Have you ever been presented with a set of accounts where you get unexpected financial results? It’s really frustrating.
Maybe you’ve had a very busy period with strong sales and you are expecting to see a very healthy profit in your accounts. In contrast, you have a poor profit or even worse, a loss. Therefore, you proceed to ask your accountant for an explanation but they cannot provide one. Instead, they reply with some unintelligible jargon hence you think that the problem is you – that you just don’t understand finance.
Unfortunately, this seems to be a very common scenario. Almost every year a new client comes along saying “my financial results aren’t what I expected and my accountant can’t tell me why? Can you help me?”
I have come to realize that there are six common reasons why accounts can differ from what the owner/manager expects.
The most common reason is that the owner/manager underestimates costs. They may have prepared projections when they set up the business or a few years ago when they were looking for a loan.
In the meantime, they have added costs here and there – an extra employee, higher insurance, more travel, new machinery or equipment, etc. However, in their head, they still think costs are what they were a few years ago. This will eventually lead to unexpected financial results.
How to avoid this
Prepare a budget every year. It actually doesn’t take that long. And if you do it every year, you should have workings – ideally on a spreadsheet – from last year that you can just update.
Also, take the time to review and understand the costs that you did incur. Are they right? Do you remember incurring or approving of those costs?
Try to have monthly or quarterly management accounts. Furthermore, if you have good accounting software, you should be able to drill down into each expense type to understand them better. This should be very easy to do if you read my article on ‘How to Choose Accounting Software‘.
Inaccurate Stock Valuations
In my experience, most SMEs don’t understand the importance of the stock figure. As a result, they don’t prioritise the annual stock take. It may be that they think they can estimate stock accurately or it may be that they want to keep the stock low to minimise their profits. Whatever the reason, understated stock means understated profits.
I worked with one retailer who carried out a rough stock take every year. He walked through the shop and the store with an assistant recording the stock items and the stock value. I persuaded him to install a Point of Sale system which had a stock module. When they entered the stock items into the system they realised that their estimated stock value was way off by an unimaginable gap.
How to avoid this
Do a reasonably accurate stock take every year.
At a minimum, apply the 80:20 rule. 80% of the stock value will come from 20% of the stock items.
Know what’s in stock and know what that is worth. In that way, you will have a better understanding of the real profits.
Most business owners do not understand the importance of timing.
If a supplier invoices you just before month-end and you do not receive the stock items until after, you will definitely have a timing issue if you don’t record the transactions properly. For example, if you record a supplier’s January invoice in your January accounts but you don’t have the stock until February so you can’t include the incoming stock in January then your accounts will reflect that you bought something that you didn’t get. In such a case you end up having a purchase invoice in January but nothing to show for it. This ultimately means your accounts are wrong.
Alternatively, if you receive goods but the supplier doesn’t invoice for a few weeks, then your accounts will reflect a “windfall”. In such a case you have stock that apparently costs nothing. Again, your accounts are wrong.
Finally, if you are working on a long project – a multi-month project you can have mismatches due to timing. You incur costs for the project in the first month but you don’t finish the project till the third month. In consequence, you don’t invoice until the project is complete. As a result, you now have costs in the first month but no revenue. Moreso, when you do an invoice in the third month you have revenue but no costs; as they were taken in month 1.
Ultimately, your accounts are like a roller coaster – up some months and down some months. You can’t understand it and wonder how you priced those projects so differently.
How to avoid this
If you receive an invoice before the goods, then show those goods as ‘goods in transit’. They are not in stock, you can’t physically count them but they are yours – you have been invoiced for them. Put them in ‘goods in transit’ and reverse that when they are received and can be counted in stock.
If a supplier delivers in one month but invoices in a later month, identify the non-invoiced goods and put a provision in your accounts for them. Accountants will call this accruing for the ‘un-invoiced’ receipts.
If you have multi-month jobs, try to put the value on the work done but not yet invoiced. Then show that as a work in progress.
Putting it into practice
I have a manufacturing client who buys packaging from another country. Two or three times a year, they are invoiced for packaging in one month. However, that packaging is not received until the following month. I have encouraged them to record the incoming goods as stock in transit.
That same client buys raw material on a seasonal basis. Sometimes the supplier will ring to say that his warehouses are full, and ask if they can take an order early. They could say they can but that they can’t pay for it yet as they hadn’t planned for it. In that case, the supplier will invoice later as per the original order. In this situation, I have advised the client to make a provision for the invoiced items so that the accounts are more accurate.
I have another engineering services client who install and maintain expensive machinery for large businesses. Many of their installation projects take several months to complete. It’s common for them to buy machinery for an install in one month but not to invoice for that job for another 3 or 4 months. This can happen because the job can take several months. Furthermore, the customer may ask them to group several jobs into one invoice. In this case, I ask my client to review all the jobs that are active in the quarter or year-end and estimate the value of the work that is done but not invoiced. They should show that as a work in progress so that the accounts are more reliable.
Poor awareness of Waste/Scrap
Sometimes a client has a lot of waste or scrap in their process but because they don’t measure it, they underestimate the cost.
In regulated industries, you may have to take a lot of samples. The costs of these can quickly build up.
You may also be issuing samples to prospects. Again, the cost of samples can quickly mount up. I am not suggesting that you should not issue samples but simply try to improve your awareness of the cost.
How to avoid this
Try to record and value the waste on an ongoing basis. You should always be doing this anyway as part of your control process and to help you identify improvement opportunities.
Unfortunately, some more traditional businesses ignore it – treating waste as something they can do nothing about. That may well be the case, but you need to know the real cost of it. Also, there is always something you can do to improve it. Maybe you can change suppliers or you can tweak your process. You should never stop looking for improvements.
In addition, you should record the number and cost of testing and customer samples. It is best practice to show these as a separate line item in your accounts so that the readers of the accounts have a better understanding of your costs.
Some businesses, particularly owner-run businesses, have a practice of giving discounts to customers. Customers come to expect it and it’s part of the buying process.
If the discounts are given and not tracked and measured, they can easily creep up and significantly reduce your gross margin.
How to avoid this.
You need to be able to accurately measure the costs of the discounts that you are giving.
If you have a point of sale system, make sure that it shows any discount separately. If you are invoicing, have a separate line for customer discounts so that your accounting system will accumulate these discounts and report on them separately.
Putting it into practice
I had one retail client scenario where the owner told his staff that if his customers came into the shop then they had already made a decision to make a purchase. Therefore the staff had to do whatever was needed to complete the sale. Understandably, the staff took this as an instruction to discount as much as was necessary to close the sale. The owner thought he was empowering them to discount up to 5%. Unfortunately, the reality was different.
When we eventually installed a point of sale system, it became very clear within the first week that the staff was discounting up to 12%. In truth, the real cost of the discounts was much greater than the owner had assumed. He quickly issued revised guidance on discounting.
For non-company clients, drawings can be an issue. For sole traders or partnerships, drawings are effectively the “net wages” that the owners are taking from the business. It’s important to realise that these are “net” so the tax due on the profits of the business remains to be paid separately.
For example, the owner may have decided to take, say, € 3000 out of the business for his/her “wages”. Eventually, over time, they may start taking money out for pension, to pay the annual income tax bill or they set up a direct debit for a membership – maybe a gym membership. Sometimes they transfer a little bit extra to their personal account if that balance is too low, but they forget about this when estimating the drawings. When you ask them how much they are taking from the business, they just report on the € 3000. When in truth after analysis you realise they are taking away much more than the initial estimate.
How to avoid this
In this case, the key issue is awareness. The client needs to understand exactly what is meant by drawings and to be able to get an accurate value on what they are taking from the business each month.
If they are using accounting software, which I highly recommend, I usually ask them to set up drawings categories (or account codes) for pension, income tax, and possibly for irregular drawings.
Putting it into practice
I have one sole trader client who approached me because his bank balance had come under continuous pressure and he couldn’t understand why, as his turnover had increased and he thought his profitability was good.
When I analysed his bank account, I discovered that he was taking regular weekly drawings or “wages” as he called it. But he had also increased his pension contribution, a change he had forgotten about. He had also begun to transfer money to his wife’s personal account as her separate business was not performing and she needed help.
When I showed him the data, he recognised immediately that it was correct. He accepted that the real problem was underestimating the total of his drawings.
These are the most common reasons that I have come across when investigating unexpected financial results and I have carried out this exercise for many clients over the years.
That’s not to say that there aren’t other reasons but these six areas are what I check first when I start on that type of project.
If you have problems understanding your financial results and you want to discuss then please get in touch.
If you found this article helpful, you may also be interested in these other articles.