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Cleaning Up the Income Statement

What are we going to do with the Income Statement after this?
The cleaned up income statement and the de-constructed view will be used to test the structure of your business, and to make sure those critical activities not performed are performed, and those crucial activities driving the Income Statement are all owned and tracked. We need to make sure that everyone in your business knows how they contribute and where the most effective levers to generate value are. Whilst the Income Statement is a set of financial numbers, we need to translate these numbers into the operational components that make them up. To illustrate. If I compare two sets of income statements to each other starting at the Revenue Line, can I make many useful deductions? If I broke the Revenue Line down showing it is actually made up of two products and one service, that's a little more useful. But if we break each of these Revenue lines into Customers by Ave. Selling Price, and then Customers into Existing Customers - Lost Customers + Brand New Customers, then I can at least start asking a few useful questions. So to do this, let's just make sure the top line Income Statement is fit for purpose to start off with, and see what data gaps might exist. A plan should be in place to make sure missing data is owned in the business, and captured properly.

A note on systems

The choice of system and the architecture you have your business processes built upon will have far reaching consequences you never even considered. This will be one of the milestone decisions made in the life of the business and requires input from every part of the business. It is always fascinating to see the different styles emerge, for the Owner of the SME or its leadership, this "Package Selection Process", creates very fertile ground for old wounds to be reopened, and tensions to flare.More on this later, as this will demand our full focus and your ownership.

The Income Statement

You should realize now that this is NOT an audit! That being said, GAAP is a good set of standards for companies to follow, but it still leaves room for misunderstandings and misrepresentations. So keeping in mind what we are using this for, we will not allow GAAP to distract us but use principles to direct us. Is a particular figure useful?, is it distorted by something else in the numbers?, and will it help us have a consistent view across tracking periods?

  • Your Investment Gains - For SMEs these in general should not be here. We want to track the operational activities and these investments are driven by forces beyond our control and only add noise to our discussions.

  • Family run businesses and remuneration of the entrepreneur - Directors of owner-managed companies are often advised to take the majority of their pay as dividends with either no salary or a very low one. This has a financial advantage, true, but for our purposes of managing the business and tracking performance it does cause a problem. What this practice does is mix up the cost of running a business function and the investment return fairly due to the entrepreneurs hard work. Our suggestion is that the salary component should reflect a fair market value for the cost of the duties performed. Think of it this way. If the owner stopped fulfilling this duty, how much would you have to pay an external hire to do it? There is another good reason for this that advisers have over-looked in the past, please check with whoever advised you on the following. This practice does have a down side, which emerges in two scenarios:

  • Firstly in the event of liquidation or going into administration, creditors may make a claim against the director's personal capacity of up to an amount equal to& as much as 5 years of back-dated salary

  • Or after the company is sold, a claim can be made against the director to pay back this legitimate expense. Depending on circumstances it can be up to 6 years’ pay!

  • Loans to Directors - This is used in combination with remuneration paid through dividends discussed above because paying a director in anticipation of a dividend is a treated as a loan. Our same thoughts apply here. Please to avoid nasty surprises check with your adviser and legal whether the supporting paper work is in place. Namely:

    1. that there is a shareholders’ resolution approving this loan
    2. that there is a ‘memorandum’ or its equivalent, detailing the loan amount, why the loan has been made and the obligations attached to the loan.

Now we can deconstruct the Income Statement and start building our Value Trees. Assuming that this is now our only version let's de-construct it into all the constituent parts. This is what we call a Value Tree, and will help us with working out which Contribution Curves to construct. Contribution Curves, Whale Curves and Value management is out next topic.