Let’s face it … for many CEO’s and business owners in the lower middle market, the Finance & Accounting (F&A) function is at best a mystery, and at worst, a resented piece of costly fixed overhead. It is overhead, to be sure. However, the person at the top can and should be one of the CEO’s most trusted confidantes, even if that person is a part-time bookkeeper. Furthermore, the F&A team should be providing certain deliverables that are crucial to the ongoing success of the business. I say “team” because it is very, very difficult for one person alone to accomplish all that is required. So, what exactly should you require of F&A in terms of deliverables? Funny you ask …
1. GAAP Compliant Financial Statements
Your company’s ability to produce monthly financial statements that are accurate, timely, and reflective of Generally Accepted Accounting Principles (GAAP) is the very first deliverable you should demand. Financial statements include: 1) balance sheet, 2) profit and loss statement (P&L), or income statement, and 3) cash flow statement. If you don’t already have a senior bookkeeper, accounting manager, or controller who can get this done monthly, then worry about nothing else on this list until you have someone in place. Your financial statements tell the story of your business and no one, including you, can truly understand results and the financial position of your business without them.
In determining who will produce the financials, this person(s) should be able to speak intelligibly about things like reconciling cash and the A/R and A/P sub-ledgers, accruing expenses, recording fixed asset additions properly and booking depreciation, recognizing revenue according to the latest GAAP pronouncements, and ensuring the balance sheet actually balances. Furthermore, they should be a proponent of a quick monthly “close” after the end of each month and, if not already achieving a timely close, should give you a road map for how to get it done. You should have financials in hand by the seventh business day of the new month. Once beyond seven business days, the prior month starts fading and your ability to take appropriate, timely action based on last month’s results is hindered.
2. Management’s Discussion & Analysis (MD&A)
MD&A is the explanation of your financial statements produced by the F&A team, and should accompany the delivered financial statements – ideally they’re delivered together, but MD&A should come no later than within one-to-two business days of the statements themselves. At a basic level the MD&A may come primarily through discussion, with notes in the margins of the financials. When well-prepared, MD&A is formalized as a written narrative and explains what happened in the business during the last period and why. Best-in-class MD&A deliverables will include not only the narrative, but supporting schedules with charts, graphs and presentation of key metrics.
Without MD&A of any kind, the value of your financial statements is limited. Can you imagine having a conversation with the bank or your investors and not knowing the answers to questions like, “What fueled your rising material costs?”, or “If you didn’t lose any customers, why the decline in revenue?” The explanations for questions like these aren’t necessarily easy at first glance, and quickly drilling down to the root cause is a developed skill. The reality is that your F&A team will likely need to review source documents and ask “why?” of your managers multiple times before arriving at the actual answer. Eventually, everyone will get the message and no one will be satisfied until the answer is clear. As an important side benefit, operational issues will start to be identified earlier.
3. Bank Covenant Reporting
Obviously this assumes you have some kind of credit facility in place with a lending institution. Most lenders will require quarterly reporting at a minimum, though many will require monthly reporting as well. Monthly reporting might include financial statements, A/R and A/P summary agings, and calculation of the borrowing base to determine adequate support of the outstanding line-of-credit balance. Quarterly reporting will additionally require calculation of the leverage ratio and the fixed charge coverage ratio, which need to fall in line with parameters that will always be defined in the credit facility agreement.
Timely, accurate bank reporting is crucial to maintain the confidence of the bank, your working relationship with them, and your ability to borrow. Once you fall behind on the reporting, you go on the bank’s “naughty list” and typically will not be able to draw on either your line of credit or your capital expenditures line. Make sure this reporting is high on the priority list for the F&A team and that deadlines are clearly understood and met.
4. 13-Week Cash Flow Forecast
Most smaller businesses, particularly those without private equity partners, do not utilize nor have they generally seen a 13-week cash flow forecast. However, we all know “cash is king,” and this report is invaluable to looking ahead three months and projecting your cash position. From a forecasting perspective, particularly when cash is tight, nothing could be more crucial.
A 13-week cash forecast is similar in design to what is called a “proof of cash”, which is designed to “prove” the cash balance on your balance sheet. It starts at the top with your cash receipts (cash inflow), and then displays expenditures (cash outflow) right below. It nets at the bottom to a change in cash for the week, adds that number to the beginning cash balance, and sums to an ending cash balance. The ending balance is added to any existing availability on a bank line of credit to arrive at an overall liquidity amount – an important piece of information!
GAAP is of no concern with a 13-week cash flow forecast – this is all about what comes in the door and what goes out – and so it differs significantly from a P&L. More robust 13-week cash flow forecasts will incorporate things like weekly invoicing from the A/R Aging, customer payment terms, as well as purchasing data from your ERP system, and require some advanced chops in Excel modeling and data extraction. However, most companies can build a simple Excel model that forecasts receipts and expenditures using more generalized collections and purchasing assumptions. When it comes to cash forecasting, something is better than nothing and generally the more detail you incorporate, the more accurate the forecast.
5. Three-Statement Financial Forecast
Similar to a 13-week cash flow forecast, many lower middle-market companies do not have a financial forecast, or even a budget. And if they do, it’s often only a projection of sales, or at best, the full profit and loss statement for the next year. Rarely do they have a three-statement financial forecast for a full five years. Don’t get me wrong, having a one-year forecasted P&L is a HUGE step forward and something to be applauded. It is the basis for the annual budget for the next year. This should be a first goal for those who are starting from scratch.
It is worth noting here that there is a difference between a budget and a forecast, which confuses many people. A budget is projected once and is static; results are compared to the budget throughout the year and variance analysis is performed (usually as a part of the monthly MD&A). A 12-month forecast is fluid and incorporates actual results with projections through the end of the year to predict where you will finish. As you would expect, years two through five of the forecast are progressively less robust than the year-one model.
Building a three-statement financial forecast in Excel is no small undertaking and requires some financial modeling expertise, to be sure. You define key assumptions, project the P&L, incorporate historical ratios for balance sheet forecasting, and ensure the cash on the balance sheet ties to the cash reported in the cash flow statement. No forecast is ever 100% accurate. However, the resulting model serves many purposes and is vitally important for the following reasons:
1) It provides a road map for the future, as best as you can see that future today; and, everyone needs to know where they are going!
2) It forms the basis for the next year’s budget.
3) It integrates the balance sheet and cash flow statement with the P&L, enabling forecasting of cash balances, working capital needs, capital expenditures, and debt and equity funding requirements.
4) Providing it to potential lenders and equity investors up front will definitely impress, and sends the unmistakable message that a) you know your business well; and b) your organization is professional and astute at financial reporting.
5) Forms the basis for putting a value on the business, which will occur when looking for any kind of recapitalization.
In conclusion, there are many things to expect and even demand from your Finance & Accounting team – more than the deliverables I’ve been able to list here. However, if your business can check the box on each of the five deliverables mentioned, you will be well on your way to understanding the financial aspects of your business with much greater transparency, depth and acumen. And, whether it’s the variance analysis that explains your financial results month to month, or having the financial horsepower to meet with potential lenders and investors, your F&A team will no longer feel like a burden but more like a true business partner.