WHAT BUSINESS OWNERS ARE SAYING

ABOUT THIS BOOK:

“Peter has precisely targeted the core financial needs of small-to-
medium-sized businesses. He zeros in on the criticality of analytics
and the underpinning data and how to practically use it to drive
results. I have seen him successfully use this approach many times.”
Scott Marvel, CEO, Nexus Cognitive

“The concepts in Profit Peak really worked for us! We were able to
double the size of our business in five years. Getting all the right
players at every position is a winning formula.” Greg Hardin, CEO,
Diverse Marketing / Diverse Toy

“We have worked with the author for over ten years and we endorse
his profit-improvement techniques. By understanding our financial
statements and improving our financial modeling, we have minimized
our financial risks, improved our strategy, and received quick answers
to critical business questions. All these factors have been instrumental
in driving our earnings.” Gary Cravens, President, Advance
Components

“I didn’t understand what I was missing in our small business until I

started asking the question “What do CFO’s do?” We had a good
CPA and bookkeeper keeping us in line, but when the author began
implementing the concepts described in this impactful book as our
fractional CFO, I began to really know the financial side of our
business. Instead of just keeping score through the rear-view mirror,
we are now looking down the road ahead with forecasts, metrics,
strategies and processes that have cast new light on how to run our
business well, and profits have soared!” Dave Reichert, President,
Davis-Hawn Lumber & Architectural Millworks

“Profit Peak is an easy read and quick reference guide for business
owners seeking to improve their financial management practices. We
have benefited from the author’s knowledge and experience over five
years.” Allison Deen, Co-Owner, Eddie Deen & Company
Catering

“The lack of financial literacy is one of the most overlooked issues

facing our society today. We have an agency full of financially literate
employees with a business owner mindset – yes, even interns. The
concepts outlined by Peter Baldwin have been helpful to us and they
will help you to become more financially literate, too.” Michael
Rose, Founder & CEO, Mojo Media Labs

“Peter Baldwin helped us build a financial culture that includes

education, collaboration and the importance of tasking team members
to be fiscally responsible with corporate resources. Because of this
education, we participate in timely reviews of our financial
performance and are now better able to adopt new technology and
processes. Profit Peak will help your company establish and maintain
an industry leadership position.” Suzanne Cravens, Co-Owner /
CEO, Advance Components

“Like it or not, Peter Baldwin will prove to you that the numbers don’t
lie. By following his disciplined approach to collecting and analyzing
critical data and adjusting organizational behavior, owners /
managers can steer those numbers in more profitable directions.”
Dan Zimmerman, Serial Entrepreneur & Past President,
Manufacturing Company

“My six-year-old business was growing rapidly but forecasting cash

had become a real problem. We worked with Peter Baldwin to build a
predictive financial model that managed our sales growth and
additional capital needs as they arose. The concepts outlined in Profit
Peak kept us on track!” Greg Wood, President, Image
Reproductions

“Peter Baldwin used his unique skill set to develop a deep knowledge
and understanding of our business in a fairly short time. We used his
dashboard reports for a strong business overview and to identify
measurable metrics. With his entrepreneurial view, he quickly knew
what was important to the business and coached our team to
success.” Alan Putter, President, Amusement Management
International
A GUIDE to understanding financial expertise providers who work
with small-to-medium-sized firms…a BLUEPRINT for structuring
your finance and accounting department…a PRIMER on using
financial statements and analytics…and a ROADMAP to financial
management success.

Peter M. Baldwin, M.B.A.

Your Ten Percent, LLC
Copyright © 2020 by Your Ten Percent, LLC. All rights reserved.
No part of this publication may be reproduced, stored in a retrieval
system, or transmitted in any form or by any means without written
permission of the Publisher. Requests for permission should be made
at www.y10p.com
Limit of Liability/Disclaimer of Warranty: While the publisher and
author have used their best efforts to prepare this book, they make no
representations or warranties with respect to the accuracy or
completeness of the contents of this book and specifically disclaim
any implied warranties. The advice and strategies may not be suitable
for your situation. You should consult with a professional where
appropriate. Neither the publisher nor author shall be liable for any
loss of profit or any other commercial damages, resulting from
implementing the strategies in this book. Your Ten Percent, LLC is not
a CPA firm.
Printed in the United States of America

y10p.com

Cover, design, and editing

by Martha Carlisle,
pbandjdesigns.com
 This book is dedicated to
the many entrepreneurs—past and present—
with whom I developed, implemented, and refined
these operational finance tools & techniques.
A special thanks to my beautiful wife Nancy for
supporting me in this remarkable journey.
A heartfelt thank you to Martha Carlisle
for adding great clarity to the manuscript
and conceptualizing the book design and cover.
 YOUR FREE GIFT!

To get the best experience with this book, download the Profit Peak for
Entrepreneurs Workbook to assess your current financial management
capability and to plan specific improvements to your business.
You can grab a copy here:
www.y10p.com/profitpeakworkbook
 CONTENTS
Approaching Financial Management
Financial Expertise Providers
The CPA Firm
Controllership/Bookkeeping
Financial Strategist
Business Coach
Business Process Designer
Before You Select Your Financial Team
The Entrepreneur’s New Clothes: A Cautionary Tale
When Bad Things Like Fraud Happen To Good People
Bookkeeping Fraud
Inappropriate Use of Funds
Minimizing Fraud
Constructing the Finance & Accounting Department
Information Collection
Predictive Capability
Divergence of Cash and Profit
Stakeholder Cooperation
Typical Operational Finance Structures and Why Many Fail
Form One = Compliance + Bookkeeping Only
Form Two = Form One + Strategy Only
Form Three = Form Two + Business Process Design
Budgeting for Optimal Department Structure
Using Financial Statements To Improve Firm Performance
Balance Sheet
Income Statement
 Statement of Cash Flows
Financial Modeling Techniques That Maximize Firm Performance
Step 1: Forecast Firm Profit
Step 2: Forecast Firm Cash Balance
Step 3: Focus on Important Metrics
Using Variances to Analyze Firm Data
The Power of the 10% Success Principles
Principle 1: Target 10% Profit Improvement
Principle 2: Work within the 10% Threshold
Principle 3: Do More with 10% Less
Protecting Profit & Minimizing Loss
Cash Plunder
Data Plunder
Relationship Plunder
Business Plunder
Conclusion
Appendix A
Four Types of Financial Ratios
Appendix B
Leading Indicators by Category
Peter M. Baldwin, M.B.A.
Glossary
APPROACHING FINANCIAL
MANAGEMENT
“Opportunities multiply as they are seized.” Sun Tzu

As you read this chapter, think about the opportunities you have as a
business owner and what those mean to you in terms of financial
success. How would you define success for you and your business?
Where are you on the path to achieving that success?

IF YOU ARE LIKE MANY ENTREPRENEURS of small-to-medium

sized firms—defined as those firms with up to a couple hundred employees
and revenue up to around $30 million[1]—you are passionate about filling
customer/client needs but not as passionate about administering the
financial aspects of your firm. Your entrepreneurial drive led you to create
something special in the competitive world of business, but your financial
training may not come from formal sources. Your knowledge of running a
firm is likely from personal, on-the-job training (in other words, the school
of hard knocks!). Or, if you’re lucky, you may have training from other
experienced entrepreneurs. If you do have formal financial training, you
may feel the need to polish those skills.

The goal of this book is to give you a simplified, common-sense

approach that empowers you to leverage the full benefits of financial
management while maximizing your time doing what you like to do best.
Indeed, administering the financial aspects of your firm should not take
away from your ability to generate more revenue. The fact that you are
most likely a subject matter expert in one or more aspects of your firm is
impressive in itself; however, being both an expert and running your firm
concurrently is even more impressive—and perhaps for some who are new
at this, even intimidating.
This book’s premise is that you are experts in your chosen fields and are
looking for basic guidance—maybe some fresh ideas—from a financial
professional. I do not expect to wow you with professionalism and polish in
this brief guide, as many of you are quite capable and polished yourselves.
You do not want me to shock and awe you with an impressive litany of
terms; rather, you want practical knowledge that includes basic tools and
techniques to improve the financial management of your firm and that
fosters successful behaviors among your associates. I have endeavored to
use basic terminology that is intuitive to you and purposeful for your firm.
For further ease, the glossary at the end of the book contains definitions of
many bolded words in the text.
By way of background, I come from a family of industrial
entrepreneurs. My career began as a financial professional reconfiguring
finance and accounting departments in big companies. I eventually worked
for a Big 4 management consulting firm specializing in financial
management and business process design. I was privileged to work in a
wide variety of geographies and industries with large companies and
budgets. During this time, I noticed the disparity between the quality and
volume of financial talent in large companies versus the lack of certification
and training among finance staff in small companies. The large companies
were better run and less prone to financial mistakes due to the immensity
and variety of talent that they accumulated. Small companies, on the other
hand, lacked the people and monetary resources to gather the best
management practices and implement them in their companies.
Because small companies needed my help more than large ones, I left
big-firm life for the entrepreneurial world. I became a management
consultant with whom many firm owners have come to associate. I
packaged my financial management approaches in ways that are digestible
and affordable to small-to-medium-sized businesses (SMBs). I became
determined that no small firm under my influence would be regarded by
industry peers as small-minded, with weak financial management practices.
I developed, tested, and refined a variety of tools and techniques that
originated from world-class organizations, then repurposed them for small-
to-medium-sized firm owners. My objective is to teach firm owners how to
financially control their firms while minimizing the resources used to
establish and maintain that control.
In order to effect consistent, meaningful change across an entire finance
department and, ultimately, across an entire organization, these concepts
should be high-quality, fully integrated, budget-friendly solutions. Over the
last 18 years (in my post Big 4 life), I packaged these concepts into a
methodology that can be used to improve the financial management of any
firm. I have continued to refine this methodology while collaborating with
numerous talented professionals in over 30 companies. I hope this
experience and refinement will be useful to you today.
Let’s agree to meet each other on equal footing. I will focus on the
principles of financial management so that you can improve the
management of your firm without succumbing to the shortcomings of trial-
and-error financial management that erroneously relies on “winging it” and
on utilizing sometimes contradictory advice from financial professionals
who might disagree on how to spend your precious time and money. The
concepts under discussion—profit, cash flow, financial statement literacy,
and financial metrics—are grounded in basic principles used by all firm
owners regardless of the type of firm. While the principles do not change,
sometimes the administration of those principles change according to the
expertise and emphasis of the financial expert.
In the remaining chapters, we will explore different aspects of the Y10P
(Your Ten Percent) Methodology in the areas of securing the right kind of
financial expertise; preventing fraud; designing an effective operational
finance and accounting department; leveraging the power of financial
statements, metrics, and variance analyses; considering three Y10P Success
Principles; and protecting profit.
FINANCIAL EXPERTISE PROVIDERS
“A prince should show that he is an admirer of talent.” Niccoló
Machiavelli

While reading this chapter, think about your current financial staff in
terms of their competency and capability to cover all the major
financial needs of your business. How is revenue recognized on your
income statement? How are related expenses matched to that
revenue? How are expenses aligned to the appropriate accounting
periods?

NOT EVERY FINANCE PERSON OR FIRM is a good fit for the unique
needs of your firm. Before choosing a finance expert, it’s important to
assess the needs of your firm and correlate them to the skills of whichever
financial expert you choose. Before discussing the different types of
financial advice that you might receive, let’s look at five different categories
of financial expertise:
1. Certified Public Accountant (CPA) firms
2. Bookkeepers/controllers and associated firms
3. Strategic financial resources (such as chief financial officers, or
CFO’s)
4. Business coaches
5. Financial business process design consultants

The CPA Firm

The most prominent and best-branded type of financial expert is the
certified public accountant (CPA). A CPA earns a license through a
rigorous credentialing process that requires intensive schooling, testing, and
work experience followed by continuing education each year to maintain an
active license. What distinguishes the CPA from other types of financial
experts is the CPA’s singular authorization to audit, review, and attest to the
financial statements of companies. The CPA holds subject matter expertise
in the areas of financial statement preparation and internal controls (i.e.,
procedural and process safeguards that companies install to minimize the
risk of financial fraud).

In addition to this attestation work, most CPA firms are known for their
compliance expertise in federal and state tax law. Tax law can be very
complex and is subject to periodic change. Due to the high number of
taxing jurisdictions, types of legal entities, and industry-specific rules and
regulations, the specialized expertise from a highly qualified CPA can be
helpful in optimizing firm tax obligations and staying knowledgeable on tax
law changes. Any accountant can compile financials; however, only an
accountant with CPA credentials can audit and review those financials.
These audit skills are principally needed in publicly traded or venture-
backed companies where a CPA ensures that a firm possesses accurate
financials statements and strong internal controls.

Controllership/Bookkeeping
As the name implies, the controller, bookkeeper, or bookkeeping firm is
responsible for maintaining the daily financial records of the firm in these
areas:
● accounts receivable and accounts payable;
● employee payroll;
 ● bank and credit card reconciliations (ensuring external bank and credit
card statements match with the client’s internal record-keeping system);
● financial statement generation including the income statement (also
called the profit and loss statement, or P&L for short), balance sheet, and
statement of cash flows.
Collectively, these financial statements constitute the financial
scoreboard a firm uses to determine its health and ongoing performance. A
good bookkeeper understands and follows basic rules of accounting that
promote financial health, accuracy, and transparency. Chapter 7 discusses in
more detail what it means to keep good financials.

Financial Strategist
The firm’s financial strategist, commonly referred to as a Chief Financial
Officer (CFO) or other suitable title, is less compliance-oriented, less daily
transactional, and more firm-performance focused. A CFO’s responsibilities
include the following:
● overseeing the financial staff and assuring the appropriate subject
matter expertise is retained within the department;
● optimizing the bank balance and cash flow and focusing the team on
the firm’s financial statements and key performance indicators;
● developing an internal goal-based, measuring system that guides the
management team on what actions to take and how those actions affect
firm performance;
● utilizing analytical tools and metrics to benchmark the firm against
itself and industry peers and working with the team to set and achieve
financial goals;
● Managing the financial aspects of relationships with financial
institutions, customers, vendors, and shareholders;
● Mitigating the firm’s financial risks and possibly managing insurance,
human resources, and information technology.
The CFO is also responsible for answering these questions:
● What will the firm cash balance be in three months, in a year?
● What profit is the firm expected to generate this month, next month,
for the entire year ahead?
 This predictive capability empowers the CFO and the management
team to set realistic financial goals, incentivize themselves, and convince
external stakeholders (such as banks) to extend a line of credit or some
other desired financial instrument.

Business Coach
Some small companies retain business coaches in place of a financial
expert. Although business coaches are not typically considered technical
financial experts (i.e., those who primarily focus on improving financial
performance), they often wield some influence over firm initiatives. The
role of a good business coach is to improve the management and leadership
skills of the executive team, to act as a sounding board when important
decisions are being made, and to focus the team on formulating strategic
initiatives and connecting them to tactical actions. Some coaches
incorporate financial concepts such as return on investment (ROI) and
performance benchmarking, but the focus tends to be people-performance
based rather than financial-performance based. It is important to distinguish
coaching expertise from financial expertise. Coaching in no way substitutes
for a lack of financial talent on the existing team.

Business Process Designer

Business process designers, who focus on engineering business processes
within software systems, are normally employed at large management
consultancies. (See Chapter 4 for additional details about these specialists.)
Traditional clients include large firms with the financial capability to
engage a team of consultants who are trained on the interactions between
people, processes, and technologies. Typically, business process designers
organize how people interact with technology, seek the best blend of
insourcing and outsourcing, optimize workflows to best leverage the people
and technology, and implement technology that automates business
processes. They rarely target small companies because this type of expertise
is expensive and out of the range of most small-firm budgets. I’ve included
the business process designer role to illustrate that small-to-medium-sized
firms are at a disadvantage when it comes to working with financial
systems and changing imbedded workflows—unless there is enough
expertise to manage the requisite changes.

These different types of financial consultants (excepting the

technology-focused business process designers) typically fight for the
attention of the owner and may even recommend solutions that are not in
the best interests of the firm. A natural antagonism often exists between
these service providers; each wants to leave the client with the perception
that they (and only they!) are best at managing all things financial. Left
unchecked, these providers could play a king-of-the-mountain, winner-
takes-all game. Then the (unsuspecting) firm owner is left paying a
premium price for a fraction of the needed help, when a better solution may
have been cheaper.
As a final caveat, financial experts in these categories may also
specialize in a designated industry. Know what you need before you begin
interviewing candidates. Ask the right questions during the interview
process and know what service level you should expect from candidates.

Before You Select Your Financial Team

Finance and accounting work should not be given to amateurs, particularly
when firms lack adequate oversight of work quality. Unfortunately, firm
owners commonly hire financial talent without analyzing the strengths and
shortcomings of that talent. My observations over the past 20 plus years
indicate that small firms with inexperienced financial staff frequently
overlook two basic and essential accounting principles: revenue
recognition and expense matching.
One means of measuring financial performance is to divide the firm’s
income statements into accounting periods. There are variations on how
many accounting periods a firm uses and the definitions of those time
periods, but for simplicity, let’s assume that a firm measures itself on an
annual basis by using twelve monthly reporting periods.
Revenue recognition. According to the revenue recognition principle,
revenue should be recorded in the accounting period in which it was earned,
i.e., when the services were rendered or when the contractual obligation
was fulfilled. This concept seems intuitive, but companies with poor
accounting practices might recognize revenue too early due to
incompetence or for the purposes of misrepresenting themselves to a
stakeholder (e.g., a shareholder, investor, or bank). Misrepresenting revenue
is an unacceptable practice that not only deceives outsiders, but also blinds
the management team to actual firm performance.
Expense matching. A second accounting principle is expense
matching, which means that the expenses directly related to generating
revenue should be matched to the same accounting period. Indirect
expenses (i.e., those expenses not directly corresponding to revenue) should
also be aligned to the correct expense period. For example, unskilled
bookkeepers (of which, unfortunately, there are plenty!) may incorrectly
input two rent bills or two utility bills in the same period. This data entry
mistake results in double expensing in one period and zero expensing in
another period, which obscures the financial results of the firm in both
periods. This mistake usually occurs when the firm neglects to reflect the
actual date of the expense (accrual accounting), and instead enters the date
the expense was paid (cash accounting). Differences between accrual
accounting and cash accounting are outlined in Chapter 4. Remember that
one bookkeeping mistake may slightly disrupt the financials; however,
frequent mistakes can corrupt the financials.
The purpose of this lengthy explanation on the importance of adhering
to basic accounting principles is to emphasize the essential nature of quality
bookkeeping in order to avoid interruption of financial goals (at best) and
financial catastrophe (at worst). Before you hire, for instance, an untrained
but trusted[2] family member to keep the books; or that uncredentialed but
seemingly qualified bookkeeper who has been doing this forever; realize
you may be entering a potential financial minefield.

The Entrepreneur’s New Clothes: A Cautionary

Tale
One final thought: be careful when bringing in consultants to your business,
or you may wind up like the entrepreneur who thought he had new clothes
but was instead stripped bare. Here’s how the story goes:
Once upon a time there was an entrepreneur who had successfully
grown a business. He wanted to take his business to the next level but
wasn’t sure how. He knew a lot about customers and products, but not much
about financial and operational excellence. A regional consulting firm
convinced him to sign an expensive, long-term contract in exchange for all
the advice he would ever need to grow his company. At first the
entrepreneur was enchanted with hearing the cryptic language of
“consultese.” He convinced himself he would be fluent in no time. From the
outset, the entrepreneur was pleased with the engagement because the
advice he received sounded important. As the engagement matured, the
entrepreneur wasn’t quite sure what his consultants were working on, but he
rationalized that it must be important, considering all the money he was
spending.
The day came when the entrepreneur wondered whether he was getting
his money’s worth. Summoning his courage, he surprised the consultants
with a bold question: “What have you done for me lately?”
 They responded enthusiastically, “We are optimizing your company
with greater efficiencies that will give you a competitive advantage!”
Frustrated with trying to understand these ambiguous words, the
entrepreneur retorted, “You have until the end of the week to deliver a
tangible result, or our engagement is finished!”
The next day, the well-paid consultants cashed their paychecks and left
—never to be found again. That same day, the banker came by and
surprised the entrepreneur by saying, “You have no money!”
All the customers, suppliers, employees, and accountants gathered
around and marveled that the company had no money. They soon left; the
company went bankrupt shortly thereafter. The “consultants” lived happily
ever after.
WHEN BAD THINGS LIKE FRAUD
HAPPEN TO GOOD PEOPLE
“A thousand friends may not be enough, and one enemy may be too
many.” Turkish Proverb

As you review this chapter, think about how you can seek a balance
between trusting your team members to honestly perform their
responsibilities and verifying that they are acting in your firm’s best
interests. How do you ensure honesty among your employees? How
do you reconcile your financial records between different systems?
Consider also the degree of openness of your financial records,
separation of financial duties, and controls instituted to protect your
cash.

MOST ENTREPRENEURS WOULD NEVER DREAM of committing

financial fraud, or even suspect they would become a victim of it. However,
entrepreneurial firm owners—typically optimistic and trusting (and
occasionally naïve)—are acutely vulnerable to fraud. In my line of work, I
encounter financial fraud with about twenty percent of my small-to-
medium-sized clients.[3]

The cost of business fraud is enormous. According to one study, “Fraud

eats up five to six percent of a company’s revenue each year and hits small
businesses the hardest.”[4] Another study determined that “small firms can
suffer more than their giant counterparts. A 2012 study by the American
Association of Certified Fraud Examiners (AACFE) found that businesses
with fewer than 100 employees that were affected by fraud suffered a
median loss of $147,000, compared with $100,000 for companies with
1,000 to 9,999 employees.”[5]
 As a CFO who typically works with privately held, family-owned
businesses, I have seen my share of business greed. These cases often
involve embezzlement and misappropriation. Grievously, the perpetrators
are usually caught too late and rarely punished. The victim, sometimes a
business owner and sometimes an investor, is left holding the bag—an
empty money bag! Overcoming a financially damaging situation can take a
long time.

The Association for Certified Fraud Examiners[6] diagramed a Fraud

Triangle showing three main factors contributing to financial fraud:
financial need, opportunity, and rationalization. The perpetrator generally
has a pressing personal financial need that is unmet by his or her current
cash flow. The perpetrator then identifies an opportunity to surreptitiously
steal money in a way that minimizes the risks of being caught. Often, the
embezzlement strategy continues over an extended timeline and includes
rationalization of an ongoing need for the illicit cash flow, such as: “My
employer doesn’t need the money and won’t notice it’s missing.” Or, “I’m
undercompensated for the work I perform, which contributed to the
financial mess I’m in.”
Unless the proper financial controls are in place, fraudulent activity can
occur in a variety of ways:
 ● Employee Embezzlement. This involves the illegal use of cash by
someone in control of those funds. Some forms of embezzlement
include, but are not limited to, bogus reimbursement schemes (such as
with fictitious expense reports and vendor invoices), fictitious payroll to
a fake employee, credit card charging scams (cards thought to be closed
are used for personal charges and kept off the radar by paying minimum
balances), and skimming cash from cash-based transactions while
omitting or writing off the difference from the financial records.

● Internal Theft. This type of theft involves consuming or selling firm

property (e.g., inventory, office supplies, or other assets) for personal
gain.
● Kickback Schemes. This kind of employee theft occurs when
products and services are selected that financially benefit of one or more
employees but negatively impact the firm and its shareholders.
I’m amazed at the creative energy expended by people who perpetrate
fraud, and find myself wondering why they don’t expend this same energy
thinking of legal and ethical ways to generate income. Here are two recent,
personal experiences of business fraud.

Bookkeeping Fraud
A professional services firm had worked hard to grow its customer base.
The ownership team hired a confident bookkeeper to manage the financial
records. He was well compensated and highly trusted. The firm gave no
thought to putting financial controls into place.
 Several years into this bookkeepers’ employment, the company asked
me to provide strategic financial oversight. I convened the team regularly to
discuss finance structure and performance. During the meetings, the
bookkeeper agreed to action items but neglected to complete those items
afterwards. He defended his inactivity with excuses. In frustration, the
ownership team eventually investigated the bookkeeper’s workspace. Their
discoveries: the bookkeeper was embezzling company funds by creating
expense reimbursements to fictitious vendors; he also spent an extensive
portion of his workday surfing inappropriate websites.
Firing the bookkeeper, while necessary, did not mitigate the collateral
damage. The president not only suffered financial losses, but, for a long
time after, experienced an inability to trust anyone with her financial data.
The moral of this story is that having financial controls in place is crucial to
the success and well-being of a company.

Inappropriate Use of Funds

A specialty durable goods retailer was anxious to grow the number of its
nationwide locations. For each new store, the management team (consisting
of the majority owners) sought investment dollars from investors who were
rewarded based on the individual store’s performance.
The management team committed to an aggressive growth plan that
relied on the routine addition and immediate profitability of new stores. The
problem: only half of the new stores were profitable. The management team
routinely misappropriated investment dollars to cover store losses, fund
project overruns, and pay excessive management salaries.
This comingling of funds made it difficult for the management team to
keep agreements with those who had invested in profitable stores. So, while
the management team owed dividends to the investors, their cash was
insufficient to pay them. Impatient investors demanded to know why their
dividend checks were not forthcoming. Once the facts were on the table, the
investors, some of whom were attorneys, threatened to file criminal charges
against the management team. Ultimately, the investors took control of the
business.

Minimizing Fraud
Examples of business fraud are plentiful. The question is, what can business
owners and investors do to minimize the likelihood and severity of financial
fraud? It’s important to create an environment with a mix of fraud controls
in the areas of employee due diligence, bottom-up accountability, top-down
oversight, and risk mitigation.
● Employee Due Diligence. Run background checks on new hires.
Interview past employers. Look for inconsistencies on resumes. Avoid
hiring the cheapest assets on the market. Enforce company policies on
drug screening, technology usage, harassment, etc.
● Bottom-Up Accountability. Create and enforce finance department
procedures that focus on maintaining transparency of financial records
and on separating work duties (in the areas of invoice entry, check
writing, and vendor/account reconciliation) so that more than one person
has responsibility for cash flow. Build employee competency. Outsource
transactional and reconciliation work.
● Top-Down Oversight. Ensure that clear cash oversight comes from the
top. Questions to consider: What checks did I write? To whom? Was
there anything unusual to investigate? Use third parties to review the
books and look for fraud. All these controls encourage honesty by
putting multiple sets of eyes on the firm’s financial records.
● Risk Mitigation. Consider purchasing employee theft insurance.
As an entrepreneur, or as one who works with entrepreneurs, you have
every right to be optimistic about the future! Just remember to temper that
optimism with pragmatism, because when money comes along, greed
usually follows.
CONSTRUCTING THE FINANCE &
ACCOUNTING DEPARTMENT
“In everything we ought to look to the end.” Jean de La Fontaine

While reading this chapter, assess your ability to manage your firm’s
cash position as well as your ability to generate consistent, monthly
net profit. For purposes of seeking funding from a financial
institution, evaluate your firm’s ability to produce timely, relevant,
and accurate financial statements as well as your firm’s preparedness
to credibly predict future cash position and profit.

GIVEN THE VARIETY OF FINANCIAL TALENT AVAILABLE and

the owner’s clear and present need to protect the firm from deleterious
actions, what is the ideal structure of a finance and accounting department?
How can this department effectively collect, safeguard, and share important
information to accomplish its firm’s objective? The answer comes down to
three essential operating mechanisms: information collection, predictive
capability, and stakeholder cooperation, each with its own set of important
questions.
 Information collection. Questions to consider: Do I have good
numbers? What are they telling me to do? This information helps develop
performance histories and predictive capabilities around the two most
important firm success drivers—cash and profit.
Predictive capability. Do I have adequate cash flow now and in the
future, and does it support profit growth?
Stakeholder cooperation. Do I have the support of stakeholders?
Could I convince a financial institution or investor to invest in my firm?
The firm’s past performance and credible predictive capability should be
packaged in a way to gain the cooperation of key stakeholders—financial
institutions, customers, suppliers, employees, shareholders, and government
entities—who are concerned with the firm’s performance.
Three Finance Department Design Concepts, above, illustrates the
connection between these three important operating mechanisms. These
concepts are outlined in greater detail, below.

Information Collection
The first finance department design concept is the importance of
information collection. Two financial experts, the bookkeeping team and
the business process design consultant, provide a solid information
foundation by gathering and organizing financial information.
Information gatherer or bookkeeper. The main purpose of a
bookkeeper is to record all individual transactions as sales and expenses. A
lost transaction, or one that is left unrecorded, can easily happen. Therefore,
every aspect of the financial system should be procedurally controlled. In
the past, these transactions were largely paper-based; much of this is now
automated in computer systems. In addition to data entry, different financial
systems and ledgers need reconciliation; i.e., the bank ledger and credit card
ledgers should be tied out to the firm’s general ledger, which summarizes
the data from multiple subledgers (inventory, payables, and receivables, as
well as supplier and customer ledgers).
Questions for consideration:
● Did we receive that product or service as invoiced by the vendor?
● Did we pay the invoice at the right time (not too soon)?
● Did we ship the right product or fulfill the promised services to our
customers or clients?
● Were we paid on time?
● What collections actions are necessary and to what extent?
● There will always be discrepancies with the ledgers, so how do we
resolve those discrepancies?
While much of the bookkeeping work is routine and can be considered
a function of the administrative back office, some focuses on solving unique
problems or managing exceptions to standard business processes. These
more non-routine items typically involve personal interaction and are
known as front-office. Information gathering is often subdivided among
differently compensated staff with the lower compensation going for back-
office work and the higher compensation going for front-office work.
Information organizer or business process designer. This individual
or team plans the appropriate mix of people, processes, and technology.
This includes separating work into logical job descriptions with appropriate
pay scales; managing organizational charts; creating methodologies for
assigning staff positions; outsourcing highly proceduralized workloads to
obtain higher quality and/or lesser cost; streamlining appropriate people-
heavy processes with software; creating process flow diagrams to manage
processes; and conducting map-and-gap analysis for technology selection
and implementation.
It is the firm owner’s responsibility to create the most engaging work
possible for his or her employees; otherwise, the words of Fedor
Dostoevsky ring true:
“To crush, to annihilate a man utterly, to inflict on him the most
terrible punishments so that the most ferocious murderer would
shudder at it and dread it beforehand, one need only give him work of
an absolutely, completely useless and irrational character.”
Drudgery should be automated or outsourced. The outcome equals an
increase in personal productivity, which leads to firm productivity increases
and further to macro-economic productivity increases. Wages rise and so
does the quality of life for everyone involved. But I digress…

Predictive Capability
The second finance department design concept is the importance of
predictive capability.
Cash vs. Profit. Before discussing the concepts of prediction and
predictability, it is useful to distinguish cash from profit. Profit is a paper
view of how well a firm is doing and is conceptualized on a profit and loss
statement (or an income statement). Profit is defined as revenue less
expenses. Cash exists in an entirely different world; or at least for our
purposes, as the first line item on a different financial statement—the
balance sheet. The balance sheet characterizes the financial health of the
firm and is a function of assets (what the firm owns) minus liabilities (what
the firm owes). The difference between assets and liabilities is the firm net
worth, which is hopefully positive. Balance sheet health is discussed later in
Chapter 6.
 To illustrate the differences between cash and profit, consider the
diagram above, Cash Flow Versus Profit Matrix. Cash is depicted on the
horizontal access with poor cash flow to the left and abundant cash flow to
the right. Profit is on the vertical access with unprofitability depicted at the
bottom and profitability at the top. This depiction of cash and profit creates
four zones:
Zone 1, the goal of every firm, shows the best-case scenario: abundant
cash and profit! In this zone, firms hold the ability to self-finance growth
and/or pay owner dividends.
Zone 2 is common—the company is profitable but cash poor. In this
case, the business owner may not understand why the company generates a
profit but shows a low bank balance. Questions under consideration might
include: “My income statement tells me my company is doing well. Why
then do I feel so poor? Why am I struggling to meet basic needs such as
making payroll and purchasing materials and additional equipment? And
when will I overcome this struggle?” These questions are answered by
financially modeling the business.
Zone 3 is where new investments come into play. The business is not
yet profitable, but after receiving ample cash usually from investors rather
than from banks, the firm is destined to turn a profit and advance to Zone 2
or Zone 1.
Zone 4 encompasses unprofitable firms with negative cash flow. To
stay alive, these firms need to surgically change their income statement
(more revenue and less expenses) or fundamentally change their business
models. Zone 4 is a very stressful place to be.

Businesses that have not yet fully developed their operational finance
function often focus on cash flow, but they have no idea if they are
profitable on a monthly or quarterly basis. Their bookkeeping method
echoes their cash-basis tax compliance emphasis. Since compliance work is
typically only completed on an annual basis, it is quite difficult for these
firms to manage their profit by making timely changes as variances
manifest themselves. Cash-basis accounting simply means that revenue is
recorded when cash is received (not when the revenue was earned) and
expenses are recorded when bills are paid (not when the expenses are
incurred). A better operational finance approach utilizes accrual-based
accounting, which simply means that revenue is recorded when it is earned
(not when cash is received) and expenses are recorded when they are
incurred (not when bills were paid). The transition to accrual accounting
ensures all the revenue and expenses are aligned to the appropriate
accounting periods so that profitability snapshots can be taken during short
time intervals – usually months and quarters. With accrual accounting
properly implemented, it is possible to predict profit and respond to
financial trends.

Divergence of Cash and Profit

There are four primary reasons, outlined below, why cash and profit might
diverge from one another.
Discrepancies between Transaction Recording & Cash Usage
A firm may record revenue for one or more accounting periods, but the cash
receipt may not be received until a later period. Conversely, a vendor may
send an invoice, which is entered on the invoice date assuming that services
were performed within that accounting period, but that invoice may not be
paid until a later accounting period. The timing between a revenue or
expense item and when cash is received or paid to settle that item widens
the gap between cash and profit. Some recurring bills are received
predictably; others vary from month-to-month; it can become quite
inconvenient to adjust for the time difference in unpredictable bills.
Expenses that are Paid at Longer Time Intervals than Most Other
Expenses
If it isn’t enough to separate cash from profit, annual events must also be
allocated to less-than-annual accounting periods. Though property taxes
might be paid in January (at least in Texas), the expense associated with
those taxes is equally accrued across the twelve months/accounting periods
of the year. Other items like annual bonuses, franchise taxes, and insurance
(paid in fewer installments than there are accounting periods) also widen
the gap between profit accumulation and cash disbursement.
Cash Usage that affects both the Balance Sheet and Income Statement
Some cash expenditures do not appear completely on the profit and loss
statement but are included on a secondary statement—the balance sheet. A
typical capital expenditure, e.g., buying a building or a vehicle or some
other piece of equipment, will have an asset on the balance sheet in an
amount equal to the purchase cost of the asset and a corresponding liability
(note payable). As monthly payments are made, only the interest expense
flows to the profit and loss statement; the principal paid reduces the cash on
the balance sheet and a corresponding reduction is made to the note
payable.
Isolated Changes to Balance Sheet Items
Finally, the balance sheet can have a life of its own without ever affecting
the profit and loss statement. Cash on the balance sheet can decrease
because the average vendor accounts payable balance has decreased;
increasing payables from one period to another has the opposite effect.
Increasing client account receivables or inventory or any other asset is like
having a promise to receive cash, but the cash isn’t there yet. A decrease in
accounts receivable from one accounting period compared to an adjacent
one results in a cash inflow. Additionally, the ownership team may elect to
pay themselves dividends or take owner draws, which both lowers cash and
siphons the net worth of the firm while having no impact on the profit and
loss statement.
What does all this mean? There are many variables that affect both cash
balance and profit accumulation and sometimes cash and profit are far
apart. These concepts explain why a firm can be very profitable but cash
poor—at least for the interim. When you land that big project, your
accounts receivable may increase, but your cash balance may yet to be
affected. You may need to pay some expenses such as payroll before your
accounts receivable converts to cash so even though the income statement
appears profitable, the impact on your bank balance may be unfavorable.
Cash is king! It takes cash to pay your people and to run a firm to
generate income. By earning a consistent profit, the cash balance eventually
builds until the firm owner achieves a minimum cash balance that allows
the firm to weather considerable cash-flow storms. It can be said that cash
precedes profit, but it can also be said that profit precedes cash. The key is
to develop a predictive capability to manage both.

A financial strategist, such as the chief financial officer (CFO),

discussed in Chapter 2, specializes in this predictive capability. He or she
uses financial modeling tools to construct the income statement and the
balance sheet and facilitates management team interaction to plan each
variable that affects cash and profit. The financial statements allow for
comparison of historical performance with current periods and prediction of
future performance. Recognizing that the financial statements are very high
level and may not measure success behaviors, the financial strategist also
develops metrics, monitors results, challenges the appropriate people to
adopt the successful, measurable behaviors, and links those metrics to the
financial statements. It has been said that a football game is won by inches.
Likewise, a firm increases in profitability by incremental improvements to
its key metrics.

Stakeholder Cooperation
The uppermost, or third, layer of the finance department design concept
is the importance of stakeholder cooperation, which involves influencing
others to help achieve firm objectives. With a solid information collection
layer, followed by a well-thought out predictive capability, you are ready to
gain the trust of those not normally familiar with the day-to-day financial
performance of the firm. Predictability is the most important concept here.
What you had predicted becomes reality. Financial statements are not
haphazard, fly-by-night operations, but credible testaments to how you run
your firm. The financial strategist also manages stakeholder relations, for
example with the lenders. Stakeholders enter into agreements that optimize
the interests of the firm without creating undue risk for a financial
institution, creating a true win-win situation.
 You may have noticed that our construction of information collection,
predictive capability, and stakeholder cooperation did not include a CPA
firm or equivalent resource as a necessary ingredient. That omission was no
mistake. Our chain can best be labeled “Operational Finance &
Accounting.” The CPA lives in the world of “Compliance Accounting” and
for small privately held firms, has a much more limited role than in public
companies. In the privately held business world, CPA’s are utilized to
comply with compliance stakeholders such as the Internal Revenue Service
and state and local taxing authorities.
That is not to say that a good CPA will not delve into the operational
aspects of a firm, but often this delving is best left to other financial experts
who specialize in those areas. When a CPA is engaged to do basic
bookkeeping work, the rates are usually higher than if a bookkeeper were
retained. The firm ends up expending its finance and accounting budget on
an overcompensated resource rather than allocating its funds for a variety of
financial experts who can ensure all aspects of finance and accounting are
covered.
You might have noticed that business coaches do not receive a financial
role here. This is intentional; a business coach has no role with either
operational or compliance finance and accounting. The value-added role of
a business coach is outside the scope of this guide.
TYPICAL OPERATIONAL FINANCE
STRUCTURES AND WHY MANY FAIL
“War is ninety-percent information.” Napoleon Bonaparte

This chapter will help you evaluate your finance and accounting
department for competency gaps. Have you assembled the right
financial team? The right people will help you assemble the right
information for the right stakeholders. Have you budgeted
appropriately to retain that team? Two budget-fatal spending flaws
include overpaying less effective talent and underutilizing highly
qualified talent.

WHAT WOULD HAPPEN IF IN A CRITICAL BASEBALL GAME,

the shortstop decided to play pitcher? Or the outfielder decided to play
catcher? Or the pitcher was switched to cleanup hitter and expected to hit
home runs? In most cases, the position switches would fail because
different baseball positions require different skill sets. Why is it then that
business owners of small-to-medium-sized businesses (SMBs) expect
their finance team members to play positions that fit them poorly? What if a
baseball team fielded seven players instead of nine? We can all agree that
each position is critical to the success of the team. Sometimes, financial
skill sets that are critical for success are completely ignored, leaving the
firm with gaping management holes.

Frequently, business owners don’t understand why their existing

financial staff cannot help them gain financial clarity. Why is our cash
balance so low? What will be the impact on our financials if we invest in
this new business initiative? What will our financial outlook be in six
months? Often this lack of clarity is caused by inadequate under-standing of
how to assemble a financial team. How do you ensure regular, quality-based
financial statements? It starts with whom you select and what tasks you
assign.
Businesses cannot afford to put unqualified people in the wrong
positions or overlook filling critical positions. However, from my
experience, it is common to find structural weaknesses and staffing
deficiencies in many small companies. Here are common financial
structuring mistakes that hinder the progress of many companies.

Form One = Compliance + Bookkeeping Only

I can’t tell you how many times I’ve heard an entrepreneur in hot water say,
“I thought my CPA was taking care of me. I can’t believe I’m in this
financial mess.” Usually the mess includes poor financial performance and
inadequate cash flow. The in-house bookkeeper kept the books, paid the
bills, and collected invoices; however, nothing strategic was happening. The
owner mistakenly depended on the in-house financial person instead of
relying on a financial strategist.

Your CPA manages the annual tax filings and periodically looks at the
financials. Sometimes, the CPA compiles financials on a quarterly or
monthly basis. Yet, responsibility for these limited interactions does not
mean the CPA is paying attention to the firm on a strategic level. If you
expect the CPA to say, “I notice you have some problems with your firm, let
me come in and help you sort things out,” then you will likely be
disappointed. The CPA, busy performing compliance work for a multitude
of clients (with the goal of maximizing his or her own income), is unlikely
to expend time selling project work; not only is such work unguaranteed,
owners of small firms can be temperamental when it comes to paying for
unanticipated project work. Most CPA’s prefer to complete non-
controversial compliance work and receive pre-negotiated pay; they also
prefer adding new tax clients rather than creating new lines of revenue from
existing clients. Lacking a CPA or CFO for an advocate, the firm is left with
a bookkeeper to identify any financial train wrecks that may be coming
down the track. The problem is that bookkeepers are trained to focus on
transactional details rather than the big picture.
The illustration Form One = Compliance + Bookkeeping Only depicts a
firm’s inability to collect vital information, predict credible outcomes, and
invite stakeholder cooperation. In sum: if you want to dampen your
profitability, leave your cash flow exposed to undue risk, and maintain
vulnerability to financial calamities, Form One is a great choice. Of course,
this scenario is ridiculous, but Form One is a common mistake. When CPAs
fail to recommend hiring an operational finance expert, they leave
themselves vulnerable to blame.

Form Two = Form One + Strategy Only

A slight improvement over Form One is adding a strategic finance resource
to the team.[7] As discussed previously, the strategic finance expert (or CFO)
leverages the information collection capability of the firm and develops a
cash and profit predictive capability that encourages stakeholder
cooperation. When the information layer is managed by a bookkeeper (who,
in general, does not gather information to analyze business processes), the
information layer is most likely suspect and even faulty. No amount of
strategy makes up for bad information. Inevitably, the firm follows the old
technology adage: “garbage in/garbage out,” meaning predictive capability
is compromised. Financial institutions, prospective partners, or acquisition
prospects may find your predictions unconvincing and implausible.
 The previous diagram, Form Two = Form One + Strategy Only,
illustrates that without adequate business process design, a firm will have
difficulty collecting vital information.
 I once made the mistake of accepting a strategic finance assignment
without having control over the underlying software systems. The firm’s
outside CPA took a hands-off approach and didn’t understand how the
books were being kept. The bookkeeper, a close relative of the firm owner
and a chronic embezzler (as we discovered later), did not understand basic
accounting principles. I used the financial information supplied by the
bookkeeper to create an impressive predictive financial model, then
presented this model to the banker responsible for evaluating the firm’s
credit worthiness. Three months later, our financial projections fell
completely flat—they had absolutely no bearing on reality. Imagine our
unpleasant experience of returning to the banker and disclosing the firm’s
actual grim financial forecast. “We’re not making money,” we confessed.
“Instead, we’re losing A LOT of money!” After that, I vowed to always
ensure the quality of any financial information given to me.

Form Three = Form Two + Business Process

Design
The objective of a well-staffed and well-managed finance and accounting
department is to include a mix of financial expertise. The CPA maintains
the compliance schedules; the bookkeeper/controller manages the daily
transactions and the quality, timeliness, and accuracy of the financial
statements; the business process designer engineers the best blend of
people, processes, and technology; and the CFO covers the strategic aspects
of the firm. With this mix of expertise, the department collects the
appropriate level of quality information, implements a reliable predictive
capability, and maximizes the likelihood of stakeholder cooperation. Form
Three: Form Two + Business Process Design, above, illustrates this best-
practice approach to structuring a firm Drafting an operational finance team
is both an art and science. Your unique mix depends on your specific set of
circumstances (e.g., business size; budget; staffing mix of full-time, part-
time, outsourced; and technology automation).
The key to assembling an operational finance team is to pick a diverse
blend of resources who can cover all the company’s positional needs. While
you may find a Lebron James-caliber resource who can cover all the
positions, my experience indicates that such a find is rare and usually too
costly for companies with limited budgets. You are better off distributing
the workload among multiple resources.

Budgeting for Optimal Department Structure

Sample Finance Department Budget Allocation, below, shows one way to

structure or restructure a finance and accounting department. Keeping in
mind the total budget (payroll) for the department, 60 to 70 percent is
allocated for controller/bookkeeping; 20 to 30 percent for strategic finance;
five to ten percent for business process design; and five to ten percent for
compliance. The compensation share may vary depending on the size of the
firm and the complexity of the finance and accounting work, but you should
carefully include each type of financial expert in the budget.
Just like a championship baseball team that fields a full mix of well-
qualified positional players, a competitive business should field a well-
qualified financial team capable of covering all the bases. This setup
promotes financial clarity and timely decision-making.
USING FINANCIAL STATEMENTS TO
IMPROVE FIRM PERFORMANCE
“Never make a decision too soon or too late.” General George S.
Patton

At this point in the discussion, we’re shifting gears from financial

department structure and staffing to the importance of using financial
statements in decision making. Before you can assess the condition
and performance of your firm, you need to ensure the soundness of
your financial statements. How well do your financial statements
reflect your business model? How well do they indicate when you
need to make changes?

IF YOU WERE ASKED TO ANALYZE a firm for purposes of making

an investment, one of the most important analysis tools is a guided study of
the firm’s financial statements. Reading the balance sheet, income
statement, and statement of cash flows allows you to find answers to these
six questions:
1. Is the firm financially healthy?
2. How prepared is the firm to weather a business cycle downturn?
3. What capacity is there to pay dividends to shareholders or make
distributions to owners (depending on entity type)?
4. How profitable is the firm and how does that profitability compare to
similar firms?
5. How much growth can the firm handle without having to seek funding
from outside sources?
6. Is there enough cash being generated? How is that cash being used?
Answers to these questions will help you gain a basic financial
understanding of the firm and give you the ability to anticipate growth and
valuation trends. To help answer these questions, let’s first explore the basic
components of the three financial statements.

Balance Sheet
The balance sheet (see Firm ABC Balance Sheet, next page) answers the
first three questions, therefore it is important to understand its construction
beginning with its two-section categorization:
● Assets
● Liabilities plus equity
Assets always equal liabilities plus equity. If not, the accountants have
made a calculation error. Assets are what the firm owns, including cash,
accounts receivable, inventory, land, buildings, leasehold improvements,
vehicles, and equipment. Liabilities are what the firm owes and may appear
as accounts payable, credit card payables, accrued liabilities, and notes
payable. Equity is a measure of the net worth of a firm and is calculated
by subtracting total liabilities from the total assets. If a firm has a positive
net worth, then total assets is greater than total liabilities. Conversely, a
negative net worth means liabilities are greater than assets.
 Assets are further sub-categorized on the balance sheet as either current,
fixed, or other. Current assets are ones that are either already cash or easily
converted to cash; accounts receivable and inventory qualify here. Fixed
assets consist of properties and equipment that are used to either run the
firm or are listed as a non-operational firm investment. Other assets don’t
easily fit into the first two categories and might include lease deposits and
prepaid expenses.

Liabilities are sub-categorized into current, long-term, and other. The

difference between current and long-term liabilities is that current liabilities
are due and payable within one year while long-term liabilities are any
portion that will be paid outside of the next 12 months. Other liabilities
include anything not in the first two categories, such as a tenant security
deposit.
The equity section of the balance sheet may have different names
(depending on the type of legal entity used for the business) but the function
is the same. This section includes the initial investment in the firm used to
purchase equity shares or partnership interests, retained earnings from prior
years, net income or loss from the current year, and any payments to owners
that decrease net worth.
Maximizing assets and minimizing liabilities is the first and primary
goal of a business. The eventual second goal is to optimize the amount of
assets on the balance sheet by paying cash out as dividends or owner
distributions as appropriate.
The relationship between current assets and current liabilities is known
as liquidity and can be listed as working capital (current assets minus
current liabilities) and current ratio (current assets divided by current
liabilities). Liquidity measures the ability of the firm to pay its bills in a
timely manner. Sometimes the current ratio is further modified into a quick
ratio by removing inventory from the numerator. The goal is to have more
current assets than current liabilities. A positive value is expected in the
case of working capital and a ratio of better than one to one is expected in
the case of the current and quick ratios. Of course, the baseline expected
values vary by industry and a higher value is always more favorable than a
lower one.

The second important relationship on the balance sheet is the

relationship between debt and equity, also known as the solvency ratio,
which measures the ability of the firm to keep its doors open by managing
its existing creditors and its ability to gain new creditors. In this ratio, debt
is divided by equity and if the ratio is smaller than one-to-one, the firm is
generally considered solvent. The ratio can go much higher and a firm can
still be considered solvent, but for purposes of simplicity I’m using the one-
to-one ratio. A high ratio indicates that the balance sheet may be over-
leveraged and saddled with debt that cannot be easily unwound. The lower
the ratio, the more flexibility the firm has in pursuing new opportunities that
may require debt, which is often the cheapest investment source. Equity is
often considered a more expensive funding source as surrendering equity
shares to a new owner in exchange for cash creates a smaller share of firm
net worth for the existing equity owners. Though it’s true that “as long as
the pie is enlarging, everyone’s shares are increasing in value,” that vision
isn’t always realized. Be careful with bringing in new owners, particularly
in small-to-medium-sized firms. These financial ratio’s are summarized in
Appendix A.
The answers to the first two questions—Is my firm financially healthy?
and How prepared is my firm to survive a business cycle downturn?—stem
from the balance sheet, which is a snapshot of the firm’s financial health at
any given time period. It is a very interesting analysis to chronologically
compare balance sheets from different time periods to determine if the firm
health is improving, remaining constant, or deteriorating over time.
The most important period on a balance sheet is the most current, most
recently closed period. The second most important balance sheet view is
probably a future view, which is a management prediction of firm health at
a designated time point in the future. If the health outlook is poor, then the
management team has time to plan changes. A firm that is both liquid and
solvent is in good financial health—at least for the time being—as long as
the income statement produces positive results.
The third question—What capacity is there to pay dividends or make
distributions to owners and shareholders?—is also answered by the balance
sheet. With good liquidity and solvency ratios, the management team can
financially model how paying distributions to owners lowers current assets
since cash is a current asset and how it also lowers equity since dividends or
owner draws also diminish firm net worth. By making distributions, the
owners are deflating the assets and net worth from the balance sheet while
keeping the liabilities constant. This action will serve to weaken both the
liquidity and solvency ratios. Certainly, an entrepreneurial firm owner needs
to be rewarded with cash distributions for taking entrepreneurial risks—the
question is how much and how soon.

The firm has less obvious uses of cash—which also must be taken into
consideration. The firm may need growth capital if asset values are
increasing such as with accounts receivable and inventory balances. The
firm may need to maintain a minimum cash balance to weather any
economic or seasonal downturns. The firm may also need to use its cash for
a capital expenditure, which decreases cash but also may increase liabilities
creating a double whammy effect on the balance sheet. Assuming all these
needs are met, the excess cash can be paid out as dividends to shareholders
or as owner draws.

Income Statement
The income statement (see Firm ABC income statement, next page) shows
the layout of a typical income statement. answers the fourth question: How
profitable is the firm and how does that profitability compare to similar
firms? The income statement measures the firm’s performance over a
designated time period and begins with a listing of revenue items. Though
it is common to see many small-to-medium-sized firms with only one
revenue line, I encourage these firms to categorize their revenue into three
to five lines in order to emphasize a diversity of revenue sources. For
purposes of projecting future results, financial-minded individuals like to
know the composition of the revenue mix and the growth rates of the
respective revenue categories. Since revenue can be viewed in different
formats—by product or service line, by location, or by some other logical
division, the listing of revenue on the income statement should only be
considered one revenue view of that firm. Alternative views can be shown
with sub-reports and dashboards. Further down, the income statement
shows that sales revenue is gradually diminished by two categories of
expenses—cost of goods sold and operating expense—until revenue is
transformed into net income. Revenue that is diminished by cost of goods
sold is known as gross profit or gross margin. Gross profit minus operating
expenses equals net income.
 Expenses most directly related to sales are said to be variable
expenses. Expenses least related to sales are fixed expenses. The goal of a
good income statement is to classify as many variable expenses near the top
of the statement–usually in the cost of goods sold section with popular
examples including direct materials, direct labor, and direct overhead—and
fixed expenses, which are those expenses that do not vary with sales in the
lower expense portions of the statement. Such categories of fixed expenses
might include sales and marketing, non-direct payroll, operational and
delivery, facilities, technology, financial-related, and office expenses. The
grouping of expenses into logical categories helps with variance analysis
and financial modeling.

The final expense grouping is operational versus non-operational.

Operational expenses have already been discussed earlier in the cost of
goods sold and operating expense sections. Non-operational expenses are
everything else. Non-operational items can also include other income,
which is where this discussion starts. If the firm generates incidental
income such as through a rental property not connected to firm operations,
then that income is arguably not operational and should not be mixed with
operations. Interest income from investments might also qualify to be listed
as non-operational. Non-operational expenses, or other expenses, might
have to do with non-operational real estate expenses, prior-year adjustments
(when cleaning up a firm’s financials), and excessive owner payroll that
flowed through the income statement (instead of being a straight deduction
from equity on the balance sheet).
When creating financial statements, the goal is to have enough income
and expense items so that meaningful firm variances can be identified and
targeted for improvement. One popular expense category is other or
miscellaneous. These generic accounts are problematic because they are
not easily supervised.
The concept of financial return is detailed on the income statement
with help from the balance sheet. Four different financial measures, net
income, EBITDA (earnings before interest, taxes, depreciation, and
amortization), ROA (return on assets), and ROE (return on equity), have
their own usefulness, depending on the circumstances. We list many of
these ratio’s in Appendix A.
● Net income can be further refined as operating net income and is the
most straightforward measure as it consists of a subtraction of all
expenses from revenue. When net income is reflected as a percent of
sales, then it can be used to compare different companies or to
benchmark the firm to itself. This measure is the most common one used
by firm owners.
● EBITDA. Financial analysts like to compare firms across different
industries and asset levels. The commonly accepted way to do this is
calculating the EBITDA, which factors out the two expenditures—
interest and depreciation—that are most associated with an increase in
capital equipment. Non-tangible assets such as goodwill are not easily
compared across different firms, so the amortization of those expenses is
also factored out. And of course, companies in different tax jurisdictions
with different legal entity structures would not be comparable unless
income taxes are factored out. EBITDA is a useful measure to compare
multiple companies and determine the firm with the best return.
● Return on assets (ROA) is calculated by dividing the net income for a
given time period by the average book value of the assets on the balance
sheet for that same time period. This measure is more useful to industries
that use a higher than average number of fixed assets such as vehicles,
industrial equipment, and property. ROA measures how well the firm is
utilizing its assets. A low return may mean there are too many assets; a
high return means the assets are being used effectively and new assets
might need to be purchased. ROA is a good benchmarking measure to
compare asset-rich companies in similar industries. Self-improvements
in the ROA metric can be targeted by increasing the utilization of assets
and by being more careful about the value proposition before buying
 new assets. It is less useful in industries where fixed assets are not a
material income producing factor. In Appendix A, we classified the ROA
ratio as an Efficiency ratio rather than as a Performance ratio since ROA
measures how well a firm utilizes its assets.
● Return on equity (ROE) is similarly constructed as return on assets
except it replaces assets in the denominator with average equity. Equity
shareholders in publicly traded companies use this metric to determine
how well their equity value is increasing based on firm earnings. In fact,
many analysts and shareholders of publicly traded companies prefer this
metric. For firm owners of privately held firms, the ROE metric is not as
useful.
The fifth question—How much growth can the firm handle without
having to seek funding from outside sources?—is the most comprehensive
question. It combines the components of the balance sheet and income
statement. To answer the question, figure out how much profit is being
generated on the income statement. Understand the lag between profit
generation and receiving cash from that profit. You might need to increase
accounts receivable, inventory, and capital assets as part of firm growth.
Model these interactions and run different iterations of the model based on
growth scenarios—aggressive, expected, and less-than-expected. Factor in
changes to liabilities that affect cash as well as any obligations to
shareholders or owners who may require cash. Since the income statement
and balance sheet are built to work together, the financial model will
indicate when to inject cash into the firm, as well as how much. Chapter 7
continues this discussion on financial modeling.

Statement of Cash Flows

Our introduction to financial statements at the beginning of this chapter
mentioned a third statement—the statement of cash flows. The statement of
cash flows categorically answers the sixth question—How is my firm using
its cash?
 The statement of cash flows focuses on sources and uses of cash over a
defined time period. The divisions of cash sources and usages are:
operations (changes to income statement items and balance sheet current
asset and current liability items); investment (changes to non-current assets
such as with equipment purchases or sales); and financing (changes to
balance sheet liability items associated with non-current liabilities and
equity changes such as with shareholder dividends). As discussed earlier,
the cash balance of a firm is affected by the amount of income generated
and is adjusted by any changes to balances on the balance sheet; therefore,
the statement of cash flows can be completely constructed by amalgamating
cash-affecting items from both of those statements. Although analysts, who
look at multiple firms from a 30,000-feet level, find the statement of cash
flows to be useful, operational finance people like me find its contents to be
worth far less than the value of any time spent in managing them. I prefer to
analyze cash at its source—the balance sheet with the influences that come
from the income statement.
FINANCIAL MODELING
TECHNIQUES THAT MAXIMIZE FIRM
PERFORMANCE
“Where there is no vision the people perish.” Proverbs 29:18

Running a business involves making sense of the past, managing the

present, and modeling the future. Your financial statements must be
precise with respect to performance measures. Profit, cash, capital
expenditures, dividends/distributions, and key performance indicators
all come into play. As you read this chapter, think about how you
measure success, then brainstorm ways to improve those
measurements.

FINANCIAL MODELING IS AN EXTREMELY VALUABLE

EXERCISE that is sometimes overlooked by smaller firms unaccustomed
to developing a strategic finance competency. Without an ongoing focus on
data compilation and comparison, firm leadership lives in the void of data-
less decision-making based on “educated” guesswork or intuition—these
decisions can be either too late or largely incorrect. A late decision is
doubly potent—it incurs both a direct cost of mis-utilizing cash resources
and an opportunity cost of not pursuing a better course sooner. Incorrect
decisions waste time and money and disrupt strategic relationships.
Conversely, the right data can empower firm leadership to make the right
decisions at the right time. Even with better firm data, entrepreneurial
owners will have plenty of “hindsight is 20/20” realizations, but it is in their
best interests to minimize the quantity and impact of those mistakes.
 Financial modeling empowers the management team to improve its
financial performance by understanding what happened in the past,
envisioning what will happen in the future, and making changes to the
present in order to achieve the desired outcome. These financial
management data sets—past, present, and future—originate from the
managed firm’s own data and from comparable companies. Often industry
trade associations compile this comparable firm data into some form of
industry dataset that can be regularly accessed for comparison purposes.
Financial modeling begins with a major focus on the income statement
and a minor focus on the balance sheet. Remember, the income statement
informs us of ongoing performance events that, for better or for worse, roll
into the balance sheet and, thus, affect the firm’s financial health. Three
areas of focus for financial modeling include income statement, balance
sheet, and key performance indicators.

Step 1: Forecast Firm Profit

Step One forecasts firm profit by developing an income statement profit and
loss predictive capability. Do this by comparing data lines to the total sales
line in the same accounting period and comparing each data line to itself in
different accounting periods. For firms that have a relatively flat revenue
stream, the percent of sales ratio works well for both variable costs and
fixed costs. In companies with meaningful revenue change (growth or
decline) scenarios, fixed cost percentages will diverge as revenue changes.
In these common revenue scenarios, the fixed cost percent of sales
helps establish a baseline, but once that baseline is established, the budget is
built based on the actual fixed cost in dollars rather than as a percentage.
Use this data to compare across any of the following time periods:
● current month vs. the same month last year;
● current quarter vs. the same quarter last year;
● current rolling three months vs. the same three months last year;
● current year-to-date vs. last year-to-date;
● current full year actual plus forecast compared to last year’s actual
performance.
In addition to comparing historical actual data, establish two types of
predictive data sets on the income statement:
 ● budget (i.e., management’s best estimate of the upcoming year’s
financial performance)
● forecast (i.e., periodic updates to the revenue and expense
assumptions as a response to monthly trends. Note that these changes do
not alter the original annual budget.)
Keeping an annual budget and a rolling forecast gives management two
predictive data sets for comparing to past performance.

Step 2: Forecast Firm Cash Balance

Step Two forecasts the firm cash balance by developing a balance sheet
predictive capability. The balance sheet changes each period as a direct
response to income statement earnings (or lack thereof) that roll into the
equity section as current year retained earnings. The goal is to manage all
other variables on the balance sheet and allow cash to be the plug number
(i.e., the uncontrolled variable) to determine if current assets (such as
accounts receivable and inventory but not cash) and current liability (such
as accounts payable) balances will change.
Next, look for changes to long-term assets and liabilities. Will cash be
used to purchase a fixed asset, or will it be financed? How will the expense
of the asset flow off the balance sheet to the income statement? What will
be the expected periodic decrease in notes payable?
Finally, calculate the owner distribution or shareholder dividend policy.
What distributions are the owners or shareholders expected to authorize as
part of an ongoing distribution strategy? Once these questions are answered,
input all the forecast variables and determine a cash projection for any
future time period.
As a matter of practicality, I don’t usually do regular forecast changes to
current assets and liabilities. I may adjust these numbers occasionally to
right-size the forecast. One discretionary tool is to boost the cash balance by
increasing collections and/or slowing payments. Since these tools are used
on an as-needed basis by a management team looking to optimize the short-
term cash flow, they really don’t affect the estimate of the mid-to-long-term
cash balance; therefore, I tend to leave these variables alone. Do the
occasional sanity check on the balance sheet to current assets and liabilities
by comparing the forecast to the latest actual performance and resetting
those balances as appropriate. That infrequent process should be enough.

Step 3: Focus on Important Metrics

Step three focuses on important metrics that reflect key financial
information or that directly drive firm success. Earlier discussions included
solvency and liquidity metrics, as well as some gross margin and earnings
metrics. These metrics as well as the following Efficiency metrics are
outlined in Appendix A.

Payroll. In addition to using those metrics, it’s important to manage

payroll costs with efficiency metrics. Payroll is usually a major cost for any
firm, but in the case of professional service firms without large expenses for
materials, tightly managing payroll efficiency (i.e., total payroll cost
divided by total revenue for a certain period) is doubly paramount.
Benchmark performance against industry expected norms. To eliminate
noise in the upper echelon of the income statement, alternatively divide
payroll by the gross margin, which naturally will be a higher percent than
payroll divided by revenue.
Marketing vs. revenue. One important metric for a small, growing
firm is marketing expense versus revenue. Small firms that rely on direct
referrals are commonly underdeveloped in marketing and underbudgeted in
traditional marketing expense categories. In these cases, the marketing vs.
revenue ratio appears low compared to industry averages.
Leading versus lagging indicators. Financial metrics can be
considered lagging indicators of success as they reflect financial success,
but they do not necessarily drive firm performance. Appendix A outlines
some common lagging indicators that reflect firm health and performance.
As part of the metrics identification process, it’s important to find leading
indicators, which are usually activity based, the completion of which lead
to financial success – the lags. Appendix B illustrates some sample leading
indicators that have been categorized as related to revenue, operations, and
sales activities. Look for activities that when performed, complete the sales
and delivery cycles.
Common sales metrics include:
● referrals generated
● prospecting calls made
● proposals given
● client deals signed.
Common operations metrics include:
● hours billed
● activities completed
● realization (i.e., work time allocated as billable work vs. non-billable
work, including any write-offs).
An internet search will suggest other metrics that apply to individual
firms.
USING VARIANCES TO ANALYZE
FIRM DATA
“Facts do not cease to exist because they are ignored.” Aldous
Huxley

As you read this chapter, think about the effectiveness of your current
budgeting process. Who are the people involved? What do they do?
How are unsettling facts uncovered and addressed? How are
meaningful successes replicated and expanded? This chapter will help
you answer these questions.

IT’S NOW TIME TO COMMENCE AN ONGOING, periodic variance

analysis and forecasting process—usually monthly, but sometimes quarterly
—in order to regularly identify significant variances and target them for
improvement. Many popular spreadsheet programs, which support
conditional formatting on variances, can help you identify and prioritize
unexpected changes to your financial statements and key performance
indicators.[8] It’s crucial for the senior management team to regularly discuss
the firm’s financial performance. By doing so, they can implement
improvements in a timely manner (vs. waiting too long to identify and
remedy a variance).

Look for three to five variances during every variance analysis review
session. Assign the study and resolution of those variances to various
management team members. Three variances categories are possible:
● Poor accounting, which creates a smokescreen over the actual financial
performance. The potential for this problem is greater when the incorrect
 resources are retained for bookkeeping work.
● One-time anomalies; i.e., a charge came through that is difficult to
budget, or several months’ worth of expenses came through in one
month.
● Systemic change for a revenue or expense item. Questions to consider:
Why did this change happen? Is it a good change? Is it permanent? Once
those questions are answered, the forecast for that item should be
updated in order to reset the profit and cash balance projections.
Once you have taken care of these variances, you are better empowered
to steer your firm to success.
In the following charts, Firm ABC Income Statement and its extension
on the subsequent page, some positive and negative variables are easily
identifiable. For instance, Revenue Line A was over forecast by $200,000
though it exceeded last year’s revenue by $190,000. Conversely, Revenue
Line B was above forecast by $50,000 and above last year’s total by
$100,000. The sales & marketing budget was increased to $50,000, but the
actual has been $40,000. Last year’s marketing expense was $25,000.
Payroll is over the forecast by $10,000 and $30,000 more than last year.
These variances and others like them may all be candidates for
investigation.
THE POWER OF THE 10% SUCCESS
PRINCIPLES
“The [entrepreneur] who moves a mountain begins by carrying away
small stones.” Confucius

The previous chapters focus on staffing, structuring, and financially

managing your firm. This chapter introduces a powerful financial
engineering principle that encourages you to set realistic goals. Over
time, these goals will empower you to achieve large victories. As you
read this chapter, consider areas in your business to target for
improvement.

THE NUMBER TEN IS CONSIDERED BY ancient historians and

philosophers to symbolize perfection. Ten is the foundation of our decimal
numbering system. The Greeks popularized the decathlon, a series of ten
competitive sporting events. In biblical times, there were ten commandments
given to Moses, ten plagues were inflicted upon Egypt, ten tribes became
lost, and a tenth of income was donated for a higher purpose than one’s own
needs.
I have organized this chapter into three financial engineering techniques
based on the number ten. I call them The Power of 10% Success Principles.
They include:
● Target a 10% Profit Improvement
● Work within the 10% Threshold
● Do More with 10% Less
These financial engineering techniques are designed to predictably and
rapidly help improve cash flow and profit.

Principle 1: Target 10% Profit Improvement

Business owners should constantly target profit improvements in the ten
percent range. I call this the Target 10% Profit Improvement principle.
 Suppose you are the owner of a $10 million revenue business that has
variable costs of 60% and fixed costs of 30%, leaving you with a net profit
margin of ten percent. Refer to the baseline assumptions table below.

That means for every dollar in sales, you are left with ten cents as
bottom-line profit. Now, let’s see what happens when we target a ten percent
financial improvement, meaning instead of generating $1 million profit, we
target a profit increase of ten percent or $100 thousand.
To achieve that $100 thousand profit increase, you have three options:
● Option A: increase revenue by 2.5%;

● Option B: decrease variable costs by 1% of sales;

 ● Option C: decrease fixed costs by 1% of sales.

Targeting any of these three improvements will increase profit by the

desired ten percent.
What would happen should you simultaneously try to improve in all
three areas and only experience an average of 50% success rate in each area?
The table in Option D outlines this scenario. If this is the achieved outcome,
you would still have increased revenue by 1.25% while decreasing variable
and fixed costs by one-half percent, respectively. The result is a 12.3% net
profit margin, exceeding your targeted ten percent profit improvement by an
additional $50,625 for a net profit increase of $150,625.

What would happen if you simultaneously implemented the targeted

profit improvements in all three areas? See Option E below. Your original
net profit margin would increase by an extra 14.5% to total over $300,000
extra profit, a 30% profit increase ($1.3 million instead of $1 million).
 Let’s say that you are confident that instead of revenue growth of 2.5%,
you can reach growth of 5% while knocking two percentage points off
variable costs and fixed costs respectively. In that case, your net profit
margin becomes a profit increase of over $600,000, a 60% profit increase!
Option F outlines this scenario.

Finally, let’s shoot for the stars and triple our revenue increase and cost
reductions. See Option G below. By increasing revenue by 7.5% and
decreasing variable costs and fixed costs by three percent respectively, we
nearly double profit. Our original profit of $1,000,000 becomes $1,922,500,
an increase of 92%! Our net profit margin increases from ten percent to
17.8%.

The difference between having a little profit and a lot of profit comes
down to how well you apply the 10% Profit Improvement Principles to your
business. The idea that you should work on product line profitability while
cutting out excess cost is a high priority and well worth the effort applied.
And even if you shoot for the stars and miss, you may just hit the moon
instead and be well pleased with the results!

Principle 2: Work within the 10% Threshold

It is easy to get overzealous and apply financially engineering techniques to
situations that require more than financial expertise. In order to promise and
achieve realistic results, we must remember to operate within a band of
improvement that focuses on steady improvements and not quick fixes. I call
this the Work Within the 10% Threshold principle. That means that if we
are working with a company that is losing 10%, or losing one dollar for
every ten dollars in sales, we have a realistic short-to-mid-term chance at
improving earnings from ten percent loss to break-even (an increase of ten
percent). In this situation, we are not yet in the position to earn a healthy
10% or even a 20% profit margin. We need to set reasonable improvement
goals and focus our efforts on steady financial improvements. Ask yourself:
● Are my financials produced on a regular, usually monthly basis, and
reliably accurate?
● What are my financials telling me to improve?
● If I could choose three to five business improvements this month, what
would they be?
Some improvements will take more than one month to complete—you
just need to be in the habit of re-selecting them each month and evaluating
the progress.
Let’s discuss a few more examples. Let’s say we have a break-even
company, e.g., for every dollar sold, we spend a dollar. Not much of a return
for business owners who would be questioning why they are assuming the
risks of being in business, if they can’t generate a return on their investment.
We can reasonably expect to target a ten percent improvement, allowing
ourselves to go from a break-even company to a ten percent profit company.
The final band is the ten percent net profit company desiring to go to 20%.
That is an entirely reasonable goal for many companies in many industries!
It is within this range, that the firm starts seeing economies of scope and
scale. Less fixed cost effort is required to generate an increased return. The
20% range is where all companies should aspire to. By all means, go above
that range if you can, but just recognize your threshold parameters and work
from one range of ten percent financial return to another.
Companies that desire or need (due to financial or investor constraints)
to increase their return by more than ten percentage points within a short
time period are most likely being unrealistic. In these cases, more expertise
is required than just financial engineering. The business model may be
inadequate to generate that level of return or the leadership team may be
misinformed or need training in multiple areas of the business. Naturally,
financial engineering will play a role in these situations, but it typically
won’t be the exclusive consulting role and often not the lead consulting role.
The business must be placed in critical care! Serious coaching is required.
Remember, when targeting financial improvements, work within the
10% threshold.

Principle 3: Do More with 10% Less

The third principle is Do More With 10% Less. Gone are the days when we
can just throw money around to make problems go away. We must do more
with less! Ten percent less is a good target. An amazing thing happens when
we link employment with productivity. The most productive resources in
your company can and should command the most of your time, energy, and
money. The least productive should not be coddled. When a company
develops a perpetual waste-trimming mindset, then your people are
constantly on the lookout for cost savings. Consider the following, a passage
from my book entitled Winning in Business: Seven Leadership Secrets from
the Battlefield.
“Let me share an example from long ago that illustrates the ability of
an organization to do more with less. The year was 1211 A.D. and the
setting of our story is Northern Mongolia. Genghis Khan has
successfully cut a swath of victories across the Gobi Desert with the
goal of consolidating the Mongol tribes. At the backdoor of his rapidly
expanding conquest path, a formidable threat arises. The Chinese
army of Cathay consisting of a quarter million well-trained, battle-
hardened soldiers is amassing itself and preparing to march on Khan’s
territories.
 “In response, Genghis Khan sends a small, but determined
Mongolian army on an arduous night march to stop the Cathay
advance. To protect themselves from conquest, the Mongolians choose
to attack before being attacked. The night before the battle, a group of
senior Mongolian officers study their plan. Among them stands a
rather unassuming leader—Yasotay—who commands the elite
Mangoday attack force. Yasotay’s humble nature cloaks his incredible
success record.
“Knowing their desperate peril, several of the officers are
worried. At the end of the meeting, one of the more seasoned officers
asks Yasotay his opinion of the pending battle. The following
conversation ensues:
“‘The Cathay are dangerous,’ responded Yasotay, ‘too bad for
them, but they, of course, will lose.’
“‘Would you permit me to ask you why you think so?’ asked the
senior reserve officer whose head was covered with grey hair, ‘since
they are known as good warriors: they are defending their homes and
their country and their numerical superiority is difficult to describe…
Don’t worry, we will fight like tigers, but don’t think that badmouthing
the enemy will bring us any advantage.’
“‘All you say is true,’ responded Yasotay, ‘however, you forgot one
small detail which changes the picture completely.’
A prolonged silence prevailed until the officer again asked: ‘And
what small detail have I forgotten?’
“Yasotay smiled: ‘You forgot the Mangoday and that is what the
Cathay will find to be their downfall.’
“‘What makes you think the Mangoday are invincible?’ asked one
of them.
“‘What is consecrated to God cannot be broken by human power,’
answered Yasotay.”[9]
“Indeed, the fate of a nation rests on a few thousand elite, battle-
tested Mangoday who have been selected as warriors for their fierce
loyalty to the Mongolian nation. They are trained to accept death as
an inevitable outcome of war and are ready to sacrifice their lives on
the battlefield. Like hungry wolves that are more deadly than contented
ones, the Mangoday abstain from food for periods of up to a week
while marching and practicing combat. Their discipline and
willingness to die sets them apart from other soldiers.
“The Mangoday attack at dawn with a deadly fury that penetrates
the heart of the sea of enemy soldiers. In response, the Cathay
counterattack from all sides and begin raining deadly fire on their
assailants; however, the fearless Mangoday will not be deterred.
Despite burning clothes, skin, and hair, the elite Mangoday continue
their bloody assault without ever halting to douse the flames that
consume them. With relentless determination, the Mangoday slaughter
large numbers of Cathay soldiers, who are dazed that so few could
beat so many. Panic-stricken, the individual Cathay units retreat
clumsily and scatter themselves in a confused fashion, making it easy
for the Mangoday to hunt them down and slay them. The Cathay
soldiers who successfully flee this bloodbath spread intense fear of the
Mongolian invaders to everyone they see. Consequently, this tiny, well-
trained force—led by an unassuming man named Yasotay—makes
conquest after conquest.
 “Commenting on this improbably victory, Yasotay is heard to say,
‘You do not need more generals, but when the hour of crisis comes,
remember that forty selected men can shake a world.’”
The “do more with less” mindset exemplified in this story is very
healthy for business owners whether that means fighting price increases or
expanding market share. Once a cost reduction is achieved in one area—
even if it’s as small as a utility bill reduction, it is easier to make other
reductions; and, in the process, the employees of your firm will develop a
mindset that resources are precious and should be used wisely or eliminated
entirely.
Well, now you know why I named my firm: “Your Ten Percent”
(www.y10p.com). These Ten Percent Success Principles can transform the
way you think about your business.
10
PROTECTING PROFIT &
MINIMIZING LOSS
“The best luck of all is the luck you make for yourself.” General
Douglas MacArthur

You’ve applied the principles you’ve learned in this book. As others

see your success, they may not realize the amount of hard work you’ve
invested in your business. Your success is no accident; instead, it’s the
result of careful thought, timely action, and self-created opportunities.
Your final challenge now is to protect what you’ve earned and
created. Think about the protections and controls you have instituted
in your firm. How will you expose your vulnerabilities and strengthen
them?

YOU HAVE WORKED HARD TO MAXIMIZE your firm’s profit; now

consider the added complexity of guarding that fortune! Unfortunately,
today’s precarious business climate overflows with marauders looking for
opportunities to infiltrate your business. They want your cash, your data,
your relationships, and even your entire company (without you in it!).
These looters might be trusted insiders such as shareholders and employees,
trusted outsiders such as supply chain participants, or even unknown
outsiders who have no existing relationship with your firm. Common sense
says don’t leave your front door unlocked with a money bag sitting near the
entrance of your home or leave your credit cards in the front seat of an
unlocked car with the keys in the ignition. Yet many business owners leave
themselves vulnerable to exploitation and theft of their hard-earned
valuables.
The parable of the fortress. Recently my daughter shared her
experience of touring an impressive fortress in Northern Poland. Malbork,
the largest castle in the world, lies near the frigid Baltic Sea next to the
major port trading city of Gdañsk. The military and religious Teutonic
Order built Malbork in 1300 A.D. in the then-Germanic state of Prussia. For
hundreds of years, the fortress served as the Teutonic Order’s headquarters
(until it was eventually assimilated into Poland). In this hostile region of
Europe, Teutonic Knights could be excellent friends or formidable
opponents, depending on the situation. For years, the order dominated the
region via the highly-impregnable Malbork and the thousands of knights
who trained, strengthened, and strategized there.
Malbork incorporates three castles: High Castle, Middle Castle, and
Lower Castle. Entering without permission was practically impossible, and
only occurred at controlled, easily defensible checkpoints. Multiple layers
of security, including military walls, numerous dry moats, and towers,
effectively limited damage that came from unauthorized access. This
fortress fended off many assaults over several centuries. As empires
consolidated, Malbork became the administrative headquarters for kings
and rulers in the area. Malbork eventually became a museum and remains
so to this day.
Five lessons from the parable of the fortress. Like Malbork, your
business should become a safeguarded fortress. I can’t overstate the
importance of applying best-practice protections to your business in order
to repel current-day marauders who look for and exploit weaknesses.
Unless you are constantly investing time and resources into protective
capability, disaster can strike unexpectedly. Take to heart these lessons
learned from Malbork:
1. Visitors need appropriate permission to enter your business fortress.
2. Entrances occur at controlled checkpoints.
3. Multiple walls slow down “attackers”.
4. Strategic combinations of moats, towers, and terrains keep out
unwanted guests.
5. Highly trained and technology-equipped sentinels always stand ready
for deployment.
The next section uses these lessons to discuss effective protections that
minimize the plunder of your cash, technology, people, and company.[10]

Cash Plunder
Cash is the most liquid of all plunder opportunities. Fortify your business
with metaphorical walls, towers, and moats by using appropriate cash
controls consisting of clearly defined procedures and multiple eyes. For
instance:
● Favor electronic transactions over paper.
● Encourage customers to pay electronically.
● Lock up or better yet eliminate entirely paper checks.
● Use second-level transaction approval for paper checks and ACH
transactions (i.e., Positive Pay). This approval process deters fraudulent
transactions.
● Tie credit card expenses to expense reports. Expense report
submissions should undergo a supervisory approval process which may
have multiple approval levels based on the expense amount and category.
● Create a second layer of supervision over people who handle money.
● Your team members who handle money should be different from those
who reconcile the bank and credit card statements to the company ledger.
● Keep petty cash in minimal quantities and out of sight. Make sure
petty cash is frequently reconciled and deposited.
● Purchase appropriate theft insurances.

Data Plunder
Though cash is the most liquid of the plunder opportunities, data is often
easily converted to cash, particularly if it is sold to outsiders who want to
know the inner workings of your company. Data plunder involves targeting
specific data sets; more than that, though, it involves stealing company data,
encrypting it, locking it down, and demanding a ransom payment. Like the
three castles of Malbork, avoiding data plunder involves three levels of
defense: people, processes, and technology.
People. Within organizations, carefully vetted and trusted people should
safeguard the data. Company procedures should clearly spell out the
following:
 ● who has access to different levels of data;
● what constitutes unauthorized data sharing (employees should realize
that not everyone has access to data, including “trusted” insiders);
● confidentiality agreements;
● non-compete agreements;
● how to avoid data phishing schemes.
Process. While it’s practically impossible to keep authorized users from
stealing data (this is why it’s important to hire trustworthy people!), set
controls that keep unauthorized personnel from accessing data files.
Controls can include having employees sign off computers (this can be
automated to happen at intervals); locking offices; and minimizing paper
printouts.
Technology. To protect against data loss, many companies store data
on-site using ineffective, cobbled-together back-up strategies. Using one
level of protection to protect data is dicey at best and catastrophic at worst.
A natural disaster (e.g., fire, flood, or tornado) or a man-made disaster (e.g.,
malware, user error), easily destroys data.
Another option for protecting data is using an outsourced technology
support company. These companies have experience creating secure,
custom-made systems, giving your company a second layer of network
security based on current technology certifications.
An even better option for storing data is using an outsourced data
center. These centers usually store your data at multiple facilities (allowing
for redundancy should something happen to one of the data centers.) This
gives you a third layer of data security based on the experience of the data
center staff (who most likely safeguard the data of much larger companies
than yours).

Relationship Plunder
Two common relationship targets are employees and customers, both of
whom are expensive to replace and quickly monetized by competitors,
costing revenue and profit.
Exceptional employees. Keep your best employees by providing a
superior work experience, one they won’t receive from competing
companies. Because these employees produce more than average
employees, you’ll receive a corresponding return on investment. Incentivize
outstanding employees by:
● paying higher than the market-average salary;[11]
● engaging their minds with interesting work;
● promoting an accepting and generous culture;
● soliciting opinions and implementing excellent ideas;
● providing timely and constructive feedback;
● maintaining an aesthetically pleasing workplace with comfortable
workstations.

Unexceptional employees. It’s an imperfect world, so some employees

are a poor fit for your business. To avoid challenges and ill will caused by
discharging employees, create an environment where these employees
decide to leave on their own. First, hold employees accountable for
achieving key metrics. Lack of success causes dissonance on the part of
employees; this discomfort can propel them to consider an employment
change. Second, use appropriate job descriptions, updated as necessary, to
make sure employees are (or continue to be) a good fit for a specific job.
During my career, I’ve seen employees resist using appropriate technology
advancements (such as software that is more efficient than their skill set). In
this situation, creating a specific job description (minus the outdated skills)
encouraged the employees to find work at companies that made better use
of their skills.
Customer plunder. Competitors want your proprietary data and can go
to great lengths to obtain it, even to the point of enticing your employees.
Restrict secure data (such as customer lists, pricing, and margins) to key
individuals. Within those individuals, compartmentalize the data so that
employees access only a portion of the customer base. Legally protect your
relationships by using non-compete and non-disclosure agreements with
your employees.
At Malbork, there came a time when the bankrupt monarch couldn’t
pay the soldiers. At that point, a rival sovereign earned their allegiance by
paying the owed wages.

Business Plunder
Nothing is more devastating to a business owner or shareholder than a
complete business takeover. These takeovers typically occur in one of two
ways: as a surprise rebellion from the inside or as an assault from the
outside.
Inside rebellion. Sometimes business agreements are lopsided, setting
up one side for failure. Other times verbal agreements are not honored. I
learned early in my career to have clear legal agreements in place that
outline expectations of all shareholders. My mistake was trusting the
verbal agreement of the controlling shareholders of a client company, who
failed to keep my shareholder interests in mind. It took a long, painful legal
battle to make things right.
Outside assault. When business owners seek cash, particularly from
non-traditional sources, they risk leveraging themselves by tying up current
assets with expensive debt. Avoid money suppliers with outrageous interest
rates who support over-leveraging their clients. A common aphorism states
that when you need money, banks won’t lend it; when you don’t need
money, banks are ready to lend. The goal of business owners should be to
make their companies bankable. If you borrow expensive money, make sure
your business model possesses a satisfactory return on investment. Curtail
your expenses to the extreme. Once a company is overleveraged, it is
difficult to disentangle it.
Numerous other examples exist of insider and outsider plunder; my
point in raising this topic is to remind you to protect your business from a
hostile and/or unexpected takeover. Be like the loyal and trustworthy
Teutonic Knights at Malbork who lived by this motto: “Help, Defend,
Heal.”

Conclusion
We have traveled quite a journey in this discussion that seeks to maximize
your profit and optimize your cash flow. I hope you consider implementing
many of these suggestions. Select a diverse blend of financial expertise
providers. Vet your numbers people and ensure they are trained on finance
and accounting principles and techniques. Steer clear of situations that
invite fraud. Prioritize the collection of information in order to instill a
predictive capability in your firm that will in turn lead to stakeholder
cooperation. Learn to read and use your financial statements—they are
important instruments that will help guide you through stormy waters.
Model your firm to the best of your ability—even when the projections
seem shaky, commit to the process and they will get better. Protect your
cash, data, relationships, and firm from marauders. Soon enough the course
ahead will be more certain and rewarding. Best of luck in your journey
ahead!
APPENDIX A
Four Types of Financial Ratios
The following financial ratios are commonly divided into four categories:
performance, efficiency, liquidity, and solvency. Some ratios, such as ROA,
could be classified in multiple categories. ROA measures performance from
an asset perspective, but also how well (efficiently) those assets are used.
The important point is to select ratio’s that allow for benchmarking between
your firm and other firms in your industry and for internal comparisons
between different accounting periods of your own firm. Note that these
measures are most likely reflective of results and do not directly drive the
results; therefore, they should be considered lagging indicators (as opposed
to leading indicators).
APPENDIX B
Leading Indicators by Category
Unlike the lagging financial ratios in Appendix A, leading indicators are
more closely aligned to firm operations. Leading indicators tend to combine
financial and statistical data. Common statistics include
customers/guests/clients, widgets, hours, headcount, quotes, orders, and
deliveries/ drops.[12] Some sample categories are revenue, operations, and
sales activity. Key questions to ask include:
● What would be the impact if we improved the performance of this
leading indicator?
● How would our improvements affect the lagging indicators?
PETER M. BALDWIN, M.B.A.

Peter Baldwin is a pioneer and thought leader in the Fractional CFO

Services Industry, having spent the past 18 years upgrading the operational
finance and accounting departments in over 30 privately held, family-
owned businesses in a variety of industries including manufacturing,
distribution, professional services, and entertainment. Prior to his CFO
work, Baldwin was a Big-4 management consultant who specialized in
systems design and financial management. As Baldwin began to understand
and meet the needs of his clients comprising a wide variety of industries in
the small-to-medium-sized firm (usually B2B) market space, he gravitated
towards a Fractional CFO client service model that serves 5-8 clients
concurrently. He continues to refine his proprietary Y10P operational
finance methodology with these companies. Baldwin received his business
degree from Brigham Young University and an M.B.A. from the University
of Oregon. Baldwin enjoys studying history with an emphasis on Central
(Eastern) European History. He is fluent in Hungarian. He is the author of
Winning in Business: Seven Leadership Secrets from the Battlefield.
Married with four children, Baldwin enjoys rugged outdoor activities as
well as tennis and basketball.
GLOSSARY
A
accounts payable—a liability to a creditor, usually for purchases of goods
and services.
accounts receivable—a current asset that is generally converted to cash
within 10 to 90 days as a result of payment terms extended to customers.
Credit checks and credit limits are usually involved when a firm extends
credit.
accrual accounting—a method of accounting that recognizes expenses
when incurred and revenue when earned rather than when payment is made
or received.
accrued liabilities—an incurred expense that has not yet been paid
assets—resources owned by a business.
B
balance sheet (statement of financial position)—summarizes the assets,
liabilities, and equity of a business at a given point in time
bookkeeper—a subset of accounting; maintains detailed records of
purchases, sales, and other financial transactions.
business coach—a person who provides support and advice to a business
owner to help improve the effectiveness of the business.
business process design specialist—a person who strategically plans,
problem solves, analyzes workflows, manages projects, leads teams, etc.
C
cash accounting—a method of accounting that records revenue when cash
is received, and records expenses when they are paid for in cash.
Certified Public Accountant (CPA)—an accounting professional who has
passed the uniform CPA examination and is qualified to work as an
accountant in a particular state in the United States.
Chief Financial Officer (CFO)—a senior-level executive who oversees the
financial operations of a company.
controller—a person who supervises the accounting-related activities of a
company.
cost of goods sold (COGS)—the total of all costs used to create a product
or service that has been sold.
credit card payables—the amount remitted to a credit card company for
expenses occurred by using that credit card.
current assets—cash as well as other resources that should be turned to
cash or used up within one year of the balance sheet date.
current liabilities—short-term financial obligations that are due within one
year of the balance sheet date.
current ratio—a company’s current assets divided by its current liabilities;
shows if the company has enough money to pay what it owes.
E
EBITDA—Earnings Before Interest, Taxes, Depreciation, and
Amortization. Measures operating profitability.
equity—the difference between a company’s total assets and total
liabilities.
expense matching—revenues and expenses are matched in the same period
that they relate in order to avoid misstating earnings for a period.
F
financial strategist—a person who analyzes and evaluates a company’s
financial information for short-, medium-, and long-term financial goals.
financing
fixed assets—items a company uses over a long period of time to generate
income.
fixed expenses—an expense whose total amount does not change when
there is an increase in sales or production.
G
gross margin—net sales minus cost of goods sold (COGS); as known as
gross profit.
gross profit—net sales minus cost of goods sold (COGS); as known as
gross margin.
I
income statement—a report that shows revenue, expenses, and net income
of loss for a period. Also called a profit and loss statement.
investment—a payment made to acquire assets that will earn a return.
L
lagging indicators—company success measurements that do not directly
drive results, but that are the beneficiaries of leading indicators, which are
more directly tied to producing outcomes. Financial measurements are
typical lags.
leading indicators—company success measurements directly tied to
activities that lead to outcomes. Such activities might include number of
sales calls, client visits, opportunities generated, etc.
liabilities—a debt owed to anyone outside the business.
liquidity — liquid assets are those that are most easily converted to cash.
Accounts Receivable and inventory assets are considered liquid. Liquidity
measures how financially prepared your firm is to meet its immediate or
short-term financial obligations, meaning those obligations due within one
year.
long-term liabilities—an expense that will not be paid off in the current
accounting year.
M
map & gap analysis—comparing the functionality of new, unimplemented
technology with existing company processes. Gaps become targets for
business process design.
N
net income—revenue minus expenses. Also called income, earnings, or
net profit.
non-operational expenses—an expense that does not relate to the main
activity of the company.
note payable—a liability that is a written promissory note in which the
borrower agrees to repay the lender a specified sum of money at a specified
interest rate over a specified time period.
O
operating expense—an expense that is not directly associated with the
production of a business’s good or services, such as insurance, office
supplies, and rent.
operating net income—income after operating expenses are deducted;
does not include non-operating (other) income and expenses.
operations (changes to income statement items and balance sheet asset
items);
other income—income that does not come from a company’s main
business, such as interest from bank accounts, profit from sales of fixed
assets, or rent.
other expense—expenses not related to a company’s operations such as
with real estate, prior-year accounting adjustments, and excessive owner
payroll.
other liabilities—liabilities that do not directly correspond to business
activities.
P
profit and loss statement (P&L)—another term used for income statement
(see income statement definition).
R
revenue—the sale of a product or service.
revenue recognition—a rule that determines in which accounting period
revenue must be recorded.
return on assets (ROA)—how profitable a company is relative to its
assets.
return on equity (ROE)—measures the ability of a firm to generate profits
from investments in the company.
return on investment—a ratio measure of the amount returned to the firm
owner or outside investor compared to the amount invested.
S
small-to-medium-sized businesses— known in shorthand form as SMBs,
these business (in contrast to large businesses) are most likely to suffer from
lack of resources and expertise. Generally, these businesses range from pre-
revenue startups to established businesses with revenues of as much as $30
million and headcounts up to a couple hundred employees. These numbers
can vary widely based on each firm’s industry and business model.
solvency ratio—measures a company’s ability to meet its debt and other
obligations.
statement of cash flows—reports the inflows and outflows of cash during
an accounting period.
V
variable expenses—production costs that change in proportion to the
amount of goods or services sold. Also known as variable costs.
variance—the difference between an actual and budgeted amount.
W
working capital—current assets minus current liabilities.
YOU CAN HELP!

My goal with Profit Peak for Entrepreneurs is to positively impact as

many businesses and families as possible.

Your input to make the next version of this book better is greatly
appreciated. You can do this by leaving me a helpful review on
Amazon.

Wishing you success!

Peter M. Baldwin
www.y10p.com
[1]
Both headcount and revenue vary widely depending on industry and gross margin.
[2]
In my experience, some “trusted” family members with access to cash accounts and bookkeeping
records are not actually trustworthy.
[3]
Unfortunately, many times the bookkeeper is involved.
[4]
Feser, Katherine (2012, October 7). Q&A: Fraud Examiner Talks About Preventing the Problem,
Houston Chronicle, Retrieved from www.chron.com
[5]
Pofeldt, Elaine (2012, August 24). Three Ways to Protect a Small Business from Fraud, Crain’s
New York Business. Retrieved from www.crainsnewyork.com
[6]
The Fraud Triangle. Retrieved from www.acfe.com
[7]
It is important to note that in this scenario, the firm is still missing a business process designer.
[8]
The greater the forecast vs. actual variance, the darker the variance is shaded on the report –
consider using shades of green for positive variances and shades of red for negative variances.
[9]
Harlew, Ethan Translator, The Mangoday of Genghis Khan, pg. 22.
[10]
Unfortunately, it’s impossible to completely eliminate the risk of plunder, but by strengthening
your fortress, you encourage plunderers to bypass you and raid elsewhere.
[11]
I prefer to keep employee pay confidential. Different pay for similar jobs can cause resentment
when it’s not understood that some employees create more value than others.
[12]
Consult your industry association(s) for more ideas for metrics.