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.
For more information, you can visit the website at http://www.rppc.net
Pam Newman is a Certified Management Accountant, Author, and Certified QuickBooks® ProAdvisor for Financial and Point-of-Sale software.