Are your Financials “Investor Ready”?
Frequently we receive calls from entrepreneurs and CEOs tell us they would like assistance in preparing to jump into the financial markets and seek outside funding, whether from banks or other investors. Over the years we have noticed common errors in their historical financials when we initially review them. Those listed below are the most common.Not having crisp financials won’t necessarily scuttle a deal for an equity investor, but likely will cause them to offer you less value for the business, and will often cause a bank to be less aggressive in wanting to provide funding. Mark Ludwig, Managing Director at Sorenson Capital, suggested that “the more of these issues I find, the less confident I am in the financials.” That lack of confidence leads to lower valuations among financial investors.
These common errors fall into 4 camps: One, Generally Accepted Accounting Principles compliance. Two, proper financial controls. Three, whether the financials provide truly relevant information. Four, the lack of a cash flow statement.
- Hybrid Cash and Accrual Accounting: Financials are a hybrid of cash and accrual accounting.
- Improper Revenue Recognition: Certainly relevant to others, but common among software companies, revenue is often not recognized properly. Generally, this means you have recognized revenue before you have fully completed the tasks for which you are being paid.
- Capital Expenses are not Capitalized: Some expenditures are for products that have value to your business beyond one year. These typically should be capital expenses. Often companies are expensing them immediately through the income statement rather than capitalizing them and amortizing them over the life of the asset.
- Accrual Management: Accruals can be manipulated to manage earnings. You can TRY to be cute with them, but these inappropriate adjustments always become transparent.
Proper Financial Controls
- Balance Sheet Accounts not reconciled: The surest way to gain confidence in your financial statement is to expect and demand 100% reconciliation of your balance sheet accounts. Demand a REAL reconciliation, not just a ledger of activity in the account…sometimes called a “roll-forward”. You want to prove logically that each account balance is appropriate…every month.
- Lack of Controls and Systems: this one can be quite broad, but having proper systems and controls around business processes gives investors confidence that the data is right…without them, financials are called into question.
- Personal Expenses: Just keep them out of the business financials…period.
- Inventory Inaccuracies: If your company carries inventory, without a concerted effort and real focus, most likely you will have inaccuracies. Unless “graded on the curve”, very few companies would receive an “A” grade on the quality of their inventory management systems and processes.
Relevance of Financials
- Improperly recording Cost of Sales: Understand true gross margin is an early quest of all investors. When some costs are inappropriately included/excluded, gross margins are misstated.
- Lack of Segment Information: Properly managing financial data for channels and cost centers, which enables profitability by segment is crucial not only for you the entrepreneur, but for any financial investor.
Cash Flow Statement
- Lack of a Cash Flow Statement: Without a cash flow statement how can you articulate where your cash has gone? And even more importantly, how will you be able to tell an investor where it will go? Without this knowledge you can’t speak with credibility around how much you need, when you need it, and what it will be used for.
While too many businesses make these common errors, the good news is that they all can be resolved with a little planning and work. In the event there are anomalies in the financials that you may feel are warts, be prepared to talk about them early, openly and honestly. This step alone will grant you credibility with a potential investor.
And if you find yourself a little overwhelmed by all this, give us a call and we can provide a free assessment of your financial health with some recommended paths forward.
David Chase, a partner at Advanced CFO Solutions, has experience in small to medium private companies and large public companies as a senior operational and financial leader. With 15 years in finance, a CFO of multiple entities and divisional EVP experience, Dave has a breadth of experience. Dave has led or been instrumental in raising multiple rounds of equity and debt in excess of $450 million.