Common Accounting Pitfalls & Solutions for Small Businesses
About 28 percent of companies go bankrupt due to problems with a company’s financial structure, according to a study undertaken by the Small Business Administration. Good bookkeeping and accounting practices not only can avoid many problems to make it easy for tax filings, new loans, and pitching to investors, but they will also provide insight into the operation and health of your business enabling sound decisions for management and growth. The following is not an exhaustive list of all common accounting pitfalls and solutions for small businesses, but a few of them are:
Using Cash Basis Accounting
The cash basis of accounting does not conform to generally accepted accounting principles (GAAP) because it records revenue when cash is received, and posts expenses only when they are paid. It does not reflect an accurate level of profit.
The accrual basis of accounting gives a true picture of your profitability since revenue is posted when it is earned, and expenses are posted when they are incurred. Using this method matches revenue earned with the expenses incurred for generating the revenue.
Mistake Cash Flow as Profits
Suppose your customer just signed a sales agreement for $100,000 that will take your company five months to fulfill and paid you $100,000 up front. You estimate it will cost you $40,000 to deliver the product, so you may be tempted to recorded a $60,000 profit before delivery. If you are cash basis, you may be tempted to record the $100,000 cash as sales. Both of these circumstances would inflate your company’s profit in the near term and is incorrect. The sale should not be recorded as revenue until the products are delivered. Before the sale is complete, the cash or billing should be recorded as deferred revenue and any related costs booked to inventory as incurred.
Lack of Budgeting
Without budgeting in advance of spending on any project can cause a business to overspend on projects that have failing ROI resulting in losses.
Before starting any projects, first allocate specific budget to each one, to allow control over possible wasteful spending. A business needs to know constantly how much to spend to continue operating, and how much to set aside for new and expanding projects for a company’s growth and continued success.
Not Planning for Inventory
Example: A company’s beginning inventory balance of gadgets is 100 units, and the company forecasts 600 gadget sales for the month. If the business wants 60 gadgets (10% of expected sales) in ending inventory, here’s how it should plan its inventory:
600 projected sales + 60 ending inventory – 100 beginning inventory = 560 purchased.
The business should purchase 560 gadgets for the month if it wants 60 in ending inventory.
Every company should plan for an ending balance in inventory at month end, which allows the business to fill customer orders in the first few days of the next month, or it risks losing a sale if inventory levels are too low. Ending inventory is often based on a percentage of monthly sales. You can use the ending inventory formula to ensure that you maintain a sufficient amount of inventory. It looks like this: beginning inventory + purchases – sales = ending inventory
Lack of Debt Management
To raise capital for operating and growing a business, you can sell ownership in your company by issuing stock (equity), or you can borrow money. Not monitoring debt and interest payments regularly will risk loss of control of a company’s financial stewardship. Late or default payment will also hurt a company’s credit rating.
One useful tool to monitor company debt is the debt-to-equity ratio. The formula is used to analyze debt as a percentage of total equity. It looks like this: (total debt)/(company equity).
Say the debt/equity ratio for companies in your industry is 2/1, or $2 in debt for every $1 of equity issued. If your firm’s ratio climbs to 4/1 or 6/1, it is time for the leadership to scrutinize if the total level of debt is manageable or not. If not, decide what to do to reduce your debt.
Insufficient Cash Flow Forecasting
Cash flow is the bloodline of a business, doing a poor job of forecasting expected cash flows each month can lead to anemia or death. Among many factors that impact the amount of cash a company will have to operate, here are a few:
Debt payments: Interest payments and any repayments of principal due in the next few months.
Inventory: The dollar amount of inventory needed to fill customer orders over the next several months.
Accounts receivable: The dollar amount of credit sales that are not collected in cash, and the average amount of time it takes to collect the receivables in cash.
If cash inflows are insufficient, a company can access a line of credit or raise more capital through a stock or bond offering – both will take time with advanced planning.
Confusing Profit Margin and Sales Mix
Sales mix of products can be changed to generate a higher profit margin (profit/sales). Not analyzing sales mix may result in missing the opportunity to increase profits.
Assume that a business earns $2 on a tool priced at $10, and $22.5 on a $150 gadget. The profit margin on the tool is ($2/$10), or 20 percent, while the gadget’s profit margin is only 15 percent ($22.5/$150). The gadget generates far more revenue, but less profit per dollar of sales. The business can increase the company-wide profit margin by selling more tools and fewer gadgets, if practical.
First analyze your company’s sales mix, then strategize your promotional and marketing efforts.
Has your business made any accounting mistakes that needs to be addressed? Do you have further accounting questions? Here at a2zCFO, we are your right and left hands, to keep your ship on course. Please call or email us for a free analysis, thank you.