Money

Finance Basics

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.

Matching

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.

Financial statements

Income statement

What it does

It measures profit.

How much money are you making on the money customers are paying you?

What it tells you

Are we making or losing money?

What trends do we see in our business?

How could we increase our profits?

Time period

Measured over a range of time—usually a month, a quarter (3 months) or a year. Often, income statements will show trends over time. (e.g. Year 1, Year 2…)

Income statement

Total value of products or services that you sell.

Recorded when you deliver, not when you are paid.

RevenueCost of goods sold

How much it costs you to make the product or service.

Recorded when finished product is sold, not when costs are paid.

Money made selling, not including the cost of running the business.

Gross profitOperating expenses

Cost of running things day-to-day, including expenses that are spread out (amortized) over several periods.

The best picture you have of your business’s financial health.

Operating profitInterest and taxes

Well, you know what they say about death and taxes...

The magic number. The actual “bottom line.”

Net profit

Balance sheet

What it does

It measures the value of a business. 
How much is the business worth and why?

What it tells you

Where is the value in the business?

Are our assets greater than our liabilities?

Have we been growing over time?

Time period

Measured at a specific moment in time. Often balance statements will show previous year for comparison. (e.g. Year 1, Year 2…)

Balance Sheet

Assets (things you own)

Cash and cash equivalents Money in the bank, stocks, bonds, etc.

Accounts receivable Money customers owe you

Inventory Finished products that you have made or bought but not yet sold

Property and equipment Buildings, machines, vehicles, tools (minus accumulated depreciation*)

Goodwill, intellectual property, intangibles Assets that have value but not physical form

Accruals and prepaid assets Stuff you have paid for but not yet received

Liabilities (things you owe)

Accounts payable Money you owe other people

Money currently owed on debt Money you currently owe to pay back debts

Payroll and accrued expenses Salaries and everything else that you owe in this period

Long term liabilities Money you will owe in the future that is not yet due for repayment, including mortgage

Owner’s equity (who owns you)

Shares Investors’ ownership stakes in a business

Retained earnings Profits that have been reinvested in the business (minus accumulated depreciation*)

*All deductibles that have been taken to date against the value of a piece of property or equipment

Cash flow statement

What it does

It measures cash on hand.

Does the business have enough cash to continue operating?

What it tells you

Do we have enough cash on hand to run our business?

Where is our cash coming from and where is it going?

Are our customers paying us on time?

Time period

Measured for a specific moment in time at the end of a specified period.

The statement shows the difference in cash between the beginning and end of the time period.

Cash Flow Statement

Cash from operations or cash used in operations

All the cash received or paid running the business. Includes payments made by customers as well as those made on salaries, supplies, rent, etc.

Cash from investing or cash used in investing

Cash received or spent in investments, including capital expenditures on new assets for the business

Cash from financing or cash used in financing

Cash received or spent borrowing or paying back loans or through investor contributions

Current cash

All the cash held by the company at the end of a specified period

Resources

That covers the basics. If you want to learn more, be sure to check out Khan Academy’s videos on accounting and financial statements. You may also want to pick up Karen Berman and Joe Knight’s book. Financial Intelligence for Entrepreneurs, which is really a must-read.

Also check out:

Buyers’ Guide to Accounting Software What does accounting software do? What’s the difference between Xero, QuickBooks, FreshBooks, Zoho? How much should you expect to pay?

Hiring Bookkeepers and Accountants Getting help with the books can be critical. Why does having good advisors matter? Determining what you need. Where should you look for help?