By HARVEY A. GOLDSTEIN
Does business keep coming in the front door while profits escape out the back door? Growth may appear to be a goose with a golden egg, but if your internal controls are insufficient, or you are unaware of the real costs of your services or products, the goose may run wild and lead you to disaster.
Owners often don't realize that growth requires tighter internal control mechanisms. Owners of small companies typically have day-to-day control over financial information, but as businesses grow, employees must be hired to keep up with increased demand.
As the owner is increasingly removed from hands-on control, he or she must make sure that a control system can be adequately monitored.
As an astute owner, you may want to retain an expert to conduct a survey of your company's internal controls, including whether the system protects your company's assets, and what previously undiscovered weaknesses may be hampering the system. It is a preventative measure to ensure that the system in place to control assets is working properly.
An internal control survey, conducted by an investigative or forensic expert, helps companies find where their assets have gone. The expert interviews everyone who has any control over assets to make sure the procedures are in place and operating correctly. This can help prevent employee fraud resulting from careless internal control.
Growth can also lead to other problems, as seen in the case of Move-It-In-Minutes Inc., (Move-It), which started as a messenger and courier service.
Move-It's first flush of success was astounding. The CEO and founder was an aggressive saleswoman who was superbly organized and able to make every minute count in hawking the company's services. The business expanded exponentially almost from day one, and by its third year had more than 60 employees. The company seemed to be in the enviable position of increasing business each year, organizing new company divisions and services, and expanding the number of employees, yet it was almost bankrupted by that success.
Cash flow analyses and profits before taxes were foreign territory to the Move-It CEO. In the third year, disturbing signs began to surface. The staff began shuffling accounts payable to pay creditors. The CEO had to sell some of her jewelry and stocks from her personal account to meet the payroll. An accountant confirmed that the company was headed for disaster.
What went wrong? The accountant explained that it was basically what occurs in many small business ventures: Entrepreneurs often don't understand the real costs of producing a service or product. Every sale that this CEO made was actually pushing the company further into insolvency, because the true costs for providing its services were going unrecognized.
It's not always easy to determine the cause of a company's problems, but there are a few analyses that may help. Profit retention and leverage ratios can help the business identify poor financial decisions. Profit margin and asset turnover ratios can disclose operating problems, such as asset inefficiency or low sales profitability. Some companies also rely on the so-called "Z-Score" to keep tabs on several critical ratios. This tool tracks a business' level of solvency, and has been called a "bankruptcy predictor" because it can spot declining trends long before financial statements disclose a problem.
The business owner can also construct an income statement for every line of business the company is operating. In the case of Move-It, the CEO figured that if she kept her sales volume high and her prices compatible with current market rates, she would be successful. After intensive analysis of all phases of the business, she discovered that some parts of the business were not profitable. Her bicycle courier service was not covering its overhead, so she shut it down. Other unprofitable divisions were also dropped or modified. Move-It operates at a less frenetic pace these days, but the business is in the black.
Another costly mistake business owners make is maintaining inadequate record-keeping systems. It pays in the long run to hire an expert to handle the business' finances. Owners often attempt to do it themselves, but usually don't have the expertise to keep good financial records.
Many business owners keep a checkbook balance, but never compare it with the bank statement. Others lose track of the hours or days that employees worked, or are unaware that they are liable for overtime pay to employees who have worked long hours. They may also neglect to keep credit-card expenses in separate accounts for bookkeeping purposes in order to avoid potential problems in the event of an IRS audit.
Regardless of what you use as a measure, it's important to develop indicators that will alert you to operational problems early on. While an indicator such as sales volume is a measure in most businesses, others are probably very specific to your company or industry.
In one automotive parts distributorship, for example, the owner says he tracks sales, gross margins, out-of-stock levels, personnel counts and overtime hours. A service company, in contrast, may want to tracks hours billed, realization rates and time spent on business development. In other companies, booking data may be a good measure.
Sometimes business owners think they can cut corners to save money, only to find they pay twice as much in the end. Without the right internal controls, even prosperity can put you in the poorhouse.
Harvey A. Goldstein, CPA, is the managing partner of Singer, Lewak, Greenbaum & Goldstein LLP, Certified Public Accountants and Management Consultants located in Westwood.
Entrepreneur's Notebook is a regular column contributed by EC2, The Annenberg Incubator Project, a center for multimedia and electronic communications at the University of Southern California. Contact James Klein at (213) 743-1941 with feedback and topic suggestions.
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