Bank Alfalah | SME Toolkit

Financial Ratios, Calculators and Impressing Investors

Provided by the International Finance Corporation

If your business is seeking to borrow funds or to find an investor who wants to invest in return for a share of the business, it is important that you understand the basis upon which they will make their decision.

Financial statements alone provide useful information both to business owners and potential investors.

Lenders and investors prefer to look in a little more detail at specific aspects of business performance. They need to be able to compare different businesses to decide which ones to lend to or invest in. They are also keen to see how businesses are doing over time, looking for trends that let them know if the business is heading in a direction they like.

Ratios are typically used to get this additional information. Some are simple percentages of profit to sales, but others rely on more specialized computations. Find out what the acceptable ratios are for your industry and country from national trade associations, chamber of commerce, or something similar. If the business is growing steadily, if there is always enough cash to meet bills when they fall due, and if borrowings are kept to a minimum, then your ratios are likely to be in an acceptable range. However, that might not meet the lender’s or investor’s criteria.

It is important to remember that lenders and investors will have their own criteria for what is acceptable in a ratio or trend and that different lenders or investors will have different criteria, sometimes wildly different.

Calculating financial ratios such as the below will give you a head start in the negotiations. If your application is rejected, you can set a target ratio for the next year or two and apply again when you have achieved your goal.

Banks tend to be inflexible when it comes to lending. If your business ratios are not in the acceptable range as decided by the banks risk committee, then you will not be offered a loan, or, if you are, it will be at a high interest rate. Investors tend to be more unpredictable. Some investors like to take risks and might be willing to overlook some unsatisfactory ratios if they can be convinced by the vision and drive of the owner, or if they can be convinced of the long-term potential of the product or service the business provides.

The key point to remember with financial information on your business, is that once it finds its way into another person’s hands, there is absolutely nothing more you can do about it. This alone should be reason enough to ensure that the information is accurate and shows off your business in the best light.

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Preventing Employee Fraud

Adapted from content excerpted from the American Express® OPEN Small Business Network

Embezzlement and other kinds of financial fraud are perhaps the most common kind of employee theft. Small businesses tend to fall prey to this swindle because they don’t have the controls in place to prevent it. Use the tips below to help protect your business from unethical staff members.

Keep duties separate

No single employee should control a financial transaction from beginning to end. The person who writes your checks should never be the person who signs your checks. The person who opens the mail should not also record the receivables and reconcile the accounts. By dividing up responsibilities, you will make it more difficult for a person to steal from you and manipulate your records to cover it up.

Get your bank statements personally

Don’t give a person who is in a position to embezzle a chance to destroy or remove evidence of the wrongdoing. The business owner or an outside accountant should receive unopened bank statements and canceled checks each month. Review these checks carefully. Examine the payees, signatures and endorsements on each check. Keep an eye out for indications of fraud such as:

  • Checks to suppliers or people you don’t know
  • Checks made out to cash that are larger than the amount you allow for petty cash
  • Signatures that look forged
  • Missing checks, or check numbers that are out of order
  • Checks made out to a third party but endorsed by someone in your company
  • Checks where the payee listed does not match the name in your register

Closely guard your company’s checks

Don’t be careless with your corporate checks. Keep them in a locked drawer and don’t give out the key. Use pre-numbered checks, and check for missing check numbers frequently. Have a “voided check” procedure in place that requires you (the owner) to validate all voided items. Require all checks above a nominal amount to have two signatures (one of which is yours). And never, ever sign a blank check.

Sign every payroll check personally

This may take some time, but it is generally worth it. Review the checks to make sure they are for people you know. If there’s a name you don’t recall, go find that person. Keep a weekly count of the number of people on your payroll, and verify that number against the number of checks you have. Make sure that changes can not be made to your company’s payroll master file without your approval and signature. Another option: have a separate bank account for payroll, and deposit the exact amount of your payroll in that account; then insist on a prompt monthly reconciliation.

Watch your receivables closely

Have more than one employee involved in counting and verifying incoming receipts. Make sure all incoming checks are properly endorsed. Consider buying a “for deposit only” stamp, and use it on all incoming checks – this can prevent an employee from cashing them. Personally investigate customer complaints that credit has not been received for payments. Get a copy of the front and back of the customer’s check, and be sure it was deposited into your business account.

Make your bookkeeper take vacation

An employee who is embezzling from you may need to make a continuous effort to conceal this kind of stealing. Many small business owners are surprised to discover employees who appear loyal-they never take vacations and never stay home sick-are actually stealing from them. The reason these people have to be in the office constantly is to cover a complicated paper trail. Insist that employees who perform accounting/bookkeeping take vacation every year. Ideally, this vacation should be at two weeks in length, and occur at month end, when the books are being closed. Use this time to have someone else review your books and look for discrepancies.

Have your books audited regularly

Bring in a third party at least once a year to conduct an audit of your books. This makes it difficult for an embezzler to cover his or her actions. This audit should be unscheduled and a surprise; make sure it does not occur at the same time every year. If you suspect fraud, consider specifically requesting a “fraud audit” instead of a “general audit.” This type of audit is designed to uncover and prevent these kinds of losses.

Make sure you understand your books

Embezzlement commonly occurs when bookkeeping is sloppy and unsupervised, which makes it easy for an employee to keep cash and receipts. As the business owner, you must be familiar with your company’s bookkeeping and record keeping system. This way you can easily review the books and make sure nothing is amiss. If you’re not a “number person,” have your accountant spend some time with you to show you what to look for, or take an accounting or bookkeeping class at your local college. Trusting someone else to oversee this most important part of your business only opens the door to fraud.

Secure your bookkeeping software

Don’t allow unauthorized access to your bookkeeping software. Don’t put the computer that holds your books on your network. Make sure both the computer and the software are password-protected. Change the password frequently to lock out unauthorized persons from this program. If you still use paper ledgers, keep them under lock and key.

Copyright © 1995-2016, American Express Company. All Rights Reserved.

Managing Debt

Adapted from content excerpted from the American Express® OPEN Small Business Network

For a growing business, having a manageable level of debt can be an effective way of doing business. While some small business owners are proud of the fact that they’ve never taken on debt, that’s not always a realistic approach. Growth often demands considerable capital, and getting that money may require you to seek a bank loan, a personal loan, a revolving line of credit, trade credit, or some other form of debt financing.

The question for many small business owners is: How much debt is too much? The answer to this question will lie in a careful analysis of your cash flow and the specific needs of your business and your industry. The guidelines below will help you analyze whether taking on debt is a good idea for your company.

Explore your reasons for borrowing

There are a number of scenarios when it may make sense to take on debt. In general, debt can be a good idea if you need to improve or protect your cash flow, or you need to finance growth or expansion. In these cases, the cost of the loan may be less than the cost of financing these moves through ongoing income. Some common reasons for seeking a loan include:

  • Working capital – when you’re looking to increase your company’s work force or boost your inventory
  • Expanding into new markets – when companies enter new markets, they often face a longer collection cycle or must offer more favorable terms to new customers; borrowed funds can help weather this period
  • Making capital purchases – you may need to finance new equipment in order to move your business into a new market or expand your product line
  • Improving cash flow – if you have less than 10 years left on an existing long-term debt, refinancing can improve cash flow
  • Building a credit history or relationship with a lender – if you haven’t borrowed before, taking out a loan can help in developing a good repayment history and can help you obtain financing in the future

Plan effectively

Before taking out a loan or any other kind of debt financing, you should spend time planning your capital needs. The worst time to take on any kind of debt is during a crisis. A sudden loss of trade credit, the inability to meet a payroll, or other emergency could force you to take on debt immediately, and that can result in highly unfavorable terms. A plan will allow you to forecast your cash requirements, allowing you to determine what you will need and when you will need it. This will give you the extra time to explore all possible borrowing sources and negotiate the most favorable terms. A capital plan should consist of a complete review of your balance sheet to help you analyze cash flow, assets and liabilities. You’ll also want to construct a pro forma statement, which is a projected balance sheet for the coming 1-3 years.

Examine short-term vs. long-term debt

Just as you need to be certain you’re taking out a loan for the right reasons, you also need to make sure you’re taking out the right kind of loan. For example, taking out a short-term loan when a longer term loan is required can quickly create financial problems since you may be forced to take unnecessary measures (such as selling a piece of the business) to meet the obligation.

In general, use short-term loans for short-term needs. This will help you avoid higher interest expense and more restrictive conditions of longer-term borrowing. For instance, if you experience a temporary rapid increase in sales — such as that brought on by increased seasonal demand — then you should look at a short-term loan. If the growth will continue over a long time, take a look at longer term options such as an expanding line of credit based on sales, accounts receivables, or inventory ratios The term of your debt will have no impact on your debt-to-equity ratio. However, you will see changes in liquidity indicators such as your current ratio, since current liabilities include only the debt that must be repaid within one year, not debt due at later dates. So longer term loans can positively affect your liquidity ratios.

Base new debt on current needs

When interest rates are low and money is cheap, you may be tempted to take out loans to buy equipment or make other capital purchases. If that’s the case with your business, be sure to base your decision solely on your current needs. The possibility of rates increasing is not a rationale for spending money on something you don’t need. For example, if your business needs additional computer equipment, you might want to take out a loan to buy it. But buying additional computers now because they’ll be more expensive next year is not ample justification. You can end up getting stuck with equipment you don’t need and debts that you are still obliged to pay off.

Copyright © 1995-2016, American Express Company. All Rights Reserved.

Selling Your Business

Provided by My Own Business, Content Partner for the SME Toolkit


Selling your business is not a process you can turn over to your broker, lawyer or CPA, although you will need all their services. This session covers what you should know before selling your business.

  • Deciding when to sell
  • Selling your business is a process
  • Careful planning is necessary
    • Most common mistake is lack of preparation
    • Accounting for past 5 years in place
    • Include or exclude real estate?
  • Recruit and pay for professional help
    • The business broker
    • Professional appraiser
    • Business lawyer
    • CPA (tax expert)
  • How to set the price of your business
    • Be realistic on pricing and financing
    • Methods of evaluation
    • Goodwill
  • Finding buyers for your business
    • Your broker’s role
    • Advantages of selling to your competitors
  • Negotiating your sale
    • See Session 5 Negotiating Tools
  • Selling the business to your employees
    • Company employees are highly motivated
    • Employee workouts
    • Employee Stock Ownership Plans (ESOP’s)
  • Top Ten Do’s and Don’ts

Deciding on when to sell your business will include consideration of both external and internal factors: for example, the condition of the economy (external) and the status of your health (internal). All of your reasons may not line up perfectly to make an easy decision and most likely there will be certain issues that will emerge as more important than others. So making the right decision will help greatly by preparing a “for” and “against” list, giving various weights to each of the considerations based on your circumstances.

Some of the considerations may become to-do projects in your overall exiting plan. For example, if you are facing a potentially damaging lawsuit, you would have reason to clear up this obstacle. Or if you have important leases about to expire, you may want to negotiate longer terms now so as not to be facing this roadblock later on when you decide to sell.

Good times to sell Bad times to sell
Times are good and everyone is buying. Your business or the economy is in slump.
Your exit plan is in place, well thought out and vetted by your exit committee. A new competitor poses a serious threat.
You are not enjoying your business. You or your family have serious health problems.
Your retirement would be well funded. There serious litigation or disputes pending.
You have received a timely and adequate unsolicited offer. Your business is facing obsolescence.
You have a productive lifestyle in mind after leaving. You are in gridlock with your managing partners.
Your industry is growing. There are business problems that would impede a sale.
Your sons and daughters are ready to succeed you. You love what you’re doing and can’t wait to get to work every day.
Your industry is shrinking.
Your key leases are about to expire.

You may have made mistakes along the way, but when it’s time to sell the business, you only have one chance to do it right. Two major points to keep in mind are:

Selling your business is not a process you can turn over to your broker, lawyer or CPA. You will be the main player throughout the process.

According to the SBA, as much as 90% of the sales of small businesses involve at least some seller financing, so it may not be realistic to expect a lump sum payment.

Most common mistake is lack of preparation

It will be important that your business is in top operating order and appearance. You should be prepared to answer probing questions and furnish specific documentation such as:

  • Copies of your leases. If any important conditions are not favorable, correct them if possible: the term, options, rent and assignment provisions.
  • Will your improvements and fixtures need to be replaced?
  • What is the quality of your inventory: overstocked or obsolete?
  • The condition and amount of your receivables. Collectable?
  • What is amount and status of your payables?
  • Is there an order backlog?
  • Do your good customer relationships justify goodwill pricing?
  • Is your primary marketplace stable or changing?
  • Are all your licenses and government approvals in place?
  • Copies of last three year’s tax returns.
  • If your buyer intends to make payments over time, be sure that all your insurance policies are kept in force.
  • Have accounting for past five years in place
  • Provide your buyer with audited financial statements, the highest level of accounting scrutiny. This will be expensive but worth the cost. It’s a good idea to begin getting audited statements two to three years in advance.
  • Your audited statements will also be an important tool for the buyer to use in helping finance the purchase.

Include or exclude real estate?

Your lawyer and CPA will help analyze if you should include the business’s real estate in the sale. In some cases, sellers will retain the real estate and lease it to the buyer. There are large tax implications to be considered.

Business broker

Both buying and selling businesses involve complexities that in most cases justify the services of a business broker. A broker’s commission is normally 10 percent and is paid after closing of the sale (much like a real estate broker.) Your business broker can assist in building your selling package, speed up the time it takes to sell the business, be responsible for marketing activities and screening of potential buyers.

Some qualifying pointers for selecting a broker include:

  • Does the broker have specialized experience in your industry?
  • Will the broker cooperate with and solicit other brokers to cooperate?
  • Will the broker prepare a business profile?
  • Will all marketing avenues be utilized including listing exchanges, newspapers, direct mail, trade journals, networking, and telemarketing?

Professional appraiser

A professional appraisal can add credibility to the valuation of your business. It can provide a comprehensive and detailed document that will withstand tough scrutiny and provide a specific opinion of value. If you have a profitable business with prudent debt, reasonable risks, and a good management, it will normally qualify as a going concern and be valued on the basis of the economic benefits it has provided to you. While an appraisal is not the only way you will be measuring value, it can stand out as a respected tool.

Business lawyer

Your lawyer will advise if your sale should be structured as an acquisition or a merger. He or she will also advise whether you should sell your assets or your stock. In most cases a buyer will want to buy the assets rather than the stock of a company to eliminate unknown liabilities. Your lawyer will also collaborate with your CPA to minimize tax burdens. Tax implications can be huge, either good or bad, so your lawyer/CPA team will be your key players.


Your CPA and lawyer should be brought into the very preliminary planning stage of your selling process. This could begin taking place years before the event.

Your CPA, with your lawyer, will help structure your sale so as to minimize your taxes. If not properly structured, the sale could leave you with less than half the sale price once all taxes have been taken out. By structuring as an installment sale and spreading the sale over several years, a higher tax rate could be avoided. Also, when providing seller financing to a buyer, you might ask the buyer to use non-business assets as security for your loan.

Be realistic on pricing and financing

Too often sellers set a high price on their business before really analyzing its value. The problem created is that how long a business remains on the market is determined by its pricing. It is much better to complete a valuation process which can then be used to justify the price. Ultimate pricing could be determined by one or a combination of methods.

Be realistic on pricing and financing

  • Sales volume. In retail businesses, the buyer may want to stand at the cash register for a week to verify the sales. Your industry may have pricing guidelines based on recent sales. Since the valuation and sales of your publicly owned competitors are known, they can provide a rough valuation guideline of valuation as measured by sales.
  • Earning power is a common evaluation method. Pricing can be based on what return on investment the business will produce. Here’s an example:
    Your business shows an annual net after taxes of $50,000 and your buyer has determined she wants a 25% return on her investment. She will offer $200,000 for the business. Here is the mathematics:$50,000/.25 = $200,000
  • If your business owns the real estate it occupies (or other real estate) the market value of the real estate could become a principle factor in pricing.
  • Intrinsic value. When you sell a business, what you are really selling is the sum of all of its future earnings. Intrinsic value is a mathematical calculation which converts all future earnings into their present value. One method is to create a ten-year spreadsheet of the estimated future year-by-year earnings and convert each of these, along with a residual long-term value, to an overall present value. This becomes the “intrinsic value” of the business. Search engines offer many solutions in determining intrinsic value and we strongly recommended you become familiar with this important tool.
  • Market comparables. Your selling price should also reflect what similar businesses are selling for at the time you plan to sell yours.


Goodwill is the value of a company’s reputation which gives it a competitive edge and earning power. Accounting wise, it is the amount paid above the book value of the company’s assets. This can come about by the company having pricing power or a potential future that is not reflected on the financial statement. For example, many Internet technology firms are valued at amounts that far exceed the financial statement value. If a selling company has built up an excellent reputation, or a valuable trade name, or has important customer contacts, it most likely will enjoy a selling price above its accounting book value.

Your broker’s role

Finding buyers is the job of your business broker. As when you sell your house through a real estate broker, you depend on the broker to deploy his or her skills in marketing including preparing the selling package, exploring resources, advertising, qualifying and closing prospects. The same should hold true when you sell your business.

Advantages of selling to your competitors
As a rule, potential buyers that are already in your business or industry are better candidates than people unfamiliar with your business. A buyer already in your business has unique motivations:

Geographical expansion

  • Expansion of market share
  • Elimination of competition
  • Gaining efficiencies of sale in buying, shipping and advertising.
  • Are in a better position to appreciate the valuation of your business.
  • Potential for rapid expansion for future public ownership.
  • Already positioned to avoid beginner mistakes.
  • Your broker will also function to pre-qualify buyers including determining if prospective buyers are financially capable of closing the sale and having a confidentiality agreement signed.

Selling your business will probably be the single most important time to exercise good negotiating skills. The earlier session, “Negotiating Tools” covers the basic do’s and don’ts. We’ll emphasize two points here:

  • Keep your buyer’s point-of-view in mind in balancing what works best from both points of view.
  • As stated at the outset of this session, as much as 90% of the sales of small businesses involve at least some seller financing…that’s you! Financing is an opportunity to be creative. For example, you could bring multiple sources of financing into play to close the gap between cash and the sale price. The buyer might combine financing from an SBA guaranteed loan plus your own subordinate financing guaranteed by some of the buyer’s other resources.

Employees are highly motivated

Nobody knows your business and its prospects better than your employees. They could be highly motivated and should not be overlooked as prospective buyers of the business. Studies have shown a direct connection between high levels of employee ownership participation and increased performance. Assuming a key employee also has the necessary business qualifications and integrity, he or she would be powerfully incentivized by ownership.

Employee workouts

If you have key employees who are capable of filling your shoes and have an entrepreneurial zeal to carry the company forward, your lawyer can structure protective provisions where the acquiring employee “works out” their ownership by making payments over time to purchase the firm. In such cases, the acquiring employee should be required to put up a significant cash down payment. The selling owner then provides financing to be repaid in installments out of earnings. In some cases, the employee-buyer may be required to secure outside financing in place of the owner or along with the owner.

Employee Stock Ownership Plans (ESOPs)

An Employee Stock Ownership Plan (ESOP) is an employee benefit plan which makes the employees of company owners of stock in the company. They are a variation of a traditional profit-sharing plan. Companies create ESOPs as an employee retirement plan for purposes of business continuity, financing, enhanced employee motivation or as a combination. In the U.S., there are now over 11,000 Employee Stock Ownership Plans (ESOPs) covering 11 million employees.

An ESOP is required by law to invest primarily in the security of the sponsoring employer. In addition to the substantial tax advantages, selling to the ESOP preserves the company’s independent identity. A sale to an ESOP also provides a significant financial benefit to employees. Selling to an ESOP also permits the seller to sell all or just a part interest in the company, and to do this gradually or all at once.

Your lawyer and accountant can give you opinions as to whether the use of an ESOP plan would be appropriate in the disposition of your business. Since its inception in 1978, the ESOP Association has represented the interests of companies that sponsor ESOP plans.


  • Spend sufficient time to polish up all aspects of the business.
  • Build your team of experts including accounting and legal counsel.
  • Establish value based on appraisal and industry standards.
  • Establish value based on intrinsic value and professional appraisal.
  • Select an industry-specialized business broker with care.
  • Have audited records for the last 2 years.
  • Develop your negotiating skills.
  • Let your broker find and qualify potential buyers.
  • Qualify the buyer’s ability to service your seller financing.
  • Get tax advice on all aspects of the sale.


  • Overprice the business.
  • Expect to be paid in cash.
  • Fail to consider some seller financing.
  • Fail to consider a key employee workout.
  • Overlook possibilities of selling to a competitor.
  • Be unprepared to furnish all important documentation.
  • Forget to consider your buyer’s point of view.
  • Disregard investigation of an employee owned ESOP.
  • Fail to get tax council on all issues of the sale.
  • Be unprepared to continue running the business.

Copyright © 1993, 1997-2016, My Own Business, Inc. All Rights Reserved.

Getting Financial Controls in Place

Provided by My Own Business, Content Partner for the SME Toolkit


Growing your business will require establishing a solid foundation of internal controls including accounting, auditing, purchasing and damage control planning. This session will give you an overview of what you need to prepare for.

  • Cash flow
  • Accounting
    • Your accountant’s role
    • Check list of internal controls
  • Audits
  • Accounting controls
    • Growth requires more disciplined controls
    • Mission of internal controls
    • Financial reporting by profit centers
    • Frequency of reporting financial statements
    • Frequency of cash flow projections
    • Monitoring your leverage
  • How to buy checklist
  • Damage control plans
  • Top Ten Do’s and Don’ts

Featured Video: Business Planning: How to meet the future needs of your businessAs you grow, your cash flow will become more complex. This will surely be the case if your expansion includes creation of debt to fund your growth. Most business failures occur because the cash flow fails to cover debt created in acquisitions or other expansion costs.

Cash flow control is a simple method of projecting your future needs for cash. It is an income statement covering future periods of time that has been changed to show only cash: cash coming in and cash going out and what your balance of cash is at the end of designated periods of time.

In cash flow control, for each future intervals of time, make conservative estimates for your future sources of cash (IN) and future expenditures (OUT). Use low, conservative figures for IN items and use high estimates for OUT items. For the initial period, start with the cash you now have. To this you add IN items and subtract the OUT items, which results in the cash at end of the month. The cash at the end of month becomes the starting cash for the next month.

Your cash flow projections will furnish the information on how much debt you can safely take on. You may want to establish a guideline ratio to establish a margin of safety between your cash flow and your debt service. For example, limiting your outstanding debt service so as to maintain cash flow that is three or more times the debt service. To estimate a reasonable ratio for your particular business, your public competitors are a good place to look for industry norms.

Any time you were to run out of cash, you would have a potentially disastrous problem. So the number one safeguard in building your business is: never run out of cash. By having information of potential negative balances in advance, say six months, you have six months to make cash flow adjustments in sales, collections, expenses or financing to correct future negative balances.

The following simplified cash flow control spreadsheet shows that ending cash for this first period becomes the starting cash for the second period. The ending cash for the second period becomes the starting cash for the third period, and so on. The projection will also be a useful tool in arranging financing and demonstrate to your banker that you are sensitive to the importance of safeguarding liquidity as you grow your company.

Your accountant’s role

Internal controls are the safeguards to ensure all the information represented on your financial statements is accurate. Your internal accountant working with your CPA will be the key overseers in managing all internal controls.

  • Separation of income and expense functions. For example, have different people handle accounts payable and accounts receivable.
  • Separate authorization, custody, and record keeping roles. Your CPA can make recommendations that are appropriate for your business.
  • Have bank statements mailed to a separate (or home) address of a managing authority or yourself. Malfeasance occurs frequently with banking transactions. Bank statements and checks cashed can be independently reviewed.
  • Do not delegate signing of checks.
  • Establish maximum limits of purchasing authority.
  • Require all payments be supported by invoices.
  • Require bids on all purchases over a stated limit.
  • Inventory controls:
  • Inventory, similar to cash, can disappear very rapidly through carelessness or employee dishonesty. Require authorization for who can sign for goods and services and who controls the release of goods and services out the door after the processing has been completed. Separation of incoming and outgoing duties is recommended.
  • Rapid delivery firms such as UPS or FedEx and just-in-time assembly systems are great tools to use to minimize your inventories. The cash you free up can be put to uses that are more productive.
  • Verify that insurance policies are in force and premium payments are current. View our “Top Ten Do’s and Don’ts” of insurance coverage in the Start a Business Course.
  • Internet technology security management in place or outsourced. Your IT consultant or manager should write out the IT policies.
  • Edit log for website changes and updates. If your business deals with e-commerce, you need to establish a log procedure for control of who and how edits to your website are to be made. All changes or edits to the site should be made through a designated employee. Your computer technology consultant can show you how to administer this tool.

You will probably need more financing as you grow and your lenders will require a closer scrutiny of your financial statements. There are several levels of how audits are performed by your CPA. Starting with the most rigid and expensive one:

  • An audited financial statement is one prepared by a CPA who certifies that the financial statements met requirements of GAAP (Generally Accepted Accounting Principles) which covers a wide range of procedures. An audited statement is required of publicly owned firms. So if you are planning a future initial public offering it is a good idea to start publishing audited statements at least two years before your intended IPO date. Some banks will require audited statements.
  • A reviewed statement is the next down from audited statement and less costly as the auditor does less examining than the audited statements. Some banks will approve a reviewed statement of small and intermediate-sized companies.
  • The second step down from an audited statement is a compiled statement prepared by a CPA. But the CPA can not provide assurance that the statements are according to GAAP standards.
  • Internally prepared statements are prepared by the company and may or may not follow GAAP nor be prepared by a CPA. Any growing business should maintain a higher level of accounting scrutiny than relying on internally generated financial information.

Growth requires more disciplined controls

As you grow, your accounting and internal control systems must keep pace to insure that the higher levels of income you generate are not wasted or siphoned off by various forms of dishonesty. Take a moment to think about anyone you know of that has suffered a loss due to embezzlement or poor internal controls. Was the loss severe? How could it have been avoided?

So it becomes increasingly important for both your internal accounting management and your auditor to be adequately qualified and experienced in implementing firewalls against various forms of embezzlement, shrinkage and other criminal activities.

Mission of internal controls

To accomplish appropriate controls, consider:

  • Developing systems to maintain efficiencies and honesty on both the supply-side and the marketing side of your business.
    • Supplied side risks include ordering procedures, incoming and outgoing inventory controls and accounts payable accounting.
    • Marketing-side risks include shrinkage (stealing by your customers and/or employees) accounts receivable mismanagement and sales not being rung up at the cash register.
  • Work with both your internal accounting manager and CPA to upgrade financial controls as needed. If you have uncommon risks beyond ones your accountants can install and administer, you might consider getting an assessment from a loss control consultant.

Financial reporting by profit centers

Your expansion should provide that your overall financial statements are broken down by individual profit centers within the company. This practice will identify areas of strengths and weaknesses and also provide the basis for profit sharing incentives for key managers.

Frequency of reporting financial statements

Individual profit center income statements (P & L’s) should be reported on a very frequent basis, with a minimum of monthly reporting. Here’s why:

  • To disclose problems or losses early, before they become big and unmanageable. The early detection of losses should not only accelerate remedies but also be followed up by promptly shutting down an operation that proves to have incurable flaws so that a financial leak does not turn into a flow of losses.
  • Profit sharing incentives work best when they are paid in frequent intervals. In some food operations, P & L’s are pulled and incentive checks written on a weekly basis.

Frequency of cash flow projections

As referred to earlier in this session, the cash needs of a growing business will add more uncertainty to future liquidity and therefore must be closely monitored. Predicting future liquidity should be updated very frequently such as quarterly.

Monitoring your leverage

Financial leverage is the use of borrowed money to supplement the cash you invest in growing your business. The general objective is to borrow money to buy an asset with a higher return than the cost (the interest) on the debt. While the purpose is to maximize your earnings, the cost is running the risk of maximizing losses.

Firms that are highly leveraged run the risk in bad times that their income may not be sufficient to make payment on their debt or even the risk of bankruptcy. The financial crisis of 2007 – 2009 was blamed largely on excessive leverage. Here are three ways you can monitor and thereby minimize your level of risk on an ongoing basis:

  • Work with your CPA to establish a maximum financial leverage ratio, also referred to as debt-to-equity ratio.
  • Work with your CPA to establish a minimum level debt-to-cash flow ratio. Cash flow is the cash you generate after eliminating non-cash expenses from your income.
  • Borrow for a longer term than you need. If you can repay in 3 years ask for 5 years. Be sure to include the provision permitting acceleration of your repayments.

As you grow in earnings and cash flow, your leverage should become less and less for two reasons:

  • Over time you will be growing your retained earnings and will have more cash to invest, lessening the need for borrowing.
  • The greater your net worth becomes, the less leverage risks you should be taking. This follows the Warren Buffett maxim: “you only need to get rich once”.

If your accounts aren’t in perfect shape, now is a great time to make sure they’re well-organized. A good piece of accounting software can make this a lot easier. The two best programs on the market are Quickbooks and Sage 50 (formally Peachtree).

Here is a checklist on purchasing to incorporate in your internal controls.

  • Never place an order without knowing the price and the terms.
  • Purchase orders must be in writing.
  • Have complete specifications.
  • Buy subject to your contingencies.
  • Have backup sources.
  • Be loyal to good suppliers.
  • Have promises and extras verified in writing.
  • Get price protection.
  • Try to award to the lowest bidder.
  • Don’t hesitate to repeatedly contact suppliers to expedite needed merchandise. “The squeaky wheels get the grease.”
  • Communicate complaints quickly and respectfully
  • Use internal controls for ordering and receiving.
  • Count and inspect everything as received.
  • Use an inventory control system.
  • Ask for and take term discounts.
  • Pay on time.
  • Pay only after verification.
  • Watch your cash flow.
  • Consider suppliers as a source of financing.

Ships at sea have no fire department to call for help. So damage control plans and training are important for survival. As a business owner you also need to be prepared for unexpected adversities. We recommend the following contingency plans be practiced and ongoing training provided:

  • Contingency plans for adverse cash flow. This could include back-up banking resources, or multiple sources rather than one. Always keep in mind that this event could happen and seek out your other resources to fund periods of need.
  • Insurance protection in place. It is foolish for an owner to look to saving money by not providing adequate insurance for all appropriate casualty events. It’s not a good idea to “bet the company” that adversities will not happen.
  • Determine if there are any special industry-related risks that apply to your business. Here are two examples:

Should you take precautions against power outages? Lights out may mean lost sales or lost computer data. Or, if you maintain frozen or refrigerated storage, would the expense of a stand-by generator be good insurance?


  • Adjust and readjust your cash flow projections.
  • Establish maximum limits of purchasing authority.
  • Require all payments be supported by invoices.
  • Use an inventory control system.
  • Work with your CPA to upgrade financial controls.
  • Require bids on all purchases over a stated limit.
  • Be loyal to good suppliers.
  • Pay on time, but only after verification.
  • Consider higher audit levels.
  • Implement an “edit log” for website changes and updates.


  • Run out of cash…ever.
  • Discount the importance of hiring an accountant and a CPA.
  • Overlook suppliers as sources of financing.
  • Disregard contingency planning.
  • Have same person handling payables and receivables.
  • Place an order without written price and terms.
  • Delegate signing of checks.
  • Assume that shipments are complete and in perfect condition.
  • Neglect to ask for and use term discounts.
  • Think that hand-shake agreements are best when buying.

Copyright © 1993, 1997-2016, My Own Business, Inc. All Rights Reserved.

Achieving Lowest Expenses

Provided by My Own Business Content Partner for the SME Toolkit


Your business growth will come about by not only making money but by carefully investing the cash produced by frugal spending. You will learn the importance of minimizing your expenses and how to achieve it.

  • Wealth accumulation is a matter of frugality
    • The man next door
    • The power of compounding
    • The value of the money you save
  • The Wal-Mart Model
    • Keeping costs low and discounting heavily
    • Ranked number one for lowest ratio expenses to sales
    • Share profits with your managers
    • Operating principles
  • Frugality does not mean compromising quality
    • Toyota
    • See’s Candy
  • Other Risks in cost-control plans
    • Deferred repairs and maintenance
    • Inadequate product development and research
  • Ways to accomplish ongoing corporate frugality
    • Create profit sharing incentives
    • Practical cost saving ideas
    • Build an image of austerity
  • Top Ten Do’s and Don’ts

The Man Next Door

The greatest motivation for your being in business is to build wealth. This goal is not accomplished just by making money…it is also a result of not spending money. There is a famous study of the characteristics of wealth by researchers Thomas Stanley and William Danko in their book The Millionaire Next Door. It revealed that most people with high incomes fail to accumulate lasting wealth because they also live high lifestyles.

On the other hand, wealthy people generally have a high income and a frugal mindset. You may be surprised to learn that the unpretentious person in your neighborhood who drives the ten-year-old Chevy (“the man next door”) may be the only millionaire on the block. According to Stanley and Danko, the common characteristics of wealthy people include:

  • They are frugal and live well below their means.
  • They allocate their lives efficiently in ways conducive to making money.
  • They value financial success more than showing off wealth.
  • They were self-made men and women (not inherited wealth).
  • They chose the right business to begin with.

Accomplishing wealth in business is also not just a matter of making money…it is also a matter of not spending money. Your business growth will come about by not only making money but by carefully investing the cash produced by frugal spending.

The power of compounding

Compounding has been called the eighth wonder of the world and the investor’s best friend. By definition, it happens when interest is added to principal so that the interest that has been added also earns interest. Compounding of interest allows a principal amount to grow at a faster rate than simple interest, which is calculated as a percentage of only the principal amount. The real power comes into play over time so it’s a good idea to start early. Its power is also based on the interest rate, or rate of return, which is earned.

Money you have put in or add to your business is called equity. How much you earn on each dollar you put in is called return on equity or ROE. Return on equity will vary from industry to industry. For example, the ROE of the top five companies in the railroads industry ranges from 15.5% to 12.2%.

Each year the money you save by being frugal will be invested in growing the business. The measurement of your success will then depend on how wisely you allocate your compounded earnings.

The value of the money you save

We can now place a dollar value on your frugality. Let’s assume you can cut out $10,000 of costs each year for the next ten years. Each year the $10,000 saved will be going into expanding the business. Your ROE is 15%. At the end of 10 years, the $10,000 you have saved each year will be worth:

$280,017 (Over a Quarter Million Dollars)

Keeping cost low and discounting heavily.

Sam Walton grew up poor on a rural Missouri farm during the great depression of the 1930’s. He learned the value of money by growing up in poverty. In his stores, he gave people what they wanted by focusing on low selling prices.

Ranking number one in ratio of expenses-to-sales.

For decades, Wal-Mart has accomplished the lowest expenses to sales in their industry which enabled them to discount deeply. However, the huge savings that Wal-Mart has accomplished did not affect the product quality: savings were entirely focused on costs unrelated to product cost or quality. According to Sam, the two most important words he ever wrote were on the first Wal-Mart sign: “Satisfaction Guaranteed”.

Following the worldwide financial collapse of 2008, firms began cutting out expensive habits that had been built up over time. Cost savings were mandated and even as businesses began recovering, the savings continued to be enjoyed. Generous spending habits were permanently replaced by lower cost disciplines. For example, many firms replaced expensive travel budgets with online conferencing and have continued the practice.

While Wal-Mart provides a good example of successful frugality in the discount department store industry, any business in any industry can enjoy the same benefit that happens when costs are reduced: every dollar saved can be reinvested in the business and continue to grow on a compounded basis.

Share profits with your managers

Implementing incentive plans that are based on profit sharing can become a powerful tool in maintaining ongoing frugality and efficiencies because the plan will be consistent with the objective of cutting out unnecessary costs. To a profit-sharing manager, a penny saved means money in his or her pocket. And as long as the plan is implemented, the incentive to cut costs will remain intact. By sharing your profits with all your managers, you can be perceived as a partner and together you all can perform beyond your expectations.

Operating principles

Along with a deeply embedded spirit of frugality Wal-Mart also embedded these operating principles:

  • Commit to your business
  • Share your profits with all your associates
  • Motivate your partners
  • Communicate everything you possibly can to your partners
  • Listen to everyone and get them talking
  • Exceed your customer expectations

A warning: a misguided frugality program can lead to the diminishment of product quality and market share. Cost reduction of expenses should not be made at the expense of product or service quality. Over-zealous cost reduction programs can impact in product quality resulting in diminishing hard-earned reputations. Here are two examples:

  • Toyota – Toyota experienced loss of market share when the emphasis on cost reduction spilled over to quality compromises that were even obvious to the customers. Even in luxury sedans, driver’s floor mats developed a hole at 25,000 miles while earlier models were still fine after 100,000 miles. Expense reduction programs must be limited to expenses that do not impact product quality or safety.
  • See’s Candy – On the other hand, for decades, See’s has been an earnings powerhouse in the boxed candy industry by avoidance of any cost reduction efforts that could detract from the quality of their candy. Their secret of success lies in their trademarked logo: “Quality Without Compromise©.”

Deferred repairs and maintenance

Deferred maintenance is the practice of putting off maintenance activities such as repairs on property or machinery in order to cut costs. As a rule, an ongoing policy of deferred maintenance will result in higher costs, the breakdown of assets and even adversely affect health and safety. For example, following the 2010 oil spill in the Gulf of Mexico it became evident that safety and cost drives had clashed and that deferred repair was a “critical factor” in the incident.

When maintenance budgets are left in the hands of managers whose compensation is based on earnings, there could be a temptation to defer maintenance in order to increase earnings. A remedy could be mandating a maintenance budget each year based on past experience.

Inadequate product development and research (Research and Development: R & D)

In businesses with fast changing technology, research and new product development is a necessary cost of doing business. Your larger competitors will disclose their research budgets as a percentage of sales in their published annual reports. Once again, managers on income-based incentives could be tempted to underfund development and research. As with deferred maintenance, a solution could be mandating the R & D budget. In cases where a pilot plant is required to prove out a concept, care must be taken to patiently take the time and expense to fully make an evaluation.

Create profit sharing incentives

Profits are diminished by expenses. So if you pay incentive compensation to your managers based on earnings you will create a powerful group of partners who will have a direct incentive to reduce costs. Basically, you will be paying bonuses to your managers in return for the value they provide to the company by cutting costs….with the result of the greater overall success of the company.

Practical cost saving ideas

Most all businesses readily claim that they’re already operating at the lowest possible level of costs. But the truth according to cost containment expert Max Friar of Alliance Cost Containment is that every company is bleeding profits through a thousand little cuts. And most companies are spending 15-30% more on indirect operating costs than necessary. While it is easy to focus on high-dollar costs such as healthcare insurance, few managers are watching the pennies. Here are some opportunities Mr. Friar points out:

  • Corporate Purchasing Cards. Why permit staff to buy items at full retail from multiple vendors rather than getting volume discounts by shopping through designated suppliers?
    Utilities. Your electric utility can provide an energy audit and give you a long list of conservation tools.
  • Association Discounts. Your industry association may offer group purchasing discounts your company could take advantage of including fleet services, insurance, workers compensation premiums and many other opportunities.
  • Travel and entertainment. If you don’t have a per diem allowance when not entertaining, you are probably paying more to feed the staff than you need to. Are employees directed to specific hotel groups to capture bonus points?
  • Supplier Consolidation. Set a goal of reducing your suppliers by 5% next year and pay bonuses to employees who figure a way to do it. This results in better pricing through higher volume.
  • Parcel Shipping. Are packages sent via overnight delivery qualified to go 2nd-day delivery? Are you using multiple shipping vendors and missing out on volume discounts? A few policy controls and supervision can pay back big dividends.

Build an image of austerity

During the economic depression starting in 2008, chief executives found their firms could function perfectly well with lower levels of spending on travel, supplies, and office space. But over time abuses can creep back in. The ongoing challenge is to adhere to tight budget disciplines and not allow expense from creeping back.

To truly accomplish the credential “Number 1 in your industry for lowest ratio of expenses-to-sales” you must also lead by example and operate in a truly modest mode. For example,

  • Operate in modest, unpretentious premises
  • Drive mid-size not luxury cars
  • Everyone flies cabin class
  • Replace travel expenses with video and Web conferencing
  • Do not delegate authority for capital expenditures
  • Limit authority on operating expenses
  • Require travel expenses to be reported monthly rather than quarterly


  • Live well below your means.
  • Value success more than showing off.
  • Invest compounded savings to build wealth.
  • Create profit center incentives.
  • Replace travel by use of online conferencing.
  • Share profits with your managers.
  • Strive for the lowest cost in your industry.
  • Maintain ongoing focus on frugality.
  • Treat your managers as partners.
  • Build an image of austerity.


  • Live beyond your means.
  • Compromise your product to cut cost.
  • Defer repairs and maintenance.
  • Delegate authority for capital expenditures.
  • Locate your business in expensive premises.
  • Ignore the power of compounded savings.
  • Drive a luxury car and fly first class.
  • Be secretive with your employees.
  • Allow abuses of expenses to creep back into your austerity plan.
  • Compromise on research and development.

Copyright © 1993, 1997-2016, My Own Business, Inc. All Rights Reserved.

Business Valuation Methods

Adapted from content excerpted from the American Express® OPEN Small Business Network

There are a number of instances when you may need to determine the market value of a business. Certainly, buying and selling a business is the most common reason. Estate planning, reorganization, or verification of your worth for lenders or investors are other reasons.

Valuing a company is hardly a precise science and can vary depending on the type of business and the reason for coming up with a valuation. There are a wide range of factors that go into the process — from the book value to a host of tangible and intangible elements. In general, the value of the business will rely on an analysis of the company’s cash flow. In other words, its ability to generate consistent profits will ultimately determine its worth in the marketplace.

Business valuation should be considered a starting point for buyers and sellers. It’s rare that buyers and sellers come up with a similar figure, if, for no other reason, than the seller is looking for a higher price. Your goal should be to determine a ballpark figure from which the buyer and the seller can negotiate a price that they can both live with. Look carefully at the numbers, but keep in mind this caution from Bryan Goetz, president of Capital Advisors, Inc., a business appraiser: “Businesses are as unique and complex as the people who run them and are not capable of being valued by a simplistic rule of thumb.”

Here are some of the common methods used to come up with a value.Asset valuation is used when a company is asset-intensive. Retail businesses and manufacturing companies fall into this category. This process takes into account the following figures, the sum of which determines the market value:

  • Fair market value of fixed assets and equipment (FMV/FA) – This is the price you would pay on the open market to purchase the assets or equipment
  • Leasehold improvements (LI) – These are the changes to the physical property that would be considered part of the property if you were to sell it or not renew a lease
  • Owner benefit (OB) – This is the seller’s discretionary cash for one year; you can get this from the adjusted income statement
  • Inventory (I) – Wholesale value of inventory, including raw materials, work-in-progress, and finished goods or products

This method places no value on fixed assets such as equipment, and takes into account a greater number of intangibles. This valuation method is best used for non-asset intensive businesses like service companies.

In his book “The Complete Guide to Buying a Business” (Amacom, 1994), Richard Snowden cites a dozen areas that should be considered when using Capitalization of Income Valuation. He recommends giving each factor a rating of 0-5, with 5 being the most positive score. The average of these factors will be the “capitalization rate” which is multiplied by the buyer’s discretionary cash to determine the market value of the business. The factors are:

  • Owner’s reason for selling
  • Length of time the company has been in business
  • Length of time current owner has owned the business
  • Degree of risk
  • Profitability
  • Location
  • Growth history
  • Competition
  • Entry barriers
  • Future potential for the industry
  • Customer base
  • Technology

Again, add up the total ratings, and divide by 12 to come up with an average value to use as the capitalization rate. You next have to come up with a figure for “buyer’s discretionary cash” which is 75% of owner benefit (seller’s discretionary cash for one year as stated on the income statement). You multiply the two figures to determine the market value.This formula focuses on the seller’s discretionary cash flow and is used most often for valuing businesses whose value comes from their ability to generate cash flow and profit. It uses a fairly simple formula — you multiply the owner benefit times 2.2727 to get the market value. The multiplier takes into account standard figures such as a 10% return on investment, a living wage equal to 30% of owner benefit, and debt service of 25%.This approach finds the value of a business by using an “industry average” sales figure as a multiplier. This industry average number is based on what comparable businesses have sold for recently. As a result, an industry-specific formula is devised, usually based on a multiple of gross sales. This is where some people have trouble with these formulas, because they often don’t focus on bottom line profits or cash flow. Plus, they don’t take into account how different two businesses in the same industry can be.

Here are a few industry multiplier examples, as mentioned in “The Complete Guide to Buying a Business” by Richard Snowden (Amacom, 1994):

  • Travel agencies – .05 to .1 X annual gross sales
  • Ad agencies – .75 X annual gross sales
  • Retail businesses – .75 to 1.5 X annual net profit + inventory + equipment

To find the right multiplier for your industry, you can try contacting your trade association. Another option is to utilize the services of a broker or appraiser who specializes in businesses such as yours.Copyright © 1995-2016, American Express Company. All Rights Reserved.