The Nature of Financial Controls

Imagine that you are on the board of Success-R-Us, an organization whose financial controls are managed in an excellent manner. Each year, after the organization has outlined strategies to reach its goals and objectives, funds are budgeted for the necessary resources and labor. As money is spent, statements are updated to reflect how much was spent, how it was spent, and what it obtained. Managers, who report to the board, use these financial statements, such as an income statement or balance sheet, to monitor the progress of programs and plans. Financial statements provide management with information to monitor financial resources and activities. The income statement shows the results of the organization’s operations, such as revenues, expenses, and profit or loss. The balance sheet shows what the organization is worth (assets) at a single point in time, and the extent to which those assets were financed through debt (liabilities) or owner’s investment (equity).

Success-R-Us conducts financial audits, or formal investigations, to ensure that financial management practices follow generally accepted procedures, policies, laws, and ethical guidelines. In Success-R-Us, audits are conducted both internally—by members of the company’s accounting department—and externally by Green Eyeshade Inc., an accounting firm hired for this purpose.

Financial ratio analysis examines the relationship between specific figures on the financial statements and helps explain the significance of those figures: By analyzing financial reports, the managers at Success-R-Us are able to determine how well the business is doing and what may need to be done to improve its financial viability.

While actual financial performance is always historical, Success-R-Us’s proactive managers plan ahead for the problems the business is likely to encounter and the opportunities that may arise. To do this, they use pro forma financials, which are projections; usually these are projected for three fiscal years. Being proactive requires reading and analyzing the financial statements on a regular basis. Monthly, and sometimes daily or weekly, financial analysis is preferred. (In the business world as a whole, quarterly is more common, and some organizations do this only once a year, which is not often enough.) The proactive manager has financial data available based on actual results and compares them to the budget. This process points out weaknesses in the business before they reach crisis proportion and allows the manager to make the necessary changes and adjustments before major problems develop.

Years ago, Success-R-Us experienced problems because its management style was insufficiently proactive. A reactive manager waits to react to problems and then solves them by crisis management. This type of manager goes from crisis to crisis with little time in between to notice opportunities that may become available. The reactive manager’s business is seldom prepared to take advantage of new opportunities quickly. Businesses that are managed proactively are more likely to be successful, and this is the result that Success-R-Us is experiencing since it instituted a company-wide initiative to promote proactive controls.

Like most organizations, Success-R-Us uses computer software programs to do record keeping and develop financials. These programs provide a chart of accounts that can be individualized to the business and the templates for each account ledger, the general ledgers, and the financial reports. These programs are menu driven and user-friendly, but knowing how to input the data correctly is not enough. A manager must also know where to input each piece of data and how to analyze the reports compiled from the data. Widely accepted accounting guidelines dictate that if you have not learned a manual record-keeping system, you need to do this before attempting to use a computerized system.

Assets

Current assets are those assets that are cash or can be readily converted to cash in the short term, such as accounts receivable or inventory. In the balance sheet shown for Success-R-Us, the current assets are cash, petty cash, accounts receivable, inventory, and supplies.

Some business people define current assets as those the business expects to use or consume within the coming fiscal year. Thus, a business’s noncurrent assets would be those that have a useful life of more than 1 year. These include fixed assets and intangible assets.

Fixed assets are those assets that are not easily converted to cash in the short term; that is, they are assets that only change over the long term. Land, buildings, equipment, vehicles, furniture, and fixtures are some examples of fixed assets. In the balance sheet for Success-R-Us, the fixed assets shown are furniture and fixtures and equipment. These fixed assets are shown as less accumulated depreciation.

Intangible assets (net) may also be shown on a balance sheet. These may be goodwill, trademarks, patents, licenses, copyrights, formulas, and franchises. In this instance, net means the value of intangible assets minus amortization.

Liabilities

Current liabilities are those coming due in the short term, usually the coming year. These are accounts payable; employment, income and sales taxes; salaries payable; federal and state unemployment insurance; and the current year’s portion of multiyear debt. A comparison of the company’s current assets and its current liabilities reveals its working capital. Many managers use an accounts receivable aging report and a current inventory listing as tools to help them in management of the current asset structure.

Long-term debt, or liabilities, may be bank notes or loans made to purchase the business’s fixed asset structure. Long-term debt/liabilities come due in a period of more than 1 year. The portion of a bank note that is not payable in the coming year is long-term debt/liability.

For example, Success-R-Us’s owner may take out a bank note to buy land and a building. If the land is valued at $50,000 and the building is valued at $50,000, the business’s total fixed assets are $100,000. If $20,000 is made as a down payment and $80,000 is financed with a bank note for 15 years, the $80,000 is the long-term debt.

Owner’s Equity

Owner’s equity refers to the amount of money the owner has invested in the firm. This amount is determined by subtracting current liabilities and long-term debt from total assets. The remaining capital/owner’s equity is what the owner would have left in the event of liquidation, or the dollar amount of the total assets that the owner can claim after all creditors are paid.”

Sales or Revenue

The sales or revenue portion of the income statement is where the retail price of the product is expressed in terms of dollars times the number of units sold. This can be product units or service units. Sales can be expressed in one category as total sales or can be broken out into more than one type of sales category: car sales, part sales, and service sales, for instance. In our Success-R-Us example, the company sold 20,000 books at a retail price of $25 each, for total revenues of $500,000. Because Success-R-Us sells all of its books on credit (i.e., you can charge them on your credit card), the company does not collect cash for these sales until the end of the month, or whenever the credit card company settles up with Success-R-Us.

Cost of Goods Sold/Cost of Sales

The cost of goods sold/sales portion of the income statement shows the cost of products purchased for resale, or the direct labor cost (service person wages) for service businesses. Cost of goods sold/sales also may include additional categories, such as freight charges cost or subcontract labor costs. These costs also may be expressed in one category as total cost of goods sold/sales or can be broken out to match the sales categories: car purchases, parts, purchases, and service salaries, for example.

Breaking out sales and cost of goods sold/sales into separate categories can have an advantage over combining all sales and costs into one category. When you break out sales, you can see how much each product you have sold costs and the gross profit for each product. This type of analysis enables you to make inventory and sales decisions about each product individually.

Gross Profit

The gross profit portion of the income/P&L statement tells the difference between what you sold the product or service for and what the product or service cost you. The goal of any business is to sell enough units of product or service to be able to subtract the cost and have a high enough gross profit to cover operating expenses, plus yield a net income that is a reasonable return on investment. The key to operating a profitable business is to maximize gross profit.

If you increase the retail price of your product too much above the competition, you might lose units of sales to the competition and not yield a high enough gross profit to cover your expenses. However, if you decrease the retail price of your product too much below the competition, you might gain additional units of sales but not make enough gross profit per unit sold to cover your expenses.

While this may sound obvious, a carefully thought out pricing strategy maximizes gross profit to cover expenses and yield a positive net income. At a very basic level, this means that prices are set at a level where marginal and operating costs are covered. Beyond this, pricing should carefully be set to reflect the image you want portrayed and, if desired, promote repeat business.

Operating Expenses

The operating expense section of the income/P&L statement is a measurement of all the operating expenses of the business. There are two types of expenses, fixed and variable. Fixed expenses are those expenses that do not vary with the level of sales; thus, you will have to cover these expenses even if your sales are less than the expenses. The entrepreneur has little control over these expenses once they are set. Some examples of fixed expenses are rent (contractual agreement), interest expense (note agreement), an accounting or law firm retainer for legal services of X amount per month for 12 months, and monthly charges for electricity, phone, and Internet connections.

Variable expenses are those expenses that vary with the level of sales. Examples of variable expenses include bonuses, employee wages (hours per week worked), travel and entertainment expenses, and purchases of supplies. (Note: categorization of these may differ from business to business.) Expense control is an area where the entrepreneur can maximize net income by holding expenses to a minimum.

Net Income

The net income portion of the income/P&L statement is the bottom line. This is the measure of a firm’s ability to operate at a profit. Many factors affect the outcome of the bottom line. Level of sales, pricing strategy, inventory control, accounts receivable control, ordering procedures, marketing of the business and product, expense control, customer service, and productivity of employees are just a few of these factors. The net income should be enough to allow growth in the business through reinvestment of profits and to give the owner a reasonable return on investment.