3 Components of Financial Clarity
Imagine you are a commercial airline pilot and you board an aircraft on which you are merely a passenger, making your way from one part of the world to another. You sit in your seat and tune everyone out so you can enjoy a book you've been waiting for weeks to read. You fail to listen to the updates from the pilot regarding the details of the flight — after all, you're just a passenger.
A couple of hours into the flight the stewardess approaches you with a concerned look. "Will you please come forward to the cockpit as quickly as you can?" she urges. You quickly learn that the pilot has become very ill and unable to continue the flight. The young and inexperienced co-pilot is reluctant to take over and asks you to serve as the pilot for the remainder of the flight.
Lack of Clarity
Being qualified and willing to help, you accept the request — but not without a little reservation. Where are we? What is our altitude? What weather conditions are behind and in front of us? How much longer is the flight? Naturally you want to get your bearings on the situation by understanding three key categories of data: where have we been, where are we right now, and where are we headed?
Your reaction as a pilot would be no different than your reaction if you were asked to take over a business. The challenge is — how many businesses really have a handle on the past (where they have been), the present (where they are at now), and the future (where they are going)? Only with an understanding of all three of these things are entrepreneurs empowered with the clarity they need to minimize anxiety and improve both their tactical and strategic decision-making.
Component 1: The Past
We cannot understand our present or future until we understand our past. Yes, historical performance is the foundation and context of financial clarity. We arrive at understanding our past by generating monthly financial statements that are completed on-time. On-time is usually no later than the 20th of the following month — or 20 days in the past.
Many businesses struggle to generate accurate monthly financial statements. Here are some of the common problems I see in this area, organized by the balance sheet, profit & loss statement, and statements of cash flows, and some tips to correct them.
Every single account on the balance sheet needs to be reconciled every month. Bank accounts are often attended to regularly, but most of the other accounts are neglected. Reconciliation refers to bringing into agreement the balance in each account with independent documentation. For example, a business with inventory needs to independently validate the balance in this account with a physical count or via some other means. Some of the most-often-overlooked balance sheet accounts include accounts receivable, depreciation, fixed assets, payroll liabilities, customer deposits, and more. Without an accurate balance sheet, the rest of the financial statements will not be accurate and clarity will be hard to achieve.
Profit & Loss Statement
The over-arching challenge most businesses have on their profit and loss statement is complying with the matching principle — matching revenues and correlated expenses in the correct period. First you need to recognize revenue when it is "earned." Even if a customer pays up-front for 3 years of products and services, the business will most likely need to spread that revenue proportionally over the entire 3-year arrangement. Second, the expenses incurred to generate those revenues need to be matched to the same period in which the revenue is recognized. This is often a complex process that differs slightly by industry. Once overcome, the profit and loss statement becomes a tremendous help in the quest for clarity.
Statement of Cash Flows
The main problem with the statement of cash flows is that it is generally ignored altogether. Every business should produce this statement, in conjunction with others, every month and begin learning how it works and what insights it can teach about the business. Some accounting programs will generate this report automatically, and others require manual creation. It often becomes the most valuable of the three financial statements, when used correctly.
Component 2: The Present
Where are we at right now? What happened today or this week? The mechanism that best defines our present is a comprehensive dashboard or Key Performance Indicator (KPI) report. Every business should generate this report daily or weekly, at a minimum.
The key to this report is to pull critical data from the marketing, sales, operations, and financial disciplines of your business to deliver a snapshot of what is happening. The most difficult part of this process is determining which metrics are the most important for your business to track. Know the Key Business Metrics Every Entrepreneur Must Know.
Component 3: The Future
Now, let's talk about clarity in the future. This involves both the short and long-term. The two most critical short-term tools include cash flow projections (at least 90 days into the future) and a month-by month budget/projection against which a business can track its performance and test its key assumptions.
In the long-term, a 5-year plan and financial model help illuminate the final destination of the firm. Completing these items once and then never returning to them again is counter-productive. These should be updated quarterly, at a minimum.
A pilot taking over an in-flight airplane earnestly needs to obtain clarity to successfully deliver the plane and its passengers to their final destination. Starting and running a business should be no different. In fact, your success will in large measure depend on your commitment to obtaining financial clarity in the past, present, and future.
This is a guest post by Ken Kaufman. Ken focuses his professional efforts on helping entrepreneurs maximize cash flow, improve profits, and obtain clarity.