If your business has significant inventory on its balance sheet, it can be costly. The carrying costs of inventory include warehousing, salaries, insurance, taxes, and transportation, as well as depreciation and shrinkage. Plus, tying up working capital in inventory detracts from other strategic investment opportunities.

Reducing these costs can help improve a company’s profits and boost operating cash flow. Here are two alternative inventory management systems to consider.

1. JIT method

Just-in-time (JIT) inventory management involves planning shipments of raw materials to arrive just before they’re required. This saves money in inventory costs by reducing the amount of inventory on hand. It also increases production responsiveness and flexibility. Elements of JIT management include:

Smaller lot sizes. This allows your company to be more flexible and meet changes in market demand. It can also decrease inventory cycle time, lead times, and pipeline inventory. Because lot sizes are smaller, companies that use the JIT method can achieve a consistent workload on the production system.

Tighter set-up times. By reducing set-up times and the associated costs, you can afford to produce smaller lot sizes. Also, if your company is inefficient on machine setups, you’ll likely change products less often.

Flexibility. A flexible workforce can quickly reassign tasks during bottlenecks or unplanned spikes in demand.

Close supplier relationships. Suppliers must provide frequent, on-time deliveries of high-quality materials. So, close ties with them are vital to the JIT system. Long-term relationships with suppliers promote loyalty and improve overall quality.

Regular maintenance schedules. For companies with a high degree of automation, preventive maintenance is critical. Unplanned downtime can be disruptive and costly.

Quality control. JIT systems are designed to control quality at the source, rather than later in the process. For that reason, production workers are responsible for their own work, and if a defective unit is discovered, it’s returned to the area where the defect occurred. This makes employees accountable and empowers them to produce higher-quality products.

2. Accurate response method

Accurate response inventory management systems focus on forecasting, planning, and production. The underlying premise of accurate response focuses on flexible processes and shorter cycle times to better match supply with demand. By speeding up the supply chain process, management can delay decisions regarding raw materials, obtain more market information, and better determine production requirements.

This inventory management method incorporates the following key elements:

Overall performance. Accurate response measures the cost per unit of stockouts and markdowns. Then it factors this information into the overall evaluation of the company’s performance. Let’s say your company can’t meet demand. The lost sales would be factored into the overall costs, which would then justify increasing production to obtain and maintain customers.

Predictable and unpredictable products. Predictable products can be made further in advance to “reserve” capacity during the selling season for unpredictable products. Then your company won’t have to accumulate and pay for large inventories.

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Incorporating JIT and accurate response techniques can dramatically improve your company’s efficiency. Lowering inventory levels cuts operating capital needs and gives you a competitive edge. Reducing the expenditures for warehouses, employees, and equipment produces a stronger balance sheet and income statement and improves cash flow.

Contact us to discuss whether it makes sense to implement these systems at your business.

Financial reporting plays a key role when a business needs funds for continued operations and strategic investment opportunities. Lenders and investors will generally want to review your company’s financial statements before they give it money. Timely, reliable reports can increase the odds that a bank will approve your company’s loan application and equity investors will provide capital.

Relevant financial information

Financial statements are a must-have for any organization. The balance sheet reveals how much its assets and liabilities are worth based on historic costs. The income statement tells investors and lenders how profitably and efficiently the company has performed during the accounting period. The statement of cash flows details sources and uses of cash from operating, investing, and financing activities. This information helps company insiders — as well as lenders and investors — make better-informed business decisions.

Lenders and investors monitor the financial condition of companies in their portfolios on an ongoing basis. They’re particularly focused on industry sectors that are susceptible to market fluctuations, such as real estate, construction, restaurants, and retail. Business owners should be prepared to respond to changes in their stakeholders’ reporting requirements if the economy gets tough or simply changes.

Levels of assurance

While financial statements can be prepared in-house, lenders and investors typically prefer reports that are prepared by outside accounting firms. CPAs offer the following three types of historical financial statements under U.S. Generally Accepted Accounting Principles (GAAP):

1. Compiled statements. These provide no assurance that the financial statements are accurate, complete, and comply with GAAP.
2. Reviewed statements. These provide limited assurance that the financial statements are accurate. Typically, your accountant will review the statements to ensure that obvious errors or misstatements are corrected.
3. Audited statements. These provide reasonable assurance that the statements are free from material misstatement and conform to GAAP. Audits are seen by many as the “gold standard” in financial reporting.

In some cases, compiled financial statements — the option that provides the lowest level of assurance — might suffice. But when a stakeholder decides to manage risk more closely, it could require reviewed or audited statements. As the level of assurance increases, so too can the associated cost to prepare the financial statements. A close partnership between your company’s accounting department and its CPA firm is critical to minimizing the cost and lead time associated with preparing financial statements.

In addition to the types of statements lenders and investors may request, the frequency of statement production also may change. For example, they may request interim statements (typically quarterly or mid-year) that summarize a reporting period of less than a full financial year.

What’s right for your business?

Financial statements provide a wealth of data and insight into what drives your company’s revenue, profits, and value. Above all, solid financials demonstrate to lenders and investors that management is proactively monitoring financial performance. Contact us to determine what level of assurance and frequency is appropriate for your company based on its current needs.

Engaging in a merger or acquisition (M&A) can help your business grow, but it also can be risky. Buyers must understand the strengths and weaknesses of their intended partners or acquisition targets before entering the transactions.

A robust due diligence process does more than assess the reasonableness of the sales price. It also can help verify the seller’s disclosures, confirm the target’s strategic fit, and ensure compliance with legal and regulatory frameworks — before and after the deal closes. Here’s an overview of the three phases of the due diligence process.

 

1. Defining the scope

Before the due diligence process begins, it’s important to establish clear objectives. The work during this phase should include a preliminary assessment of the target’s market position and financial statements, as well as the expected benefits of the transaction. You should also identify the inherent risks of the transaction and document how due diligence efforts will verify, measure, and mitigate the buyer’s potential exposure to these risks.

 

2. Conducting due diligence

The primary focus during this step is evaluating the target company’s financial statements, tax returns, legal documents, and financing structure. Additionally, contingent liabilities, off-balance-sheet items and the overall quality of the company’s earnings will be scrutinized. Budgets and forecasts may be analyzed, especially if management prepared them specifically for the M&A transaction. Interviews with key personnel and frontline employees can help a prospective buyer fully understand the company’s operations, culture, and value.

Artificial intelligence (AI) is transforming how companies conduct due diligence. For example, AI can analyze vast quantities of customer data quickly and efficiently. This can help identify critical trends and risks in large data sets, such as those related to regulatory compliance or fraud.

If a target company maintains an extensive database of customer contracts, AI can analyze every document for the scope of the relationship, contractual obligations, key clauses, and the consistency of the terminology used in each document. Sophisticated solutions can analyze the target’s financial records and even produce post-acquisition financial statement forecasts.

 

3. Structuring the deal

Information gathered during due diligence can help the parties develop the terms of the proposed transaction. For example, issues unearthed during the due diligence process — such as excessive customer turnover, significant related-party transactions or mounting bad debts — could warrant a lower offer price or an earnout provision (where a portion of the purchase price is contingent on whether the company meets future financial benchmarks). Likewise, cultural problems — such as employee resistance to the deal or incongruence with the existing management team’s long-term vision — could cause a buyer to revise the terms or walk away from the deal altogether.

 

We can help

Comprehensive financial due diligence is the cornerstone of a successful M&A transaction. If you’re thinking about merging with a competitor or buying another company, contact us to help you gather the information needed to minimize the risks and maximize the benefits of a proposed transaction.

As audit season begins for calendar-year entities, it’s important to review issues that may arise during fieldwork. One common issue is materiality. This concept is used to determine what’s important enough to be included in — and what can be omitted from — a financial statement. Here’s how materiality is determined and used during an external financial statement audit.

 

What is materiality? 

Under U.S. auditing standards and Generally Accepted Accounting Principles (GAAP), “The omission or misstatement of an item in a financial report is material if, in light of surrounding circumstances, the magnitude of the item is such that it is probable [emphasis added] that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.”

This aligns with the definition of materiality used by the U.S. judicial system. However, it differs somewhat from the definition set by the International Accounting Standards Board. Under International Financial Reporting Standards (IFRS), misstatements and omissions are considered material if they, individually or in the aggregate, could “reasonably be expected to influence the economic decisions of users made on the basis of the financial statements.”

 

How do auditors determine the materiality threshold?

Auditors rely on their professional judgment to determine what’s material for each company, based on such factors as:

• Size,
• Industry,
• Internal controls, and
• Financial performance.

During fieldwork, auditors may ask about line items on the financial statements that have changed materially from the prior year. A materiality rule of thumb for small businesses might be to inquire about items that change by more than, say, 10% or $10,000. For example, if shipping or direct labor costs increased by 30% in 2023, it may raise a red flag, especially if it didn’t correlate with an increase in revenue. Businesses should be ready to explain why costs went up and provide supporting documents (such as invoices or payroll records) for auditors to review.

Establishing what’s material is less clear when CPAs attest to subject matters that can’t be measured — such as sustainability programs, employee education initiatives, or fair labor practices. As nonfinancial matters are taking on increasing importance, it’s critical to understand what information will most significantly impact stakeholders’ decision-making process. In this context, the term “stakeholders” could refer to more than just investors. It also could refer to customers, employees and suppliers.

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Materiality is one of the gray areas in financial reporting. Contact us to discuss the appropriate materiality threshold for your upcoming audit.