“This kid is a 2-2-2-2 with 1-1-1 support and 1520 Board scores. He looks pretty strong to me. What do you think?”
“Well, I have a 3-3-2-2 with 2-2-1 recommendations and mid-1400s. Great kid, but it may be tough to find a slot for him,” came the response.
The shorthand of the college admissions process didn’t really reduce applicants to mere numbers, but these numeric rating designations were useful. In assessing academic, extra-curricular, athletic, and personal qualifications on a 1-6 scale, a “4-4-1-3” was significantly different from a “1-3-6-3” or a “3-3-4-1.”
In my early days as a college admissions officer – a long way away in time, but not so far in distance – the college’s apparent practice of quantifying much of what was really a qualitative process struck me like fingernails across a black board (a reference that unquestionably dates me as being pre-“Millennials”).
But once I caught on, once I realized that a “1” academic was more likely a Westinghouse National Science awardee than an 800 Board scorer, or a “1” athlete was a likely Olympian and not “just” an All-League selectee, and that “1”-rated teachers’ reports resulted not from just checking the “Outstanding” boxes but from an obviously enthusiastic and well-documented testimony to unusual scholarship, I began to understand. In fact, the method was useful shorthand for the story, one that allowed me to spend my time most productively on the most competitive cases.
In similar fashion, for the uninitiated, understanding a company – at least in part – by reading its financial statements seems like demeaning a legacy of accomplishment, or at least of effort. What is product development if reduced to an “R & D Expense” line? How can a memorable advertising campaign (think: the E-Trade baby) be encompassed in eight (nine?) digits next to “Marketing Expense?”
And, yet, when it’s all there in standard order – when you start at the top of the balance sheet and see Cash, followed by Accounts Receivable, and by Inventory, and so on down the page, and then you turn to the income statement which leads with Gross Revenues and then subtracts Discounts on one line and Returns and Allowances on the next to get Net Revenues on the fourth line – you get a sense that this company knows what it’s doing financially and for a financial person that’s reassuring, especially if you’re a financial person considering a loan or an investment.
This is not arcane stuff. It’s available with two clicks: (1.) Google search for Chart of Accounts, followed by (2.) the very first listing here with a sample chart of accounts. Simple, but apparently still daunting for a lot of smaller companies and their staff accountants. Because even with the menu-driven screens of common small-company accounting programs like QuickBooks and Peachtree to provide direction, fundamental analytical options are overlooked. And this tells the deep-pocketed financing source that he or she is dealing with a financially unsophisticated company, which means that his or her arms immediately get shorter and unable to plumb the depths of the pockets.
So here are some navigation guideposts, seven simple plotting tips to get you out of the swamp before you start your financing conversations:
- Segregate the functions – On the income statement, group your expenses into at least four categories: Direct Costs, Research and Engineering; Sales and Marketing; General and Administration.
- Allocate the payroll – For each functional area show the payroll expense (including payroll taxes and benefits) that is specific to that function, splitting an individual’s pay among two departments, if appropriate.
- Include a percentage analysis – To the right of each line item of expense, show the percent to one or two decimal places that the expense bears to Net Revenues.
- Interest below the line – Interest is a non-operating expense. It should be deducted from Net Operating Profit resulting in Profit Before Taxes.
- Show your collateral – Bankers typically make loans against Receivables, Inventory, and/or Fixed Assets. Your balance sheet should show Receivables net of Doubtful Accounts, Inventory net of a Reserve for Obsolescence, and Plant and Equipment net of Depreciation.
- Split out short-term borrowing – Your Bank Line of Credit is typically payable (or renewable) within a year. It should be grouped with Current Liabilities, as should the Current Portion (principal payments due within a year) of Long-Term Debt.
- Use summary statements – Too much detail bores even a banker. For initial conversations produce (a.) a summary income statement that includes just the total of each major category of expense and (b.) a balance sheet with no more than eight line items on each side.
Financial statements don’t record the full story of a business any more than admissions shorthand provides meaningful insight into a college candidate. But ensuring that proper guideposts – the navigational beacons – are appropriately placed in your chart of accounts will help you find your way out of the swamp without sending distress signals to the ‘gators.
Draining the Swamp
Largest suburban* accounting firms
|Overall Rank**||Total MA Staff||CPAs in MA|
|Braver PC, Newton||9||162||74|
|DiCicco Gulman LLP, Woburn||13||90||43|
|Kevin P. Martin Associates PC, Braintree||14||64||43|
|O’Connor & Drew PC, Braintree||15||72||41|
|Gray Gray & Gray LLP, Westwood||17||75||38|
|Kahn Litwin Renza Ltd, Waltham||19||40||35|
|Levine Katz Nannis & Solomon PC, Needham||20||59||33|
*Non-Boston/Cambridge **Among 50 largest in Boston Area
Source: The Book of Lists, 2011 Boston Business Journal
Navigating the CPA’s reports:
Compilation: This is the basic level of service that CPAs provide with respect to financial statements. Performed in accordance with AICPA standards, the Compilation expresses no assurance that the statements are in conformity with generally accepted accounting principles (GAAP). Compiled financial statements are often prepared for privately held entities that do not need a higher level of assurance for an outside lender or an investor.
Review: In addition to the foregoing, a Review requires that the CPA perform certain analytical procedures leading to an expression of “limited assurance” that he/she did not become aware of any material modifications that should be made in order for the statements to be in conformity with GAAP. A Review is often required as part of a closely-monitored financing agreement or by trade creditors with significant exposure to the company.
Audit: This provides the highest level of a CPA’s assurance regarding the veracity of the financial reports presented. It results from confirmation and substantiation procedures that usually include direct correspondence with creditors and/or debtors to verify the amounts owed, physical inspection and count of inventory, inspection of minutes and contracts, and determination of government reporting compliance. On completion, the standard auditor’s report states that the audit was performed in accordance with generally accepted auditing standards, and it expresses an opinion that the financial statements present fairly the entity’s financial position and results of operations. This is known as an expression of “positive assurance.”