When you look at your company’s income statement do you trust the net income number at the bottom? Or stated more directly, is your net income a fact… or a fantasy?

One thing that is important to understand about evaluating profitability is your net income is reliable only to the extent you have an accurate balance sheet.

• Your gross margin is only as accurate as your inventory
• Your sales and bad debt expense are only as accurate as your net accounts receivable
• Your repairs and maintenance (and related expenses) are only as accurate as your property and equipment balances
• Your overall operating expenses are only as accurate as your accounts payable and accrued expenses

In short, a sloppy balance sheet creates a fictional view of profitability. Which creates a whacky formula: smart managers + bad numbers = poor business decisions.

Here’s a little accounting secret that few entrepreneurs or CEOs truly understand. Financial statements prepared in accordance with Generally Accepted Accounting Principles (GAAP) are full of estimates. And the balance sheet is where most of those estimates reside (and accumulate).

It requires the time and attention of someone who understands financial statements to ensure those estimates don’t accumulate (and eventually rot and die) on your balance sheet. The accounts on your balance sheet need to be monitored, evaluated, supported and documented every month to make sure they are as accurate as possible.

Your Balance Sheet is Where All the Bodies Are Buried

It’s amazingly easy for “bad news” to accumulate on a balance sheet and remain hidden (sometimes purposefully and sometimes not).

Hidden surprises like:

• Old or outdated inventory
• Receivables whose collection is unlikely
• Prepaids that may or may not still be there
• “Other assets” with no detail to support the balance
• Payables and accruals that no one can see (because they aren’t on the books)
• Amounts recorded as capital expenditures that really should be expensed when incurred
• … and a lot more

Here’s a quote from a great book by Robert H. Hacker titled Billion Dollar Company:

“Most sophisticated readers of financial statements start with the balance sheet as evidenced in part by the fact that every audited statement prepared by a CPA begins with the balance sheet.”

He makes that point to encourage entrepreneurs to become knowledgeable about the financial side of their business… to become knowledgeable about their financial statements… to become intimately familiar with their balance sheet.

The Wise Approach

Maybe now is a good time to sit down with your CFO and have them walk you through your balance sheet. Have them show you at a summary level what makes up each of the balances. Have them show you that your balance sheet is super clean (hopefully it is) and that there are no nasty surprises or dirty diapers lying around in there.

You seldom walk into a really nice home only to find a dirty, messy, disorganized interior once you walk in. Let’s hope your business (and your balance sheet) is at least as nice and clean as your home.