The New Companies Act will usher in significant changes for all companies, and particularly for small-to-medium enterprises (SMEs).
It will affect their accounting practices, obligations and requirements. All companies will be required to prepare financial statements, in line with international best practice.
Requirements for financial statements
The Act sets out that these financial statements must:
- Satisfy the reporting standards as to form and content
- Present fairly the state of affairs and business of the company and explain the transactions and financial position of the business of the company
- Show the company’s assets, liabilities and equity, as well as its income, expenses and any other prescribed information
- Set out the date on which the statements were produced and the accounting period to which the statements apply
- May not be false, misleading in any material aspect or incomplete
- Bear, on the first page of the statements, a prominent notice indicating whether the statements have been audited; if not audited, have been independently reviewed; or have not been audited or independently reviewed; and the name and professional designation, if any, of the individual who prepared or supervised the preparation of these statements.
Audits and independent reviews
Historically, all companies – both public and private – needed to have their financial statements audited on an annual basis. But this has changed under the New Companies Act, which has introduced an alternative to the audit that is of particular relevance to SMEs.
The Act stipulates that only public companies and companies where it is considered to “be in the public interest” will need to be audited. All other companies are only required to undergo an independent review. This will be carried out by an independent accounting professional and not by a registered auditor and the aim is to lower the regulatory burden for small businesses.
Of course, small companies can still choose to be audited if they so wish, and there are benefits to be considered when making such a decision.
The independent review
The current draft regulations to the Companies Act allow for three different levels of “independent reviews”. Theashen Ashley Vandiar, project director, auditing and members’ advice, at the South African Institute of Chartered Accountants (SAICA), explains that depending on the size of assets and turnover, a company subject to an independent review may be required to:
- Only produce a compilation report, as is currently the case with close corporations
- Have a review performed in accordance with International Standards on Related Services (ISRS 4400), a standard that relates to “agreed upon procedures”
- Have a review performed in accordance with International Standards on Review Engagements (ISRE 2400)
Pros and cons
On the one hand, the independent review could work out to be cheaper and less time-consuming and for these reasons has been welcomed by many small companies. An audit involves substantive procedures and requires the services of a registered auditor instead of an accounting professional.
However, as Vandiar explains, “what most fail to realise is that a review is a double-edged sword” and they need to seriously consider the value they will be getting from an independent review versus an audit.
A review will not provide the kind of assurance afforded by an audit (and frequently required by third parties such as financial institutions). Only the third kind of review, performed in accordance with International Standards on Review Engagements, provides some form of assurance.
“An audit involves tests of controls and substantive procedures and would ultimately result in an opinion being expressed by a registered auditor. An audit results in a reasonable level of assurance. An independent review performed in accordance with ISRE 2400, on the other hand, involves only enquiry and analytical procedures. An independent review thus results in only limited assurance being expressed by a practitioner,”says Vandiar.
A review may also not necessarily be quicker or cheaper, he adds. “In order for analytical procedures and inquiries alone to be meaningful, the person performing the review needs to have an in-depth understanding of the client’s industry and business environment, as well as a detailed knowledge of the client’s internal controls, management’s background, operating functions, and prior financial performance. A trainee clerk is unlikely to possess the minimum knowledge required to conduct a review engagement that will be of benefit to the entity.” In other words, the minimum qualifications and experience expected of the person conducting the review has a direct impact on the cost of a review. Reviewers should at least have a theoretical knowledge of auditing and belong to a professional body.
They are required to perform the review engagement in line with international best practices.
In summation, Vandiar says that the most significant difference between a review engagement and an audit boils down to the time taken to complete the engagement; and the outcome in terms of the difference in the level of assurance obtained.
“An audit is likely to take longer than a review, which, however, would result in the highest level of assurance, whereas a review performed in accordance with ISRE 2400 can only provide a limited level of assurance.”
Vandiar maintains that the cost of an audit would not be significantly different to that of a review performed in accordance with ISRE 2400. “Yes, other levels of independent reviews as described in the draft regulations would be cheaper, but they do not provide any form of assurance whatsoever,” he says.
A recent survey in the UK showed that of those companies exempt from being audited, some 80% chose to have their financials audited anyway. Vandiar advises that when it comes to deciding whether to have their financials audited or not, non-public entities should consider their stakeholder needs as well as their future plans to grow and engage public interest.
[box style=”gray,info” ]How to Calculate the Public Interest Score of Your Business[/box]
Small Business Has A Critical Role To Play In The Economy – But Entrepreneurs Need Better Financial Skills
While government is stepping up to support small business more than ever before, the sector will not thrive unless entrepreneurs are also equipped with the financial tools to optimise their organisations – UCT Associate Professor Mark Graham.
The role of small business in promoting growth and development has shot to the top of the agenda this year with both President Ramaphosa in his inaugural SONA and Minister Malusi Gigaba in his budget speech highlighting the critical role of this sector of the economy.
Globally, SMMEs are recognised as one of the key drivers of economic growth and job creation – and it is clear that the small business sector has led the world out of several global recessions – but in South Africa, the sector is under-performing.
Entrepreneurs need help to become sustainable
Recent data from the Global Entrepreneurship Monitor shows that South African entrepreneurship lags behind that in similar economies. And for every 1.5 people who were engaged in early-stage entrepreneurial activity in SA in 2016, one was exiting a business.
According to Mark Graham Associate Professor in Accounting at the University of Cape Town, typical reasons for business failure include: insufficient start-up funding, incorrect pricing for products or services, growing too quickly or prematurely, and inadequate cash flow.
“We need entrepreneurs to run their businesses successfully so that they can be sustainable,” he says. “Most of these issues can be addressed through a proper understanding of financial and accounting principles and concepts to help entrepreneurs run their businesses better.”
A growing understanding of financial principles
Graham, who runs the Finance for Non-Financial Managers programme at the UCT Graduate School of Business (GSB), emphasises that finance and accounting terms are really just a language that uses numbers to tell a story about a business.
“If you understand the fundamentals of financial principles you will be able to analyse what is happening in any organisation,” says Graham.
“Concepts like profit and cash flow are basic to business. However, people are often surprised to find that while a business can be extremely profitable, there may be a cash flow problem that will soon bring it to its knees.
Most people don’t know the basics of financial reports, what the right capital structure (i.e. the mix of debt and equity) might be. By getting to grips with concepts like working capital management and cash flow vs profit, business owners and managers can give themselves the best chance of success.”
Financial literacy is key to entrepreneurial success
Jannie Rossouw, head of Sanlam’s Business Market, agrees that financial literacy is key to entrepreneurial success and has argued that it should be integrated into the school curriculum so that future business owners can understand critical concepts like the time value of money.
“It is imperative that SA starts to spend significant time and resources to address the need for access to quality education aimed at those who want to pursue entrepreneurship and business ownership. We shouldn’t only start teaching these skills at the tertiary level,” says Rossouw.
And it is not just entrepreneurs that would benefit from a better grasp of the basics of finances, says Graham. All businesses should invest in developing the financial skills of their people – especially those in managerial roles.
“It is important for everyone working in business to understand the basic language of business and demystify the jargon – which is one of the things that the course I run at the GSB seeks to do,” he says.
“Feedback from previous course participants shows that people really appreciate being able to see how the numbers are telling a story about the health – or lack thereof – of a business and that this helped them make better business choices.”
Financial tools are needed to optimise businesses
“Sustainable small businesses have big potential to make a significant contribution to the SA economy and put a dent in the unemployment figures. So when Gigaba said that by enabling new businesses with new ideas to emerge and thrive, ‘we are radically transforming patterns of production in the economy’ he is not wrong.
But unless serious steps are also taken to equip owners and managers with the financial tools to optimise their companies, we will find that despite more proactive government policies and funding, the small business sector will still not thrive.”
Build A Financial Model
Start-ups often struggle to develop a suitable financial model for their new businesses. Here are some of the most important financial modelling considerations.
All budding entrepreneurs spend long hours typing up a well versed strategy document for their new entity, as expected. However, very often there is insufficient time allocated to the crux of the business, the numbers.
Definition: Financial modelling is the process by which a firm constructs a financial representation of some, or all, aspects of its business.
For any new start-up entity the initial necessity for assessing potential returns on new investment or seeking external funding can be a daunting process. Whether you are soliciting funds from an institution, or a high net worth individual investor, the financial projections could make or break your deal.
Although you as the founder are naturally optimistic about the new venture, be mindful that most investors would rather see the worst case scenario. This allows the potential investor/banker to take a realistic view on the maximum potential losses, should the business fold in the first 12 – 24 months. As such, it is recommended to produce a low, middle and high road model, for a three to five year period.
Inputs and outputs
Most importantly, always keep in mind that your financial model is nothing more than certain inputs producing certain outputs. By designing the model correctly, a user should be able to change certain inputs to assess the impact of these changes on the related outputs (commonly referred to as a ‘what if analysis’ or ‘stress testing’ a model).
By way of a simple example, your sales revenue line for any specific month should be a function of the number of products sold, at a specific sales price.
For ease of use, both you and a potential investor should be able to adjust either of these variables in order to see how resilient the business model is, should your assumptions be incorrect.
Other basic recommendations when building your model:
- Create an assumption page, clearly defining any assumptions on which the model is built. By linking certain variables to the assumption page the model becomes robust and user-friendly.
- Be as transparent as possible, showing all formulae that lie behind calculations. This allows the user to easily follow logic through the model.
- Aim for simplicity and ease of understanding. Over-complicating a financial model with unnecessary worksheets can confuse and overload the reader.
- When inputting projected overheads, deal with each line item separately, without consolidating. This demonstrates detailed thinking, and allows discussion around each expense if necessary.
- The model should evolve with the business. You should be looking to check the assumptions made at the inception of the business, with the reality of what is achievable, after having the benefit of hindsight. By tweaking the numbers accordingly, the model becomes a more accurate prediction of the business in the future. This should be an ongoing process.
- Beware of attempting to use a generic template that may not apply to your business. Trying to customise these generic models could complicate a would-be simple model. Building your own bespoke model from scratch is the cleanest approach, even if assistance is necessary. This forces you to learn the intricacies of your model, which will hopefully stand you in good stead.
- Many books and websites recommend a myriad of options when it comes to building financial models. As a principle, lean towards the concept of simplicity, provided you are able to integrate your model into regular projected income statement, balance sheet and cash flow statements.
Are You Crunching The Right Numbers?
Measure what matters and you will find hidden money in your business.
Defining true profits
Just because you sell at a profit, is that enough to be profitable? A mistake that many business owners make is that they don’t factor in net profit when calculating selling price.
The natural tendency of business owners is to focus on sales growth rather than net profit. So, what is net profit? Profit is on paper — it is not in the bank. It is the money left over each month after deducting all the cost of sales and expenses it generates and subtract them from all the revenue it creates. Net profit is also calculated after paying a market-related salary to the business owners.
Identifying the winners
What are your profitable products or services, and which aren’t? Gross margin is the most important component of any business as it enables your business to pay its overheads, pay you and make a net profit to continue to grow and be protected from adverse economic times.
Gross margin is calculated by taking the gross profit, that is, the selling price less the cost of the product or service, expressed as a percentage over sales. Most business owners make the mistake of just measuring gross margins, and if they are being achieved, cannot understand why there is no money in the bank. To find hidden money, gross margins cannot be calculated alone.
Measuring cash flow together with gross margins for each and every product you sell or service you provide will determine which products or services make you money, and which don’t. For example, if product X has a gross margin of 33,3% and takes six months to sell, you have effectively lost your margin as money has been used to finance the product instead of being utilised to purchase more of the same products at a far higher turnaround.
Which customers make you money, and which don’t? You need to know how much of each product or service each customer has purchased from you and the gross margin earned on each of those products or services sold and how much money each one owed your business at any given time.
This analysis will determine the profitability of each customer. If your marketing efforts are directed only at those customers that give you a higher gross margin without also measuring the cash flow of that customer, you’ll be making the unwitting mistake of selling to some of the least profitable customers.
Unlike products and services, customers are people, some very nice, others either hostile or simply undesirable. If you have any hope of building a business that maximises profit, fun, and your free time, you should focus on attracting customers that respect you and your team, who allow you to use your full talents, are respectful of your time and have reasonable expectations and demands of your business.
If a customer does not resonate with you and your business, don’t deal with them, as they will invariably take a chunk of profit from your business, and that’s not a good thing, is it?
Return on investment
Your business cannot make money for you if your investment in assets increases at a faster rate than your net profit. The two assets we are concerned about are inventory and accounts receivable.
Let’s say your inventory and accounts receivable increases by R58 000 and your net profit was only R35 000 for the same year, you will not see money in your bank. Don’t fall into the trap of increasing net profit and ignoring your business’s overall investment in assets.
By measuring what matters, you’ll be amazed how you can find hidden money lying in your business.
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