Business
owners rarely go into business to deal with the financial aspects of running a
business. It’s easy to understand why! You are passionate about the products or
services you provide and want to focus your time there. The financial aspect
usually falls to the bottom of the “desired responsibilities” list. It is
critical to the long-term success of your business that you understand some of
the Financial Fundamentals of being a business owner though. You don’t have to
be an accountant or financial analyst, but it is important that you have some
key skills in your business toolkit to measure the financial aspects of your
business. It’s okay to outsource this activity so that someone else can do the
work you don’t like to do, but make sure you understand the output of the
financial information. You’ll need it to help you make informed decisions about
your business. Remember! Accounting is not just about taxes. There’s so much
more to know about the numbers, so you’ll know how your business is doing from
the management perspective.
There are a
variety of key aspects of your financial picture that you need to be aware of
and they can be outlined based upon the three critical financial statements:
Profit/Loss, Cash Flow, and Balance Sheet.
I meet with
entrepreneurs every day that are unsure of their profitability. They “think”
they are making money because they have money in their checking account. This
is NOT how you should be running your business. Having money in your checking
account doesn’t mean you are profitable. It could mean you haven’t paid all the
bills so you have a little cash. Cash and profit are two different concepts. If
you aren’t profitable, you won’t have longevity in your business.
So what is the
difference between profit and cash? Profits are determined through an equation
of Revenues – Cost of Goods Sold = Gross Profit – Overhead Expenses = Net
Profit. This equation is the makeup of your Profit/Loss Statement. Revenues are
dollars from generating sales within your business. Cost of Goods Sold reflects
the direct costs for labor and materials incurred in your business. Overhead
Expenses are all those other costs that you incur so that your business can
function (i.e. Rent, Taxes, Insurance, Marketing, Accounting, etc.)
You can have
activities that affect cash but are not considered revenues or expenses. For
example, when you borrow money from a lender, it is not considered income. It
is classified as an increase in your liabilities (i.e. debt). When you repay
that loan, it will not be considered an expense. It is a reduction in your
liability. Any interest you might incur on that loan would be classified as
interest expense, but the principal portion is not. Similar concept applies for
owner investments and withdrawals.
Often times
the two concepts of cash and profit are not clearly defined for small business
owners; therefore, you don’t have a good handle on your finances and how to
interpret any outcomes from financial reporting. You can show a profit and have
a negative cash flow if your loan payments, owner withdrawals, and other
non-expense activities are taking more cash out of your business than you have
profit. Same goes for the opposite flow, you can have a lot of cash coming into
the business through an increase in personal or lender-financed activities vs.
revenues. The most basic of cash flow statement information can be outlined as
Beginning Cash Balance + Cash Inflows – Cash Outflows = Ending Cash Balance. It’s
important for you to understand the concept of your Profit/Loss Statement and
your Cash Flow Statement. They provide two different views of our business.
The third
financial statement you should be preparing monthly is the Balance Sheet. The
Balance Sheet provides information on your Assets, Liabilities and Equity.
Assets are what you own that is of value. Examples include Bank Accounts,
Accounts Receivable, Inventory, Property, Plant, and Equipment. Liabilities
represent your obligations to others. Examples of liabilities include Accounts
Payable, Notes Payable to Lenders, Loans from Shareholders, etc. The Equity
balance reflects the value of your ownership in our business. When you take the
value of the assets less the value of your liabilities, the remainder is your
equity.
It doesn’t
matter the size of your business, profitability and ongoing financial stability
is something you should be monitoring on a regular monthly basis. Some will say
that they are too small for creating financial statements. That is your way of
not holding yourself accountable to managing your business wisely. It’ll always
be someone else’s fault when your business fails…or at least that is what
you’ll say. Though it won’t be the truth, it’ll be your fault for not managing
your business wisely. You can choose to succeed, or to choose to fail. It is
always a choice, not a default. So make the choice to be a financially informed
business owner. Your business will thank you through increased profitability
and longevity!
Contact: Pam
is the author of Out of the Red, a book that covers various
important aspects of management accounting for small business owners. Topics
include Break-Even Point, Cash vs. Profit, Budgeting, and more. To order your
copy, call 816.304.4398 or go to www.getoutofthered.com.
For more information, you can visit the website at www.rppc.net. Pam Newman is a Certified
Management Accountant, Author, and Certified QuickBooks® ProAdvisor for
Financial and Point-of-Sale software.