Running your business requires you to manage dozens of tasks each day, and delivering a quality product or service to your customers is the first priority. Some owners become overwhelmed by daily business operations and neglect their financials, which may cause big problems down the road. Use this list to evaluate your financial fitness and to keep your business on track.
An Example – Getting to Fiscal Fitness
Assume, for example, that Julie owns and operates WoodCreations, a customized furniture manufacturer that generates $10 million in sales each year. The company buys wood and other components parts to create high-end furniture. What to do? Where to start? Good thing we have a handy 15 point plan…
#1- Formal business plan
Every business owner should put a formal business plan in writing, including a set of projected financial statements. You can find software packages that can generate both the written plan and a set of linked financial statements.
The business plan should clearly state the problem that the firm’s product or service solves for the customer and the size of the market for the product. Management should note the price range that consumers are willing to pay for the product and an estimate of annual sales.
A business plan is important for several reasons. Writing a plan forces management to think carefully about the viability of the business, and what changes should be made. The business plan also provides a starting point for creating an annual budget.
#2- Create an annual budget
Successful businesses generate an annual budget, and the budgeting process should be completed before the start of the new fiscal year. You should get feedback from each company department, including sales, purchasing, and production.
The budget should include estimates of your expenses, which are called standard costs. WoodCreations, for example, will decide on standard costs for wood and other materials, as well as standard hourly rates for labor costs.
#3- Review variances
A business should review variances shortly after month end, so that changes can be made to improve financial results.
A variance is defined as a difference between budgeted and actual results. WoodCreations should review variances each month and investigate large variances.
Most companies review the variances with the largest dollar amount first, because those results have the biggest financial impact on the company. If you can determine why the variance occurred, you can make changes to improve your business results.
Say, for example, that WoodCreations uses $20 more maple wood for a $400 table than is budgeted. The firm produced 30 of the tables last month, which generated a $600 variance from the budget. Julie investigates the variance and determines that mistakes were made in the manufacturing process. With better training, her workers can manufacture the table with the budgeted amount of maple wood.
#4- Operating vs. non-operating income
You should look closely at your company’s operating and non-operating income, because generating operating income is the key to long-term financial viability.
Operating income is income that a business generates from its day-to-day operations. WoodCreations generates operating income from furniture sales, and that source of income can be consistent and repeatable.
If, on the other hand, WoodCreations sells a building for a gain, the transaction is posted as non-operating income. Non-operating income is unusual and not produced by the firm on a regular basis. A financially healthy business is able grow sales and operating income each year. If Julie’s firm is struggling to generate operating income, she needs to make improvements to the business.
#5- Earn a return on assets
A successful business should generate a reasonable return on the assets invested in the enterprise. Return on assets (ROA) is defined as (net income) divided by (total assets), and ROA measures how well a business is using assets to produce earnings.
An asset is defined as a resource that is used to generate revenue and profits. Assume, for example, that a plumber uses a $25,000 truck that carries $15,000 in plumbing equipment. The plumber has a $40,000 investment that he uses to generate residential plumbing sales. If he earns $80,000 in income, he has a return on asset ratio of 2:1.
Julie should check the ROA results each month to see how efficiently WoodCreations is using assets, and compare her ROA results to other business in the industry. ROA is an indicator of a well-managed business.
#6- Plan for capital expenditures
Every company needs to maintain and replace assets over time, and that process can be expensive. Managers need to plan for capital expenditures (Cap-X), which refers to future spending on long-term assets. Cap-X can have big impact on cash flow and a firm’s debt position.
Assume that WoodCreations uses a $300,000 piece of equipment that has a remaining useful life of three years. Since the firm can’t produce furniture without this equipment, it must be replaced before the existing asset wears out completely.
WoodCreations can save cash out of current operations to pay for the new machine, which reduces available cash for other needs. The firm could also borrow the money and plan for interest payments on the debt. Both decisions have an impact on the business, so Julie should carefully plan for the purchase in advance.
#7- Chart of accounts
A comprehensive chart of accounts ensures that your financial reporting will be clear and accurate as your firm grows. The chart of accounts is an accounting term that refers to the list of your accounts and the account numbers. This chart is important, because it drives all your accounting transactions and ultimately the format of your financial statements.
WoodCreations, for example, uses account #7000 for Sales, and the firm’s chart of accounts includes a subcategory for each product line. Account #7100 is for tables, #7200 for cabinets, etc. This chart of accounts structure allows the firm to post revenue and expenses by product line, so that Julie can calculate each product line’s net income.
#8- Use accrual accounting
Julie’s business should operate using the accrual basis of accounting, because this method matches revenue earned with the expenses incurred to generate revenue. The accrual basis differs from the cash basis of accounting, which posts revenue when cash is received and expenses when cash is paid.
When WoodCreations owes employees wages at the end of May, for example, it posts accrued wage expense and wages payable for payroll owed to employees on May 31st. When workers are paid in June, WoodCreations removes the wages payable balance and pays cash. Accrual accounting posts the wage expenses to May, when the hours are actually worked.
Using the accrual accounting method gives Julie an accurate picture of a company’s true financial condition.
#9- Complete a formal monthly closing process
A company should have a formal process for closing the accounting records at the end of each month, so that the financial statements are accurately maintained. At month end, WoodCreations should review the accounting records and make adjustments so that revenue and expense transactions are posted using the accrual basis of accounting.
All revenue and expense accounts are adjusted to a zero balance at the end of the month. The difference between total revenue and expense is a firm’s net income (or loss) for the month, and net income is posted to retained earnings.
Completing a formal monthly close ensures that the financial statements are correctly started at month end.
#10- Timely bank reconciliations
Managing cash may be your most important financial task, and you should reconcile your bank accounts as soon as you can access your monthly bank statements. You can find and correct a variety of problems during the reconciliation process, such as a revenue or expense entry that is missing from your accounting records. You should investigate any reconciling items immediately, in order to work with an accurate cash balance.
#11- Useful management reports
Every business has some key financial indicators that make a large impact on company profitability. You should identify these metrics for your business, and review the results each month.
Since WoodCreations is a manufacturer, its largest expense is cost of sales, particularly material and labor costs. To monitor these costs closely, Julie reviews material and labor variances immediately after month end.
#12- Organize your record keeping system
Organize your record keeping so that you can quickly assess data to make business decisions. Use a cloud backup system to minimize paperwork, and create a system of online files and folder that makes logical sense. These steps will minimize the amount of time you spend looking for information.
If your records are organized, you’ll spend less time generating your financial statements. If you have an audit performed by a CPA firm, you’ll spend less time preparing for the audit. Finally, if a potential buyer wants to perform due diligence, you’ll be able to access documentation much faster.
#13- Check for segregation of duties
Make sure that you have procedures in place to separate important tasks between different employees. This process will reduce the risk of employee theft.
There are three specific duties that should be assigned to three different people. To illustrate this concept, consider how WoodCreations segregates duties for managing cash:
- Custody of assets: Julie’s assistant Mike has access to the company checkbook, which he keeps in a locked drawer.
- Authorization to move assets: Julie and her general manager are the only two people who are authorized to write checks or use the company debt card.
- Record keeping: The company controller reconciles the bank account each month. The controller does not have access to the checkbook, and he is not authorized to sign checks.
It’s common for a business owner to have two (or even three) of the duties assigned to them. It’s important, however, that no employee has more than one duty assigned. If the controller, for example, could also sign checks, he could write a check payable to himself and not document that check in the bank reconciliation provided to Julie.
#14- Build a team
As your business grows, the decisions you make become more complex, so it’s important to build a team of trusted advisors. That team should include an attorney and a CPA. If you’re considering selling your business, add a valuation expert to your team.
#15- Get independent advice
Seek out professionals who can give you a frank, honest assessment of your business. Consider forming a board of directors, and include board members from outside your management team. Independent board members can put the best interests of your business first.
Implement these concepts
Managing a business can be overwhelming, and it can be difficult to stay on top of your finances. Invest the time to implement each of the items on this financial fitness checklist. You can apply these concepts to your business and maintain profitability as your grow.