Financial controls for a small business

As you grow, your cash flow will become more complex. This will surely be the case if your expansion includes creation of debt to fund your growth. Most business failures occur because the cash flow fails to cover debt created in acquisitions or other expansion costs.

Cash flow control is a simple method of projecting your future needs for cash. It is an income statement covering future periods of time that has been changed to show only cash: cash coming in and cash going out and what your balance of cash is at the end of designated periods of time.

In cash flow control, for each future intervals of time, make conservative estimates for your future sources of cash (IN) and future expenditures (OUT). Use low, conservative figures for IN items and use high estimates for OUT items. For the initial period, start with the cash you now have. To this you add IN items and subtract the OUT items, which results in the cash at end of the month. The cash at the end of month becomes the starting cash for the next month.

Your cash flow projections will furnish the information on how much debt you can safely take on. You may want to establish a guideline ratio to establish a margin of safety between your cash flow and your debt service. For example, limiting your outstanding debt service so as to maintain cash flow that is three or more times the debt service. To estimate a reasonable ratio for your particular business, your public competitors are a good place to look for industry norms.

Any time you were to run out of cash, you would have a potentially disastrous problem. So the number one safeguard in building your business is: never run out of cash. By having information of potential negative balances in advance, say six months, you have six months to make cash flow adjustments in sales, collections, expenses or financing to correct future negative balances.

The following simplified cash flow control spreadsheet shows that ending cash for this first period becomes the starting cash for the second period. The ending cash for the second period becomes the starting cash for the third period, and so on. The projection will also be a useful tool in arranging financing and demonstrate to your banker that you are sensitive to the importance of safeguarding liquidity as you grow your company.

Your Accountant's Role
Internal controls are the safeguards to ensure all the information represented on your financial statements is accurate. Your internal accountant working with your CPA will be the key overseers in managing all internal controls.

Checklist of Internal Controls

• Separation of income and expense functions. For example, have different people handle accounts payable and accounts receivable.
• Separate authorization, custody, and record keeping roles. Your CPA can make recommendations that are appropriate for your business.
• Have bank statements mailed to a separate (or home) address of a managing authority or yourself. Malfeasance occurs frequently with banking transactions. Bank statements and checks cashed can be independently reviewed.
• Do not delegate signing of checks.
• Establish maximum limits of purchasing authority.
• Require all payments be supported by invoices.
• Require bids on all purchases over a stated limit.
• Inventory controls:
  Inventory, similar to cash, can disappear very rapidly through carelessness or employee dishonesty. Require authorization for who can sign for goods and services and who controls the release of goods and services out the door after the processing has been completed. Separation of incoming and outgoing duties is recommended.
• Rapid delivery firms such as UPS or FedEx and just-in-time assembly systems are great tools to use to minimize your inventories. The cash you free up can be put to uses that are more productive.
• Verify that insurance policies are in force and premium payments are current. View our Business Risk and Insurance session of the Starting a Business course for more information.
• Internet technology (IT) security management in place or outsourced. Your IT consultant or manager should write out the IT policies.
• Edit log for website changes and updates. If your business deals with e-commerce, you need to establish a log procedure for control of who and how edits to your website are to be made. All changes or edits to the site should be made through a designated employee. Your computer technology consultant can show you how to administer this tool.

You will probably need more financing as you grow and your lenders will require a closer scrutiny of your financial statements. There are several levels of how audits are performed by your CPA. Starting with the most rigid and expensive one:

1. An audited financial statement is one prepared by a CPA who certifies that the financial statements met requirements of GAAP (Generally Accepted Accounting Principles) which covers a wide range of procedures. An audited statement is required of publicly owned firms. So if you are planning a future initial public offering it is a good idea to start publishing audited statements at least two years before your intended IPO date. Some banks will require audited statements.
2. A reviewed statement is the next down from audited statement and less costly as the auditor does less examining than the audited statements. Some banks will approve a reviewed statement of small and intermediate-sized companies.
3. The second step down from an audited statement is a compiled statement prepared by a CPA. But the CPA can not provide assurance that the statements are according to GAAP standards.
4. Internally prepared statements are prepared by the company and may or may not follow GAAP nor be prepared by a CPA. Any growing business should maintain a higher level of accounting scrutiny than relying on internally generated financial information.

Growth Requires More Disciplined Controls
As you grow, your accounting and internal control systems must keep pace to insure that the higher levels of income you generate are not wasted or siphoned off by various forms of dishonesty. Take a moment to think about anyone you know of that has suffered a loss due to embezzlement or poor internal controls. Was the loss severe? How could it have been avoided?

So it becomes increasingly important for both your internal accounting management and your auditor to be adequately qualified and experienced in implementing firewalls against various forms of embezzlement, shrinkage and other criminal activities.

Mission of Internal Controls
To accomplish appropriate controls, consider:

• Developing systems to maintain efficiencies and honesty on both the supply-side and the marketing side of your business.
• Supplied side risks include ordering procedures, incoming and outgoing inventory controls and accounts payable accounting.
• Marketing-side risks include shrinkage (stealing by your customers and/or employees) accounts receivable mismanagement and sales not being rung up at the cash register.
• Work with both your internal accounting manager and CPA to upgrade financial controls as needed. If you have uncommon risks beyond ones your accountants can install and administer, you might consider getting an assessment from a loss control consultant.

Financial Reporting by Profit Centers
Your expansion should provide that your overall financial statements are broken down by individual profit centers within the company. As discussed under the section covering delegating authority, this practice will identify areas of strengths and weaknesses and also provide the basis for profit sharing incentives for key managers. Learn more about key elements of successful incentive plans. This is from our Growing a Business course, the Expanding and Handling Problems session.

Frequency of Reporting Financial Statements
Individual profit center income statements (P&L's) should be reported on a very frequent basis, with a minimum of monthly reporting. Here's why:

• To disclose problems or losses early, before they become big and unmanageable. The early detection of losses should not only accelerate remedies but also be followed up by promptly shutting down an operation that proves to have incurable flaws so that a financial leak does not turn into a flow of losses.
• Profit sharing incentives work best when they are paid in frequent intervals. In some food operations, P&L's are pulled and incentive checks written on a weekly basis.

Frequency of Cash Flow Projections
As referred to earlier in this session, the cash needs of a growing business will add more uncertainty to future liquidity and therefore must be closely monitored. Predicting future liquidity should be updated very frequently such as quarterly.

Monitoring Your Leverage
Financial leverage is the use of borrowed money to supplement the cash you invest in growing your business. The general objective is to borrow money to buy an asset with a higher return than the cost (the interest) on the debt. While the purpose is to maximize your earnings, the cost is running the risk of maximizing losses.

Firms that are highly leveraged run the risk in bad times that their income may not be sufficient to make payment on their debt or even the risk of bankruptcy. The financial crisis of 2007 - 2009 was blamed largely on excessive leverage. Here are three ways you can monitor and thereby minimize your level of risk on an ongoing basis:

1. Work with your CPA to establish a maximum financial leverage ratio, also referred to as debt-to-equity ratio.
2. Work with your CPA to establish a minimum level debt-to-cash flow ratio. Cash flow is the cash you generate after eliminating non-cash expenses from your income.
3. Borrow for a longer term than you need. If you can repay in three years ask for five years. Be sure to include the provision permitting acceleration of your repayments.

As you grow in earnings and cash flow, your leverage should become less and less for two reasons:

• Over time you will be growing your retained earnings and will have more cash to invest, lessening the need for borrowing.
• The greater your net worth becomes, the less leverage risks you should be taking. This follows the Warren Buffett maxim: "you only need to get rich once."

If your accounts aren't in perfect shape, now is a great time to make sure they're well-organized. A good piece of accounting software can make this a lot easier. The two examples are Quickbooks and Sage 50 (formally Peachtree).

Here is a checklist on purchasing to incorporate in your internal controls.

• Never place an order without knowing the price and the terms.
• Purchase orders must be in writing.
• Have complete specifications.
• Buy subject to your contingencies.
• Have backup sources.
• Be loyal to good suppliers.
• Have promises and extras verified in writing.
• Get price protection.
• Try to award to the lowest bidder.
• Don't hesitate to repeatedly contact suppliers to expedite needed merchandise. "The squeaky wheels get the grease."
• Communicate complaints quickly and respectfully
• Use internal controls for ordering and receiving.
• Count and inspect everything as received.
• Use an inventory control system.
• Ask for and take term discounts.
• Pay on time.
• Pay only after verification.
• Watch your cash flow.
• Consider suppliers as a source of financing.

Ships at sea have no fire department to call for help. So damage control plans and training are important for survival. As a business owner you also need to be prepared for unexpected adversities. We recommend the following contingency plans be practiced and ongoing training provided:

• Contingency plans for adverse cash flow. This could include back-up banking resources, or multiple sources rather than one. Always keep in mind that this event could happen and seek out your other resources to fund periods of need.
• Insurance protection in place. It is foolish for an owner to look to saving money by not providing adequate insurance for all appropriate casualty events. It's not a good idea to "bet the company" that adversities will not happen.
• Determine if there are any special industry-related risks that apply to your business. Here are two examples:

THE TOP 10 DO'S

1. Adjust and readjust your cash flow projections.
2. Establish maximum limits of purchasing authority.
3. Require all payments be supported by invoices.
4. Use an inventory control system.
5. Work with your CPA to upgrade financial controls.
6. Require bids on all purchases over a stated limit.
7. Be loyal to good suppliers.
8. Pay on time, but only after verification.
9. Consider higher audit levels.
10. Implement an "edit log" for website changes and updates.

THE TOP 10 DON'TS

1. Run out of cash...ever.
2. Discount the importance of hiring an accountant and a CPA.
3. Overlook suppliers as sources of financing.
4. Disregard contingency planning.
5. Have same person handling payables and receivables.
6. Place an order without written price and terms.
7. Delegate signing of checks.
8. Assume that shipments are complete and in perfect condition.
9. Neglect to ask for and use term discounts.
10. Think that hand-shake agreements are best when buying.

If you are currently writing or have developed a business plan, consider taking a moment now to include any information about your business related to this session. MOBI’s free Business Plan Template and other worksheets, checklists, and templates are available for you to download. Just visit the list of MOBI Resource Documents on the Resources & Tools page of our website.