7 Ways to Take Your Accounting to the Next Level in 2021: Tip #2

The new year is a golden moment to make a fresh financial start. Between Thanksgiving and Christmas I'm planning to post seven practical tips for improving your company's finances in 2021. This is Post #2. Stay tuned for the other five!

Tip 1: If you have to enter more than 5 numbers by hand, find a better way

Tip 2: Lead with your balance sheet, not your profit and loss

Grasping this key point is like ditching desserts and switching to a diet of salads and lean meat. It's not comfortable, and old habits constantly take over.

If you've spent 95% of your financial statement time on the income statement (aka profit and loss) and 5% on the balance sheet, it time to flip those percentages around.

The reason you should spend 95% of your time on the balance sheet is not because of the valuable information that's there (although it is very valuable!), but because the balance sheet is the anchor of all accounting.

In fact, if you haven't kept your balance sheet up-to-date, you should walk to the nearest mirror and say:

"My profit and loss reports are not correct. My profit and loss reports are NOT correct. My profit and loss reports ARE NOT CORRECT!"

There's a 99% likelihood you're telling the mirror the truth.

Maybe you're thinking, What is a balance sheet anyway?

In that case, back up and read You Really Should Understand the Difference Between a Balance Sheet and Income Statement.

Otherwise, read on.

How do you lead with your balance sheet?

Step 1: Do a line-by-line review of your balance sheet to verify accuracy.

Imagine you own Midwest Kitchens, Inc. and have just generated this balance sheet from your accounting system:

Leading with your balance sheet means "tying" each amount to a supporting document with the same date as the balance sheet. That's why it's best to review a balance sheet at month end.

The checking amount is matched to a bank statement (or a reconciliation to a bank statement). The accounts receivable amount is matched to a list of customer receivables on this date. The inventory balance needs to agree to an appropriately dated inventory valuation detail.

Nothing should look fishy. In the above balance sheet, one amount that is almost certainly incorrect is the negative balance in Note Payable-Ford Credit. Likely the loan has been paid off and needs to be adjusted to zero.

Step 2: Think about what might be missing from the balance sheet entirely

Almost every company has accrued payroll (i.e. payroll earned one month but paid the next) on any given month end. That amount needs to be on the balance sheet as a current liability. It's often missing, which causes labor expense on the income statement to be skewed.

A kitchen company almost certainly has unsold, half-built kitchens at month end. The cost-to-date of those kitchens needs to be entered on the balance sheet as Work-In-Progress inventory. A surprising number of companies need this critical line item. This is true even for companies that don't make a physical product.

Other common balance sheet accounts that get missed are Prepaid Expenses (e.g. insurance paid ahead) and Customer Down Payments (prepayments for orders not processed yet).

A properly cleaned up balance sheet might look like this (changes highlighted in gray):

The big takeaway here is the change in net income. By correcting the balance sheet, Current Year Net Income went from $50,000 to $80,000, a 60% increase!

The clean up entries could just as easily have swung the company to a $40,000 loss. Until you have a clean balance sheet, you might as well forget your profit and loss. It will only mislead you.

Step 3: Use your accurate balance sheet to determine the health of your company

An accurate balance sheet shows two critical metrics:

• The amount of gas in the company's tank (Equity).

Equity is the difference between the company's assets and liabilities. Equity is cushion, or wiggle room.

When equity runs out (or even gets close to running out), the business is typically over, unless you put more equity in.

Midwest Kitchens has $230,000 in Total Equity which means the company could lose up to that amount in 2021 and still theoretically have a viable company (although a very shaky one!)

• The ability to pay bills in the short term (Working Capital)

Working capital measures a company's ability to pay its current bills. In this example, working capital is $80,000, which is the difference between Current Assets ($200,000) and Current Liabilities ($120,000).

If working capital gets close to negative (which means there are more bills due than liquid assets to pay them), a company is in serious trouble.

Step 4: Rely on your income statement because you know it's accurate

Now that the balance sheet is accurate, freely pop open your income statement and spend the remaining 5% of your time seeing how your company is doing from a revenue and expense standpoint.

The income statement IS extremely important. I don't want you to think otherwise. The problem is that it's the tail of the dog, and can only be useful after the dog is in good shape.

• Side Note 1: If your income statement still doesn't look right, it means:

1. You simply put a transaction in the wrong "bucket" (e.g. Job Supplies got incorrectly coded to Professional Fees), OR
2. Your balance sheet still is not correct.

• Side Note 2: The first month you fix your balance sheet will probably result in a skewed income statement.

Only when you have back-to-back accurate balance sheets will you have a trustworthy income statement in the middle.

Step 5: Rinse and repeat, every month

After you fix one month, the next month you'll be tempted to lead with your P&L again, without going through the pain of correcting your balance sheet. That is an exercise in futility.

It's hard to lead with your balance sheet. It's also hard to run your company on misleading profit and loss numbers. Like they say, "choose your hard!"

This is Tip 2 of 7. Stay tuned for the next post!

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