When you talk to your accountant or bookkeeper, do you actually understand what they are telling you? Or are you just assuming they are doing the right thing? An understanding of how money works in business is, of course, a critical part of running a successful enterprise.
While you do not need to have same kind of depth of knowledge that an accountant or a financial analyst might have, you need to ensure you have an awareness of some basic financial concepts. You need to understand what your accountant or bookkeeper is talking about so that you can make sure you are asking them better, more useful questions. If you don’t know what you don’t know, then how can you know what to ask?
You do not need to be able to draw up your accounts, but you do need to be able to understand them. Once you can appreciate how the money flows through your business, you can begin to see which decisions make more sense for your business. A mistake we often see a lot of business owners commit is to look at their bank account statement or their ‘cash based accounts’ as their management reports.
This is a good way to ensure that your business stays alive – but a very bad way to grow and develop your business. The place to start when it comes to finances in the game of business is that there are two ways that numbers can be captured in your business. Those two ways are cash-based and accrual-based.
In the simplest business model you have sales bringing you income, expenses that are costing you money, and the profit, which is the difference between the two. Sales – Expenses = Profit. (We can keep it simple for this and do not need to worry, at this stage, about things like gross profit or net profit.) If you are using cash-based accounting, you only take the income from the expenses once the money has actually changed hands.
In other words, only once you actually get the cash or the money is actually transferred to you, do you consider that sale in your accounts. Equally, only once you have actually paid out the salary to your employees or paid out an invoice, do you account that expense. That is cash-based accounting in a nutshell: based on the actual cash you have. It is what a lot of business owners use when they are first starting out – to keep track of the cash going in and out of the business.
What accrual means is that it is “due”. So while you may not have received the cash just yet, it is due to eventually come and you can still account for it. In this way, you can then make plans for the sale or contract that you have currently just completed. The customer or client may only have to pay you after 30 days or 15 days (and you should have a good system for chasing up your debtors), so the cash is not yet in your account, but the sale has been confirmed, so is being taken into account.
With this form of accounting, you can then have the sale sitting alongside, say, an expense like the rent that will be going out at the end of the month. So you know that that money for the rent has to go out, but you also know that you will be receiving money from a sale by then. You can therefore see the resulting profit and get a better picture of long-term profitability.
Should you be using Cash-Based or Accrual-Based Accounting?
Through business coaching in London we have obviously seen a full range of businesses’ accounts. Every time we see cash-based accounting being done, here’s our advice – change your accountant first and then move to accrual-based accounting. There is a very good reason why accrual based accounting was invented in the first place – to separate out a P&L from a cash flow statement and ensure that the accounts capture the ongoing nature of the business rather than its cash movements.
If you are a very small business and keep your accounts on a sheet of paper or an excel sheet, or you are using partial accrual-based accounting, then cash-based accounting might make sense. However, for any growing or slightly larger business, you really should be doing this accrual-based so that you are producing the most useful numbers for your business. Now, armed with an understanding of all of this, go to your accountant or your bookkeeper and find out – are you doing cash-based or accrual-based accounting?
Next, ask what about VAT – are you on cash VAT or accrual VAT? Why have you chosen that? What happens to your cash flow if you move from one VAT method to another? These are one of those “better” questions to ask.
This combined with your marketing knowledge, your understanding of sales, and augmented with knowledge of other important concepts such as markup and margin, you can start making smarter decisions and more calculated risks that will accelerate your business growth.
As a leader of business, you need to get a good overview of a range of concepts – and there isn’t always time to sift through the reams of information on the web.
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