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]
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.
What Makes a Good Financial Management System?
There is no one financial management system that works for everyone. However, every effective financial management system is based on a few simple principles.
Imagine for a moment you had the recipe to the best strawberry jam in the world. This recipe, a closely guarded family secret, has been passed down from one person to the next for decades. When people taste your strawberry jam, they are in raptures. They can’t get enough of it. Occasionally people even write poems about the stuff. People wait in long queues in the street just to taste it. And you’re the only person who knows how to make this product that brings in a limitless number of customers. Sounds like a recipe for success, doesn’t it?
Related: Not All Money is Created Equal
But imagine now for a moment that you have nothing to store your jam in. You have no jam jars or bottles or cans. You could make pots and pots of strawberry jam, but you have no way of bottling it.
There is simply no way to contain your precious jam. People arrive at your doorstep, eager to buy a bottle of the fruit-laden delicacy, and you have to turn them away. You offer a few good friends a lick off your wooden spoon, but you have no way of transporting any more than that.
Having no jam jars is a little like having a great business with no financial management system. You could have the best business idea, and the most talented financial staff to help you action it. But if there is no financial management system ‘containing’ the financial information of your company, then there is no way of keeping your business effective. Without a financial management system, your business is not much more than a big pot of jam.
We’ve combined our own ideas with some suggestions from Knowhownonprofit.org to help you establish good practice in the financial management of your business.
Your financial policies and systems must remain constant over time. If you establish a cash on delivery rule, for example, then your company needs to stick to that policy regardless of where you are in the cash flow cycle.
Your financial management system should create a paper trail that shows how resources have been used and who has authorized the decisions behind their use. Your system should create transparency, rather than make processes so complicated that it is difficult to determine who has done what.
The processes that your business adopts should demonstrate that your organisation values its financial resources and uses them for the purposes they are intended.
Compatibility with existing technology:
There are various bespoke financial management systems on the market, most of which come in the form of software, and all of which tout a complete financial management solution for your business. Before you spend many thousands investing in a system, make sure it is compatible with your existing technology.
What computers would be required to run the system? What level of training would employees need in order to use it? In addition, investigate who or what would be required to support the system, and at what cost.
Related: Do This to Improve Your Cash Flow
Accounting standards in South Africa are rigorous and extensive. Ensure that your financial management system complies with the latest accounting standards, and that there is a process whereby the system will be updated to reflect the latest changes, when they take place.
If you need guidance in implementing a financial management system for your company, The Finance Team can assist you. We have a team of highly qualified financial professionals who can provide you with part-time or interim advice according to your business’s needs. Together we can help you establish an effective system that will be the jam jars to your company’s secret recipe.
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