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So your clients think they're successful.

So Your Clients Think They're Successful

What do you mean, I'll have trouble getting a loan? I have a successful business here. I've worked hard to keep this business going." Or, "I can't believe that's all my business is worth ... and what does negative equity have to do with anything? I've made a comfortable living off this business and it's got a great future."

Such may be the start of a discussion between a small business owner and his accountant/consultant. Such a conversation really drives home the need for an understanding of what success is all about.

Success is an elusive term that evades precise definition. Edward de Bono in a recent book, Tactics: The Art and Science of Success, notes that, "To be successful, you have to be lucky, or a little mad, or very talented, or find yourself in a rapid-growth field." He refuses, however, to attempt a definition of success. Accountants are accustomed to the phrase, "different costs for different purposes." Similarly, there are "different success measures for different purposes." For example, small business owners may emphasize qualitative factors as contributors to success while other groups may stress financial measures. Those whose measures of success conflict with those of the owner create no problem until such time that the two groups need to get together to form some business alliance. Disagreement about the degree of success achieved by the business suddenly becomes an issue.

Capital Providers' Perception of Success

Investors and lenders alike have a definite penchant for measuring success via financial accounting measures. Since their responsibility is to safeguard either their own assets or to act as an agent for managing assets of others, such an inclination is not surprising. The common denominator for all investment activity is dollars and cents.

For start-up ventures, historical financial trends are obviously not available. In place of trend analysis, investors and lenders will depend heavily on the projected cash flows and pro forma financial statements as evidence of success. Such evidence is also indicative of a well-conceived business plan.

Once a historical perspective is established, financial ratios become critical success measures. Ratios which gauge a firm's profitability (return on sales or return on investment), asset productivity (asset turnover), liquidity (current or quick ratio) or debt utilization (debt/equity ratio) are all important to measuring past success as well as serving as indicators of future success.

Bankers in particular use hard financial data as the primary input variables in their bankruptcy prediction models. The qualitative, softer data are admittedly a factor but difficult to use. For investment decisions gone awry, loan officers would prefer not to defend their positions based on an assessment of qualitative data.

Owner Perception of Success

Previous research has demonstrated that bankers and small business owners have very different ideas about what it takes to be successful in business. These differences exist even on qualitative issues. Entrepreneurs tend to place more emphasis on less measurable characteristics than do loan officers. Owners may feel that initiative, confidence and caring are most important, whereas bankers are more likely to look to goal direction, planning and problem-solving ability.

A recent three-year study by the National Federation of Independent Businesses and American Express reports results which indicate that indeed entrepreneurial activities are initially motivated by qualitative factors. These include: using specific skills and abilities, having greater control over one's life, building something for one's family or simply tackling a challenge. The report further indicated that these motivations intensified over the three-year period. Fewer than half of the respondents indicated that "making lots of money" was a prime inspiration for starting their business.

It is not surprising then that small business owners are not in touch with financial success measures. From a financial perspective, as long as cash flows are adequate to maintain solvency and some cash is available for withdrawals, the owners are happy. Psychic income and dreams of the future make up for any deficiencies in real economic income.

Study Results

Given that owners and investors view success differently, an important question arises: Is there a relationship between business owners' self-assessment of the success of their business and the success of that same business as measured by its financial performance? In a study of small multi-unit retailers, our results indicate that there is very little correlation between business owners' self-reporting of success and their financial success as measured by profitability ratios.

Two sources of data supported this analysis. First, a questionnaire was sent to 162 small multi-unit retailers in Virginia. Each retailer surveyed was asked to use a five-point scale to rate the general level of success of his or her firm. Financial data for these firms were obtained from Dun and Bradstreet reports. These data permitted the computation of return on sales (ROS), return on assets (ROA), return on equity (ROE) and asset turnover (ATO) for each firm. In order to allow interindustry comparisons, these ratios were normalized using appropriate industry averages.

Retailers from eight different three-digit SIC code classifications were included in the study. These included women's apparel, men's apparel, shoes, gifts, jewelry, sporting goods, furniture and carpets.

As shown in Table 1, the respondents to the survey not only considered themselves to be successful, but successful at an above average rate. Overall the retailers saw themselves as successful at a 3.75 level on a five-point scale. This average varied very little when stores were separated by type of merchandise. Owners of home furnishings stores thought themselves slightly less successful (3.67) than did the gift, jewelry and sporting goods stores owners (3.86). Yet any real difference between store types on self-reported success was minimal.

Comparing the scores on self-reported success with the measures of financial success (ROS, ROE, ROA and ATO) revealed virtually no relationship. If self-reported success and financial measures were perfectly correlated, that is, both measuring equal levels of success, we would expect correlations at or very near to 1.00. As can be seen in Table 2, little correlation was demonstrated. Only the correlation between self-reported success and asset turnover for the total sample was significant at the 0.10 confidence level. Even this correlation is very low (-0.1812) and, surprisingly, is negative. Thus, the only significant relationship shown between firm owners' perception of success and financial measures of success is a slight inverse relationship with asset turnover.

Based on the results of this study, it appears that the way an owner views the success of the firm has little to do with typically-used measures of financial success. This dichotomy of views of success creates an area of possible misunderstanding between the "successful" small retailer and financial institutions to which they might turn for capital.

A Growing Market

New small businesses are growing at the rate of over 600,000 per year. Further, according to U.S. Department of Commerce figures, the rate of new business formation increased throughout the '80s. At the same time, Commerce Department figures also demonstrate an alarming increase in the failure rate of new businesses.

Many of these new firms will survive, however, and many will consider expanding their "successful" business. It is usually at this time that owners will seek out help from their accountants to assist with their expansion plans. Most ventures at this level are financed with commercial bank loans. However, capital may be available from other sources. New partners or shareholders may enter the business, venture capital may be available, or perhaps special arrangements can be made with vendors. Regardless of the source of new capital, as implied earlier, capital providers will incorporate some analysis of the financial statements as a major part of the investment decision. The same can be said if the owner is considering selling the business. The accountant will serve as a good independent source for injecting a dose of financial reality into the owner's vision of success.

Owners of firms considering expansion are not the only group to seek financial consulting help from their accountant. Firms facing seasonal or "terminal" cash flow problems will also be looking for additional capital. They too must understand the importance of their financial history as it influences outsider forecasts of the firm's future prospects.

The Consultant's Role

When a firm is ready to tap the capital markets, a discussion such as the one at the beginning of this article might well occur. The expertise of the accounting consultant is now invaluable to the owner in explaining how those important investors or buyers will view the success of their business. The accountant musts be prepared to explain several issues ill understood or perhaps forgotten by many entrepreneurs.

The explanation must do more than indicate what issues are likely to be stumbling blocks to deal-making. The accountant should be prepared to explain the validity of the concerns raised by outsiders. This may prove to be a more difficult task than one might imagine. Convincing business owners that their brainchild is not valued very highly by anyone but themselves can be quite stressful.

Some examples may serve to illustrate specific issues not well understood by some business owners. Much confusion can arise because of a misunderstanding of the difference between cash and profit. Over a period of time, cash withdrawals can seriously erode the firm's capital. Such erosion may feel very much like profits. However, the result of continuing to withdraw cash in excess of profits will eventually result in a deficit balance (negative equity) in the capital accounts. Owners who base withdrawals on what they think their expertise is worth (market value) as opposed to what the business can afford are prime candidates for this problem. Explaining the effect of negative equity to a client considering sale or liquidation can be a real eye opener for owners. Real growth, and thus value, can occur only when some profit or equity remains in the business.

The growth and value issue can lead to a discussion of financial ratio analysis, specifically, those ratios measuring debt position. The debt/equity or debt ratio give investors an indication of how much leverage or risk the business has assumed. All else being equal, firms financed largely by debt are not good candidates for either loans or prospective buyers.

Depreciation is another concept not well understood by owners. Again, the source of confusion is the distinction between cash and income. Since depreciation charges provide a drain on profit but not cash, the owner may be misled. Cash may be available during the early years of a new business while assets are being depreciated. At some point, however, those assets must be replaced. When that time comes, the owner may find that replacement has not been provided for and will thus seek external financing. Equity poor firms will find this financing hard to come by.

In summary, it appears that just as beauty is in the eye of the beholder, so it is with success. Owners who perceive their business to be successful must keep this axiom in mind when they find it necessary to convince others of their firm's success. This will be especially true when the owners plan a trip to the financial market for capital. Since the yardsticks for success may be significantly different, owners must be prepared to present their case using language and rationale capital providers find meaningful. The firm's accountant will serve well as tutor and liaison between these two groups. [Tabular Data 1 and 2 Omitted]

Larry N. Bitner, PhD, is assistant professor of accounting at the E. Clairborne Robins School of Business at the University of Richmond, Richmond, Virginia. His research emphasizes accounting for and management of small retail business. Judith D. Powell, PhD, is assistant professor of marketing at the E. Claiborne Robins School of Business at the University of Richmond in Richmond, Virginia. Her research includes small business exporting and retail security.
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Title Annotation:a small business owner and his accountant
Author:Bitner, Larry N.; Powell, Judith D.
Publication:The National Public Accountant
Date:Nov 1, 1990
Words:1974
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