finance 101: master the basics
Let's try a math problem: You have a great idea. You go to the store, buy $4 in supplies and build a widget. You sell the widget to Joe for $10 cash. You have $10 in income, $4 in expenses and a $6 profit.
You have another great idea. You go to the store, buy $86 in supplies and pay $12 in taxes and shipping. You take out a credit card to finance a $700 piece of equipment. You hire a friend for a few hours to help design your widget, and pay him $180. You make 12 widgets. You sell one to Bob for $60, who agrees to pay you in three $20 installments. What is your profit?
Accounting seems easy in the beginning, but as you can see from your second great idea, it's easy to get confused on how to account for your business and all of the complications. There have been many books written on accounting and finance for small businesses, but let's run through just a few essential concepts and terms:
Cash vs. Accrual
There are two main methods for tracking income and expenses, and to a certain extent most businesses need to do both.
The cash method tracks every dollar into and out of your business. It is easiest, in the beginning, to have one checking account for your business and ensure that all money flows through it. This includes actual cash. Borrowings from loans should go to your checking account too, and then checks can be written out of it. This is the easiest, most streamlined way to track cash. It also makes bookkeeping easy, as you only have to look in one place. Once all cash is recorded, both in and out, you can see a cash income statement for a certain period of time. While helpful for planning cash needs, this method can be misleading when looking at profitability, as it doesn't take into account things like accounts payable and receivable, inventories and the timing of financing. In our second great idea above, we would have spent $278 and only brought in $20.
To better understand profitability, you must use the accrual method. In this method, you account for revenue when earned (even if you haven't been paid yet). You also account for expenses as used (regardless of when you pay for them). This better lines up income and expenses and gives you a more accurate bottom line, although it may take awhile to actually see that cash profit, depending on the timing of your cash receipts and expenditures. You can also convert a cash income statement to an accrual one through a series of adjustments based on balance sheets. This is a good method if you are on a cash basis for tax purposes, but are interested in your accrual profitability.
Balance Sheet Basics
A balance sheet can seem boring (I suppose it is), but it is crucial. It can accurately tell you how your business is growing over time, and how much you have made. A balance sheet is simply a listing of all the things you own - called Assets:
- accounts receivable
And everyone you owe money to - called Liabilities:
- lines of credit
- accounts payable
- machinery debt
- long term loans.
The key here is that a balance sheet is a snapshot of time. For each category, just write down exactly what it is worth today. Do not account for something next week, things you think will happen, or the way you wish it was. If you quit today and closed up shop, what could you sell all your things for and who would you need to pay to walk away? Make it a priority to do an ACCURATE balance sheet.
Balance Sheet Metrics
Two main metrics are derived from the balance sheet: working capital and equity.
Working capital is a measure of liquidity and is measured by taking all current assets (cash and other assets easily turned to cash like accounts receivable and inventories) and subtracting current liabilities (all debt owed in the next year like operating lines, accounts payable and a years worth of longer term debt payments). What you are left with is available cash that can be used to run the business, fill holes in usable cash, and grow the business. Too little and you will run into cash flow problems often.
Equity, or net worth, is a measure of what portion of the business you own. Total assets minus total liabilities, this number represents what your business is worth. If you do balance sheets each year, you can see this number move and hopefully grow. Your ownership of a portion of your business is key to attracting investors and obtaining financing and it will grow as the business makes money.
I am sure these ideas are not new to many of you, but it is easy to get confused by what is necessary and important to running an effective business today. Become a master of the basics and they will take you far!
Make it a great day!