Small Business Accounting – How Year End Financials Can Mislead

Monitoring the financial health of your business is one of the most important elements of properly managing your business operations. You want your monthly and quarterly reports to be correct and to accurately reflect what is happening in your business. The same can be said for the culmination of those quarterly reports, the Year-End Financial Statement. As hard as we try to be accurate and correct in reporting our numbers, it is very easy for the Year-End Financial Statement to tell an inaccurate tale to your board, investors, and lenders. It is always important to review the numbers holistically, in light of all the activities that occurred in your business during the year. Based on that review, you then are able to provide an explanation of the numbers that reflect the true financial status of your business.

It is hard to comment on these types of matter because there are so many businesses with varied operations and circumstances. There are some basic operating parameters and issues that are true for most all businesses and we are going to try to address these in this article.

The first thing to understand is that the year-end balance sheet and income statements are often reduced to a summary for review by financial firms. They reduce your numbers to key ratios and metrics that allow them to analyze your financial health according to some standard benchmarks. The first thing you have to do is understand what ratios or metrics are being used in the analysis by the entities to which you are reporting the information. By understanding these metrics, you can provide the background necessary to understand the operations and activities behind the numbers.

There are a few elements that can directly affect any financial statement on your Balance Sheet and Income Statements. First lets address the Balance Sheet, which is a representation of your financials for a particular period. As we all know, a picture taken at the wrong time – or that catches you in a bad light – can render an imprecise and misleading image.

Some causes of this in your financials may include large year end purchases or sales, often made due to advantageous year-end close-out pricing from suppliers or to reduce your own inventory. This type of purchase can increase your Accounts Payable (AP) and/or inventory. A large year-end sale would increase your Accounts Receivable (A/R) suggesting larger than normal outstanding invoices, bad accounts that are uncollectable, or an industry downturn. Without being told about these transactions, and the reason they were made, people reading your financial statements would think they appear out of line with industry standards or your own year-to-year performance.

On your income statement, misperceptions can occur from a variety of events – even good things like landing a large account. Many financial analysts see large contracts as increasing risk, even as they provide additional revenue. The usual culprit, however, is the one-time large expense for things such as capital items, product development, or personnel. This may give the impression of cost increases or unsustainable operations and reduce your profit margins. Another culprit could be a change in your sales, either due to introducing a new product or seeking out new customers.

Any or all of these issues can cause fluctuations that need to be explained to fully understand the year-end financials and get a true and accurate picture of your operations. It is important to remember that an explanation that gives context to the raw numbers is essential to providing a balanced and accurate perspective on your business operations.