Making the Case for Financial Analysis by Owners of Small Businesses

Since the economy has soured, business owners are likely to start taking a closer look at their expenses in an effort to discover “unnecessary” costs.  In some cases, this may lead to uncovering fraud that might not have been discovered otherwise.  The point is that business owners should make this an integral part of their routine.

I am amazed at the number of business owners who do not take an active part in actually reviewing and understanding their financial statements.  Many of these owners are passive investors in a three or four owner business.  Some of these passive investors, who do not take an active role in running the day-to-day operations of the business, feel like they would be imposing by asking too many questions.  Other passive owners may feel “shut-out” by their active partner who runs the administrative and financial part of the business.  If this is the case, the alarm in your head should be sounding at full volume.  The active business owner should not feel “inconvenienced” to provide his or her partners with some basic financial information. What a shame it would be for a passive owner to discover that he has been hoodwinked by his active partner, simply because the passive owner lacked the resolve or did not want to “rock the boat” by insisting upon a review of the Company’s financial statements with all the owners and a knowledgeable member of the Company’s accounting staff.  Oftentimes, even owners who are very active in the daily affairs of the business do not devote the necessary time to actually understanding what their financial statements are trying to tell them.  Not only does this type of review help detect fraudulent activity, it also helps the owners realize where their business is headed financially.  As a result, any changes in operations that are deemed appropriate can be initiated before conditions deteriorate further.

Reviewing basic financial statements does not have to be a complicated ordeal.  Armed with some common-sized historical financial information and some working knowledge of the business, most business owners can quickly review their financial statements for trends and suspicious activity.

Common-size analysis is the process of presenting income and expenses as a percentage of total net sales; assets and liabilities are presented as a percentage of total assets.  These percentages could be presented next to the dollar amounts in each account.  Most small business accounting packages can present this information on a month-by-month basis with year-end totals in a single report. 

Month-by-month information can easily be reviewed to spot increases or decreases of activity in relation to the other months of the current year or prior years.  For instance, if someone in your organization is writing checks to a fake company for operating supplies, this account should appear unusually high when compared to other months or prior year monthly activity.   Whereas, a comparison of year-to-date activity might not be as obvious unless the dollar amount of the fake invoice was much larger.

Another advantage to a common-sized analysis is the ability to compare your company with other companies in the same industry.  Significant differences should be investigated.  Although your company may not be comparable to its peer group, you should know the reasons why (local competitive market, local economic differences, etc.).

Best case scenario would be a periodic “State of the Business” meeting whereby a packet of financial information was prepared and sent to the owners of the business one week before the meeting.  This should take place at least annually or more frequently, if needed.  In addition to the common-sized and historical financial information, other supporting information could be provided for review by the owners, such as bank reconciliations, aged accounts receivable schedule, detailed depreciation schedules, aged accounts payable schedule and other items supporting significant items of assets and liabilities.  Year-end payroll reports listing annual payroll for each employee could also be presented and should agree in total with the salaries and wages presented on the income statement.  It is always recommended for a company to prepare budgets to see where the Company is headed.  If these are available, a budget comparison report could also be presented for review.

Although a company may have an annual external audit of their financial statements performed by a Certified Public Accounting firm, the Company would benefit from an owner review of the financial statements.  CPAs use materiality levels to assist them in determining what dollar amount of items to examine.  This is necessary in order to keep the cost of the audit down.  However, an account fluctuation considered as an immaterial item in terms of the audit, may be something that the owners of the Company would be very interested in.  In addition, active owners of the Company have a working knowledge of the company that is inherently more in-depth than the public accounting firm’s knowledge of the Company.  An unusual account fluctuation that would be very noticeable by an active owner, possibly might escape detection by an outside auditor.  In addition, auditors normally perform common-sized analysis on a year-to-date basis.  As mentioned above, a month-to-month comparison would be more likely to uncover unusual activity.

An added benefit to this common-sized business review would be the knowledge gained by the owners who may lack financial statement experience.  In order to educate the owners, the Company should consider inviting one of our CPAs to participate in the business review meeting.  We could help the Company’s bookkeeper explain things and add credibility to what the bookkeeper has presented. 

When a common-sized business review is conducted along with a good internal control system for the Company’s cash transactions, the Company will have gone a long way in making it more difficult for a thief to steal without detection. 

If the review of this financial information reveals suspicious activity, the Company should consult with its legal counsel who may recommend contacting a Certified Fraud Examiner (CFE) for a more in depth analysis.  Baldwin has two CPAs who have been credentialed as CFEs and would be happy to help you with a “State of the Business” review or show you how to perform an analysis of your Company’s financial information.  Please contact us for assistance. 

/Posted By Billy Upchurch, CPA/ABV/CFF, CFE, CVA