of the most important indicators of a successful franchise system is the repeatable methodologies embedded into the franchisee culture that both optimizes revenue and minimizes expense. Having a great brand, a great product and a great delivery system are critical to getting any franchise system off the ground. But it is repeatable methodologies that the franchisee can execute against that bring in new franchisees and helps existing franchisees grow. These repeatable methodologies must assume that there is a fundamental lack of business skills available within the franchise system to implement these methodologies. Doing so assures that the methodology will be mildly successful for most and wildly successful for the rest.

Most franchise systems provide excellent tools, if used properly and consistently, that help the franchisee become and stay successful. The problem arises when the franchisee either doesn’t have the skills required to use the tool properly and consistently, or doesn’t have the time. The tool, expensive to acquire, does not achieve its goal of improved profitability. Most of the time, the tool is blamed for the lack of success. Pragmatically the assessment is right. If the user can’t use the tool, then it’s the wrong tool.

Franchisor need to start looking at providing the required skills along with the required tools. The franchisor can either have the franchisee outsource these activities to the franchisor or an independent third party. There are some inherent benefits to outsourcing to an independent third party, but either will work. The franchisor should determine what high value activities MUST be done by the business manager for the business to be successful. They should then see which of those activities must be done exclusively by the business manager and what can be done by support staff. Most small businesses can’t afford a support staff. The franchisor should then help the business manager acquire the required support staff on either a part-time or ad-hoc basis. Every business must provide accounting and marketing expertise. Why leave it up to the franchisee to find the appropriate resource. If you know then have to have it, make it part of the value of your franchise by providing access to it.

The tools help reduce the cost of acquiring the prerequisite skills by automating as many of the process as possible. Automation reduces errors and cost. Tools can’t replace human involvement; they can only improve their results and reduce the cost.

The goal of any franchisor is to fill their franchise system with people who are not as focused on the day-to-day transactional processes as they are focused on finding transformational programs and projects that will take their business to the next level. Franchisors need to provide tools and the prerequisite resources required to operate these tools so that the business manager can solve problems before they become problems.

Healthcare Reform is Not Just About Healthcare

Part of H.R.3200 - America's Affordable Health Choices Act of 2009 is Starting January 1st 2012, all businesses, DBAs, sole proprietors, independent contractors, etc., will have to report ALL transactions (goods & services) through the use of an IRS 1099 form. All "accumulated" transactions of $600 or more per year, will require a 1099.

The IRS currently has a reporting requirement for businesses who hire independent contractors. If a business hires a contractor, and pays them more than $600 in a tax year for services, the business must file a Form 1099. One copy of the Form 1099 goes to the contractor to remind him/her that taxes must be paid on the amount of income received. Another copy goes to the IRS which utilizes the form to ensure that the contractor accurately complies with the tax code by paying the proper amount of taxes on income.

As of 2012, every business -- big and small -- will be required to issue a Form 1099 to any vendor of services or property to which the business has paid more than $600 in a tax year for those services or property, regardless of the method of payment. A copy of the Form 1099 must also be sent to the Internal Revenue Service. Think about the hundreds of millions of transactions performed daily...credit card transactions, checks, money orders, cash, bank wires, E-pays, etc.

According to a survey conducted by the National Association for the Self-Employed (NASE), micro-businesses (fewer than ten employees) issue approximately two to three Form 1099's to independent contractors under the current reporting requirement. Under the new expanded regulation, these businesses have estimated that they will have to issue roughly twenty-seven Form 1099s, mostly to large corporations. This is a 1250% increase in the amount of paperwork that will be required of small business come 2012. In addition to issuing form 1099s, a business will have to get Taxpayer Identification Numbers (TINs) from all qualifying vendors. Should the business owner be unable to do so, they would be required to withhold a portion of that vendor payment and send it to the IRS. The IRS will have to use a significant portion of the 16,000 new employees authorized by H.R. 3200 just to audit the flow of new 1099’s.

Should a business not file or inaccurately file their form 1099s, significant penalties will apply.

Is there good news along this front? Yes, Small Business Paperwork Mandate Elimination Act of 2010, S.3571/ H.R. 5141, is designed to repeal or modify this regulation.

Five Acronyms Every Small Business Should Know

P&L – Profit and Loss Statement

Your Profit and Loss Statement (or income statement) describes your company's overall performance. The P&L tells how much money you're making in your business and how you're making it. It measures revenues received and costs incurred over a certain period of time. It tells you if you're making money or not, and how much you're making or losing.

Go over each line item, and compare it with the previous month's P&L. If you don't understand what a line item represents, find out. The numbers should make sense to YOU, not to your accountant. And if you haven't already, organize the line items so that similar items are closer together. The default setting in most financial software usually lists the expenses alphabetically. For example, it makes sense to see "Product Packaging Materials" next to "Merchandise Purchased for Resale." Feel free to combine line items to make your P&L more concise, and/or break apart line items to show you more details so you can make some sound business decisions based on what the numbers are telling you.

COGS - Cost of Goods Sold

Also referred to as the "cost of sales," COGS are the direct costs attributable to the production of goods sold. This includes material cost and production (labor) costs but does not include indirect cost like advertising or R&D. COGS will show up on your P&L Statements. Watch the percentages, not the actual dollar amounts from one month to the next. The percentage should stay pretty much the same with regards to revenues.

EBITDA - Earnings Before Interest, Taxes, Depreciation and Amortization

This is the most complicated of the acronyms we're discussing today, but essentially EBITDA measures the core income that your company earns before your cover your debt payments and income taxes. It's an indicator of operating performance and profitability, but it's not a good measure of cash because it doesn't include changes in working capital.

EBITDA will be important if you want to sell your business; it allows buyers or investors to evaluate your operating profitability and profit trends without the unique variables that might distract from bottom line performance.

EBITDA is a good way to measure your profitability, but be forewarned: even businesses with a great EBITDA can go out of business due to cash flow. EBITDA leaves out the cash needed to fund working capital and the replacement of old equipment. Profits are great, but if you have no cash, your business will "bleed out" pretty quickly.

BEP – Break-Even Point

This is one of those numbers you want to know by heart and just like it says, this important indicator tells you at what point your business "breaks even." It is the dollar amount of revenues that exactly covers all your operating expenses (variable and fixed costs), with nothing left over for profit. It's an important indicator of risk because it shows you how close your business is to the "no profit" line. For instance, if your business is currently producing revenues at the level of $100,000 per month, and your break-even point is $60,000 per month, you are comfortably above your no profit line. You want your BEP swimming in your head at all times. It's your minimum target for slow months, and it's where emergency on your hands.

CR and QR: Current Ratio and Quick Ratio

Current Ratio = [Current Assets ÷ Current Liabilities]

The current ratio measures your ability to meet short-term obligations by determining if you have enough current assets to cover current liabilities. Ideally, your current ratio should be near 2.00, meaning your current assets are two times, or 200%, of your current liabilities. If your current ratio is below 2.00, your short-term debt-paying ability is reduced. This is an unstable financial position, and you should examine your finances to see where improvements can be made. If your current ratio is above 2.00, you have above average debt-paying ability; however, if it is too high, it may mean that you are not utilizing your assets effectively. If it's below a 1, then you've got an emergency on your hands.

Quick Ratio = [(Current Assets - Inventory) ÷ Current Liabilities]

Like the current ratio, the quick ratio measures short-term debt-paying ability. It is calculated without inventory because inventory is not as easy to turn into cash as your other current assets. Thus, the quick ratio examines assets that can be turned into cash in the least amount of time. Businesses that carry a lot of inventory need this important planning tool. Ideally, your quick ratio should be at 1.00 or higher. If it is lower than 1.00, you may have trouble meeting your current obligations. Below 0.5 is an emergency. Note that if you don't carry inventory, your current ratio and quick ratio will be the same.

This doesn't have to be complicated, or difficult to control

All it really takes is a commitment to two things: (1) understanding the relationship between money and your business activities and (2) creating and implementing—on a regular, ongoing basis—a few straightforward money management tools and strategies. When you understand how money flows in your business and you can control your money systems, you will make informed decisions about prioritization, management and investments.

You don't have to be a finance expert; you just have to understand enough to make the decisions that matter. You begin all of your budgeting and forecasting. At a minimum, your revenues (sales) should be at least as high as your BEP. The goal, of course, is to increase this number over time so that revenues (sales) are above the BEP.

If you don't know what your BEP is, you need to find out now. And how many customers does it take to hit your BEP this month? Per week? Per day? How many leads do you need to get that many customers? Also: if you want to lower the breakeven sales number, reduce your cost of goods sold or your operating expenses.

Co-Dependency in Life and Business

Sorry I have been distracted. I have been traveling lately. I've attended several meetings of small business owners and franchisors. I had an interesting moment yesterday. I started to think about relationships. Most lasting relationships start as a passion, and then grow into love. Interestingly many continue to evolve into co-dependence. This is not always a bad thing, but many times it is. As the relationship matures, lives get intertwined. There are bills and houses and cars and children. All of the sudden many couples find themselves needing each other. Neither is capable of supporting all the needs of the relationship alone. You hear terms like "stayed together for the children". In good strong relationships the passion may fade, but the love matures into a friendship that has many of the attributes of co-dependence without the baggage.  One party is willing to subordinate their need for the good of the relationship. They see this as a good thing, not a compromise. Bad relationships disintegrate into keeping score. Co-dependence becomes the ball-and-chain that bonds the relationship. Trying to control a co-dependence by keeping a ledger of who did what, when and how will only breed anger and resentment. The relationship either dissolves or continues in desperation (some quiet, some not so quiet).

So from a business standpoint what's the deal? Small business owners start a relationship with their business that is based on a passion that grows to love. Let me expand that by saying most working people start a career based on a passion that develops into a love for what they do.  Careers and businesses can continue to evolve (or dissolve) into co-dependence. People find as responsibility grows and expands there is a need to bring other players into the mix. Money is required to fund this expansion. The natural order of things becomes complex. Co-dependence is natural. The key, just like in human relationships, is to not let the co-dependence enable bad behavior out of fear of uncertainty.

When there is a co-dependence there is a loss of control. You can't run your business or your work group without other people. The co-dependence may not be on individuals, but processes that need staffing. This loss of control creates uncertainty. Uncertainty is the main driver to stress. This stress will suck the life out of any organization or individual. You want to reduce stress in your life, analyze and act upon the underlying uncertainty.

Letting people do things that are not good for them or the relationship out of fear of losing them is not the answer. Allowing a bad process or culture to continue because there is a fear that changing it will produce adverse reactions is compounding the problem. When bad relationships fall apart there is a retrospective understanding that bad behavior was enabled out of fear of loss.

If you are dealing with a lack of satisfaction in what used to be the passion of your life, accept the existence of a co-dependence. Get to the root of that co-dependence. Deal with the underlying uncertainty. Relying on others is how you leverage ideas. Living with the fear that accompanies loss of control is not the answer. Understand the co-dependence and reduce downside risk. Clarity is the by-product. Clarity reduces stress. Create a friendship with your business. Like all friendships there is give and take that creates trust.

 

Glen Campbell, "Wichita Lineman" "… I need you more than want you and I want you for all time…"