The following are some diagnostic questions to gauge the quality of your financial reporting:

  1. On what basis are financial statements prepared?

Accrual basis accounting matches the revenues to the expenses incurred to generate the same revenues in order to provide a more accurate view of profitability, whereas cash basis accounting essentially mirrors the cash flows of the business as they occur, potentially distorting profitability and failing to account for future obligations. It’s better to use cash flow statements to understand cash flows than an income statement using the cash basis accounting method.

  1. How/when is revenue recognized?

When contracted? When paid? If revenues are subscription based, then they should be recognized over the life of the subscription period. Professional services are typically recognized using either percentage of completion or milestone completion method. In conjunction with the appropriate accrual accounting methodology, the revenue recognition policy should match the revenue earning cycle and take into account any contractual obligations for the “completion” of the sale and acceptance of the “purchase.”

  1. Are variable gross margins clearly (and accurately) segregated from fixed overheads?

Identifying and allocating all direct variable costs that are incurred in producing revenue is essential to understanding product or service profitability. Companies should be careful in delineating non-variable costs from gross margin metrics.

  1. Do you track the cost of customer acquisition, churn, and payback period?

Companies that are investing aggressively for growth need to have a good grasp of their unit economics to determine if growth is profitable, and if it is profitable, exactly how profitable it is. They should also be able to identify which revenue segments are more and less profitable, in order to optimize allocation of growth investments.

  1. Have all appropriate and likely expenses been accrued? How timely is the accounts payable recorded?

Not only do expenses need to be recorded accurately and in a timely fashion, businesses must also “accrue” for expenses that are known and likely, but not yet billed or realized. This can be through a general “catch-all” accrual, or a specific expense accrual. Knowing what expenses will be incurred in the future is critical to understanding the company’s financial position, and projected cash flow requirements.

  1. Have expenses been categorized and allocated well enough to understand total cost of customer acquisition, R&D vs. service delivery COGS, etc.?

Allocating salaries departmentally should be easy enough when one individual has a dedicated role, however in smaller companies certain individuals may wear multiple hats, and therefore allocation of time by function is important to get at a more accurate sense of functional costs. Another area where time tracking is critical is in situations where the company is claiming tax credits, as time sheet review often forms a key part of the tax credit claim review process. Equally important is ensuring appropriate expense classification around General & Administrative expenses – knowing which expenses are discretionary vs. not is helpful in managing business finances, particularly when cuts need to be made.

  1. Do you produce cash flow analysis and 12 month projection?

If a business is strong but has little or no cash in the bank, it is almost ALWAYS due to poor planning and financial management. Cash flow statements and projections are an essential part of the survival of a growth business.

  1. Do you dynamically adjust cash flow (and other) forecasts based on actual results and how often?

Projections get stale eventually and need to be revised regularly to reflect actual experience. This in turn leads to better planning in future cycles.

  1. Are you tracking performance by segment, be it by customer size, product version, pricing model, vertical market, geography, etc.?

Segmentation analysis can yield valuable insights, identifying opportunities for operational improvement and investment prioritization.

10.  Do you present reporting with comparison to prior periods?

In order to fully understand your financial position at the end of any given period, it is important to review it in the context of the change (or trends) in key metrics as compared to relevant prior periods.

11.  How long does it take to produce month end statements?

Timeliness is essential in the production of financial information as most monthly statements can have a “half-life” of two weeks or less. The longer it takes to produce, the less valuable this essential information becomes.

12.  Are non-cash items such as depreciation and amortization clearly delineated or understood?

Understanding what items are non-cash and corresponding balance sheet implications is critical in analyzing the cash that is generated (or consumed) by the business.

Blog Post by Enio Lazzer, BrightIron.