Note: This is a guest post by Ken Kaufmann, founder of CFOwise®. We’re honored to have him on our blog:
Bankers and investors speak a common language of accounting, most purely manifest in the financial statements of a business. If you want them to understand and get excited about what you are doing, your financial statements will tell them a story, and either validate or invalidate everything you actually say.
Not having accurate, informative, timely, accessible, and comparative financial data will hurt your chances if you need to raise money and get a business loan, underscoring just one of the reasons to make sure this part of your business is handled professionally. Here are the most common errors and pitfalls that will hinder your business from raising funds:
1. Revenue Recognition
Actually “earning” your revenue is almost never directly correlated to when you send and invoice to or receive money from your customers. Each industry has one right and many wrong ways to recognize revenue, and bankers and sophisticated investors will be familiar with each. If you are a software company and the banker does not see that you have an account called “Deferred Revenue” on your balance sheet, for example, they will lose confidence in your ability to run your business.
2. Gross Margin
There are two main expenses in a business, and they should be separated on your profit and loss statement. Specifically, all expenses directly related to the manufacturing of your products or the fulfillment of your services, also referred to as costs of goods sold or cost of sales, should be subtracted from your net revenue (correctly recognized as mentioned above) to determine your gross profit. Then divide your gross profit into your net revenue to find your gross margin. Many businesses fail to show this separate from the rest of their expenses and net profit before taxes, but it is a number bankers and investors want, and need, to know.
3. Balance Sheet Reconciliations
Every single account on your balance sheet should be reconciled every month, not just your bank and credit card accounts. This includes a thorough review of your accounts receivable, inventory, accounts payable, payroll liabilities, inter-company loans, and more. You need to be able to explain to a banker or investor what each account represents and even be able to provide documentation, upon their request, to validate the balance reflected on your balance sheet. Too many businesses pay little or no heed to their balance sheet, but investors and bankers know it drives the accuracy of everything you present in your financial statements.
4. Lack of Metric and Ratio Knowledge
You need to know your numbers, and, even more importantly, you need to know what they mean in the context of your past, future, and industry as well as the perspective of bankers and investors. Bankers care about current ratio, days sales outstanding, working capital days, inventory turnover, fixed charge coverage ratio, and other proofs of your liquidity, stability, sustainability, and wherewithal to pay them back. Investors care about EBITDA, free cash flow, burn rate, and others things dealing with the cash required to grow the business and the potential return their investment may garner.
Perhaps the most interesting take-away from this discussion is that even if you’re not looking for outside funding for your business, cleaning up your financial statements and understanding them in the ways mentioned above will improve the information you receive about your performance. And, in every case I’ve ever seen or been involved with, clarity about performance always improves performance. Having banker and investor-worthy financial statements, therefore, will put you on a path to a more profitable business. And it will help you get funded, too.
About the Author
An award-winning CFO and entrepreneur and best-selling author of Impact Your Business, Ken Kaufman has committed his career to helping start-up, small, emerging, and even medium-sized companies obtain the clarity they need to maximize their potential. He founded CFOwise®, which serves customers internationally, and is an adjunct professor of New Venture Finance at a local University. He can be reached at ken[at]CFOwise.com and on Twitter @CFOwise.