In a nutshell: No matter what role you play in an organization, you should have a basic understanding of how to track revenue, how cash flows work, how transactions are recorded — and what to watch out for.
Note: This is the second article in a series about small business finance and accounting.
The health of every business can be determined quickly with the answer to this question: How much cash is flowing in versus how much cash is flowing out?
Proper accounting provides the means to make sure the first number remains higher than the second. No matter how complex a business becomes, successful entrepreneurs must never forget that fact.
In a previous article, we looked at some of the finance basics every small business owner should understand. The following offers an informational introduction to small business accounting basics. You should always consult with an accounting professional before making any major business decisions.
Why It’s Important to Know Accounting Basics
Proper accounting for expenses and revenue is central to every business, no matter the size. It’s especially vital for small businesses, where the margin for error is often thin. One misstep, particularly in the early days of a business, can result in failure.
Or, as Charles Dickens succinctly explained it in “David Copperfield”: “Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pound ought and six, result misery.”
Unfortunately, misery can be a common outcome. About half of all business fail within the first five years. Improper accounting is one of the central issues, as it can lead to bad budgeting, inaccurate projections and (most deadly) mishandling of cash flow.
Basic Accounting Concepts to Know
The following terms cover some of the major areas of accounting in which business owners need to develop expertise.
- Gross revenue: All the money flowing in. This includes the total of all revenue from sales beforeyou deduct any expenses.
- Expenses: All the money flowing out. This includes rent, payroll, cost of materials, taxes, interest on debt and ongoing operational expenses.
- Net profit: This is your gross revenue minus expenses. This number needs to consistently be a positive one to maintain a profitable business (although this might not be possible in the early days of a startup, which is to be expected).
- Cash flow: This goes beyond profitability, as cash flow can become an issue even in profitable businesses. That’s typically because revenue for a small business does also flow consistently month-to-month. Net cash flow is found by comparing the cash available at the beginning and end of an accounting period (typically monthly, quarterly and yearly). Cash flows in from sales, loans, investments and asset sales. It flows out to pay for the areas listed above under expenses, as well as loan repayments and one-time capital expenditures such as purchasing equipment.
- Break-even point: As mentioned under net profit, an entrepreneur may experience a net loss in the first months or even years of a business. The break-even point is when revenue match expenses, which signals that a business has reached the turning point into profitability.
Cash Vs. Accrual Basis
Tracking the above areas through accurate, consistent accounting is required for a small business. But how you do it can fall into two general categories.
Many entrepreneurs use cash basis accounting, according to Investopedia. It typically works well for a business with less than $5 million in revenue. In the cash basis method, you record transactions when money is received or spent. That’s a simple, clear accounting strategy.
Larger companies may be required to use accrual accounting. With this method, transactions are recorded when the work is completed to earn the revenue or when a liability is incurred, even if cash has not yet changed hands.
Accrual accounting addresses some of the disadvantages of cash basis accounting. For example, your business could be down in one quarter, but payments are flooding in from past work. If just considering cash, this looks good. But in reality, you will receive far less in the coming quarter because business was down.
Accrual accounting can provide a better picture for future earnings and is expected when seeking a loan from a commercial bank or financing from investors.
Red Flags in Accounting
Entrepreneurs do not plan to fail, of course. When a business does get into trouble, it can seem to come out of nowhere and accelerate fast.
There are red flags to watch for when handling the accounting for a business. If any of the following are happening in your business, take corrective action immediately.
Low Inventory Turnover
With proper accounting, you know how much you are spending on inventory and warehousing space. It’s wise to know how often your inventory turns over on at least a yearly basis, but track it monthly or quarterly. If inventory turnover slows, that’s an indication sales are lagging and you may be overspending on inventory and warehousing.
Long Collection Periods
Accountants should know the typical time between invoicing and receiving payment, as well as the running difference between the amount in accounts receivable and cash on hand. If the time between invoicing and payment begins to extend for longer periods, it can impact cash flow. That leads to a common cause of a company’s demise — not having enough cash to pay bills.
Lack of Profitability
Entrepreneurs need to watch net profitability like a hawk. It’s expected that a new business may operate at a loss for a period of time — but that should be projected at the beginning. Once you’ve hit your break-even point, the business should not slide back into costs running higher than expenses for any extended period. If your accounting shows that happening for several consecutive months, it’s time to act before the dreaded cash flow problem arises.
These are some of the basic issues — and red flags — when taking on small business accounting. It’s an area entrepreneurs should know inside and out. Proper accounting offers a way to quickly determine the health of your company. Understanding it thoroughly is the responsibility of every business owner.