I started my career in accounting and finance in 1986 working for Peat Marwick Mitchell, a Big 8 Accounting firm, as an auditor. In that role, we were taught to examine the balance sheet accounts in detail and perform spot checks of the Income Statement accounts.
Why would you do this?
The answer is simple. Accounting is a process of recording your business transactions by creating debits and credits in your “books.” Every journal entry must balance or have the same value of debits and credits. If you prove out that the balance sheet accounts are correct, the Income Statement must be correct in total with, at most, a reclassification that might need to be made between revenue and expense accounts.
How to Use the Balance Sheet
As a small business financial consultant working with owners over the years, I found that a majority of them don’t pay any attention to their balance sheet and really only care about revenue and profits.
Putting myself in their shoes, I can understand why.
You are in business to make a profit, right? And the profit comes from generating more revenue than expenses. So, the logic makes sense. But I can tell you that I find countless issues when looking at the balance sheet.
Here’s how I do it.
If I receive an owners balance sheet for 2 years, I like to go to the liability section of the balance sheet to look for changes in the accrued liability accounts — accrued payroll, payroll withholdings, payroll tax liabilities etc. In many instances, I will see the same balance being carried from period to period or a balance that continues to grow and never become smaller. When I see that, I know there is an issue.
Depending upon the payroll cycle, these accounts should increase after processing a payroll then when the liability is funded, preferably within a few days, the liability is reduced by the payment to the various vendor — retirement account, tax agency etc. If these accounts are not showing the proper pattern of debits and credits, you can bet there is a problem that needs further investigation.
Accounts Payable and Accounts Receivable
I also like to look at the accounts receivable detail and the accounts payable detail. As a small business financial consultant, I like to ask myself some questions:
- Are we collecting our money in a reasonable fashion?
- Are we paying our vendors on time or are we paying them too soon?
Looking at this detail will give you a great idea of the cash flow cycle of the business.
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I once worked with a not so small business owner who had $50,000 in monthly expenses that he could have been putting on a rewards credit card and receiving $1,000 in monthly cash rewards!
Reviewing the Income Statement
I don’t ignore the Income Statement by any means, especially as a small business financial consultant. I will perform an analysis of gross margin (in total and by product line) and will review the various accounts to determine if they appear reasonable as a proportion of revenue for the company.
We may uncover some inefficiencies during this process, but it is less likely to uncover errors in the Income Statement (although it does happen). Most people know where to record revenue and understand where to record wages or rent paid to a landlord. But, more often than not, knowing exactly how to record payroll withholdings or how to record customer deposits received in advance can be difficult for a small business owner.
Do you think you may have errors in your financial statements? Want to make sure that your financials are in good shape before pursuing a Line of Credit or a business loan to expand your business?
A small business financial consultant can help!
Contact ChoiceFinance and we can do a review of your financials and let you know what we find.