FINANCIAL STATEMENTS AS A MANAGEMENT TOOL
by Douglas Moat
Like most businesspersons, insurance agency owners and managers want to know how well they are doing and how much their business is worth. If you are among the lucky ones, your financial statements can help you find the answers. If you're especially lucky, you know how to use your financial statements to do so. Unfortunately, very few agencies have financial statements that are useful for managing the business, and even fewer agents use them for this purpose.
Most of the agents we work with are hesitant, if not intimidated, about discussing their own financial statements. However, it need not-and certainly should not-be this way. With little effort and cost, you should be able to obtain financial statements that are friendly and useful to you, the owner/manager. We believe that a good operating statement should be structured so that it represents the components of the business as you see it and run it. Whether you rely on someone inside your firm or pay an outsider to generate your financials, you should not fear revealing to him or her the way you manage your business and your priorities-GAAP accounting notwithstanding.
What is GAAP accounting? GAAP stands for Generally Accepted Accounting Principles: established answers to questions on how business is accomplished. Accountants agree as to how all things should always be done, but see different approaches to the same set of facts. There's a good reason for this. Accounting involves art as much as science, and you have much input into how your financials look. Ideally, your financial statement should be understandable and serve your purposes.
Although all financials are produced by your agency's systems (whether manual or automated), many agents choose to have them formalized by an independent accountant. In this case, you will find three levels of formalization: compiled statements, review basis statements, and audited statements. All will conform to the GAAP; however, this distinction determines different levels of acceptance and costs to you.
First come audited financials. If you are a public company, thinking of going public, or considering a loan, you need audited financials. The statements will officially be certified by the accountant to assure the reader that the independent auditor has taken steps to confirm the accuracy of all the information. For example, the auditor will actually write to your outstanding billings to verify that they do in fact owe you money.
The second form of financial statements are review basis statements, which resemble the audited statement's format and review procedures. However, unlike audited statements, review basis statements lack the accountant's certification.
Compiled statements occupy the bottom rung of financials. They are simply an independent accountant's acceptance of your numbers professionally reformatted with a fancy cover and a statement for services rendered. They offer little value to third parties, such as banks and carriers, and are generally useless as management tools. Yet this doesn't mean compiled statements and other financial statements, in the competent hands of your accountant can-with your input-be important resources in managing your agency.
HOW YOUR FINANCIAL TOOLS SHOULD AID YOU
Your financial tools come in two forms-the income statement and balance sheet. The income statement summarizes how well your business did over a period of time (year, quarter, or month). A good statement details how and why you did well or poorly. The balance sheet provides the book value of your business by summarizing what your business owns (its assets) and what it owes (its liabilities). An agency's book value seldom represents the true value of the business.
An accurate income statement enables you to answer easily the key questions about your company's performance and operations. Because these questions differ between agencies and their owners, financial statement presentations are never alike. If you have 'formally' prepared statements, examine them now. The first line is usually 'Commission Income,' which is a good place to start, since it is urgent to know whether your commissions are rising or declining. But how useful is this information when it typically combines Personal and Commercial lines commissions with Life insurance commissions and contingent and bonus commissions in a single entry? Is this the proper way to manage your agency?
The summary financial statement can't help you answer all your questions, but it should be designed and presented to help you answer the questions that concern you most. Are you interested in separating Property/Casualty commissions from Life? Are you interested in separating new business commissions from renewal? Does it matter how much was paid to outside brokers in contrast to the amount earned by your in-house producers? What are your critical expense areas? Are they sufficiently detailed on your financial statement to allow you to confirm quickly that you are successfully managing your operations?
If you have adopted standard operating procedures for your agency, your financial presentation should allow you a quick determination of your status for that period and should help facilitate comparisons to prior periods (how well you have performed against your standards).
Because personal expenses embody an agency's major outlay, I recommend that your financial statement consistently aggregate salaries, inside producer commissions, payroll taxes, and benefits under one heading so that you can readily see whether this major item is being managed and how well your business is faring against your standards. Personnel expenses usually range from 50% to 60% of net revenues; well-run agencies occasionally generate below 50%. Similarly, an agency's variable business-related expenses (which include advertising and public relations; communications, including telephone, postage, messengers, etc.; and travel and entertainment, including all automobile expenses) are often aggregated into one category, which typically ranges from 8% to 11% of net revenues. The key question is how do you run your agency? What important operating standards or 'benchmarks' do you have? The format of your financials should show you these figures quickly and consistently.
I have found that most agents neglect the balance sheet. Many agents assume that if they have more cash in the bank than last year, business is fine- but they're often wrong. I have worked with many agents who increased their cash reserve and yet were in dire financial condition. Here again, your financial statements should be designed to help you manage your agency and see at a glance how well you are doing against your standards. Here are a couple of suggestions that can easily be incorporated into a balance sheet:
Separate cash on hand into working funds and fiduciary funds, and separate accounts receivable into less than 45 (or 60, etc.) days and greater than 45 (or 60, etc.) days.
Rather than simply 'eyeballing' differences between periods, it is instructive to use financial ratios to measure your operations and financial condition. These, however, should reflect how you desire to run your agency. You might publish many detailed ratios, but we caution you against concluding, 'This is what we are going to look like.'
The categories listed below are probably important to you, but standards should be set to reflect your goals and your operation:
OPERATING RATIOS
1. New Property/Casualty account commissions: At least 10% of prior year commissions
2. Property/casualty contingent commissions: At least 5% of Property/Casualty commissions
3. Life insurance commissions: at least 10% of Property/Casualty commissions.
4. Personnel expenses: less than 60% of total net revenues
5. Variable expenses: less than 10% of total net revenues
6. All other overhead: less than 20% of total net revenues, including:
A. Rent of less than 7%
B. Bad debts of Less than 2%
BALANCE SHEET RATIOS
1. Current assets: at least 110% of current liabilities, but
A. Fiduciary funds plus accounts receivable of less than 60 days at least equal to accounts payable
B. Working cash (nonfiduciary funds) equal to 45 days expenses
As you can see, you can easily make your financial statements a user-friendly, valuable part of your management process.
Reprinted with permission from Professional Insurance Agents Of New York, March 1995.