If you’re like many people, numbers can make you a little nervous. We get it.
But having a grasp on the fundamentals will pay off.
You only need to understand a few key ideas to get the basics. And if you learn how the three main financial statements work, you’re already ahead of the game.
Cash vs. Accrual Accounting
Think of cash-based accounting as the way you balance your checkbook every month. Money comes in, and money goes out. If you bring in more than you spend, great. Otherwise, watch out.
That works well for people, but for most businesses it’s not enough.
That’s because businesses do a lot of different things to make and sell a lot of different products and services to a lot of different customers. Understanding if and how all that stuff is generating profit means having a more detailed picture.
Accrual accounting gives us that detailed picture. It does that by linking revenues with costs more accurately than cash accounting can.
But that accuracy comes with an important caveat: most numbers in accrual accounting are estimates that are not equal to cash.
So for example: Profit ≠ Cash
That’s a very big deal. It’s how people go broke while “making money.” The profit is there, but the business doesn’t survive long enough to see it. We’ll get to cash again later.
The heart of accrual accounting is the matching principle. This is how accountants are able to link the cost of making or delivering a product or service to the time the revenue is earned.
Note: this is not when the sale is made or even when payment is received.
This concept can be a little tricky at first, but seeing some examples will help.
A consulting firm signs a $20,000 contract on January 15.
The project starts February 1 and runs to April 1.
The client pays $10,000 on March 1 and $10,000 on May 1.
Revenues are recorded when the services are delivered: February and March.
Operating vs. Capital Expenditures
Businesses incur many different kinds of expenses. For each expense they determine if it is a normal part of operations or a longer-term capital investment. (This is the kind of decision for which you will want to consult and accountant.)
Operating expenses are all of the day-to-day costs associated with running your business. These include things like rent, the salaries and benefits you pay your employees and the electricity required to “keep the lights on.” Some of these operating expenses will be fixed, meaning they remain constant no matter how much business you do. Others, such as the raw materials needed to create a product, will be variable-—rising with the volume of business you do.
Capital expenses are longer-term, higher-cost investments you make in the business. No matter when you actually pay for these investments, they are recorded as expenses over the life of the asset. The process of spreading out these expenses is called amortization (in the case of intangible assets like software or patents) or depreciation (in the case of tangible assets like machinery). Let’s look at an example.
Cash Still Rules
We started out this chapter explaining that accrual accounting was a more accurate measure of profit than cash-based accounting. That’s true, but you have to remember an important point: profit is not enough.
Remember, Profit ≠ Cash. That’s where trouble can start.
Let’s say your business is humming along. Customers love the new product and orders are coming in up to 3 years in advance. Your team’s in place and everything seems to be going great.
Then you get a call from your accountant: there’s a problem. You have a cash crunch coming and if you don’t do something about it, you’ll be out of business.
You’re lucky you have such a good accountant.
While accrual accounting is a powerful tool, you always have to keep your eye on liquidity and cash flow. We’ll get back to this when we cover the cash flow statement.