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7 Questions Small Business Owners Should Ask Themselves When Considering How to Set-Up Their Books

Posted on March 28th, 2016

Jack Kern
Owner / President
Outsourced Accounting Department, Inc.

Some business owners view their financial statements as something that is necessary for tax purposes and don’t really understand what the numbers mean beyond that.  However, the real value of financial statements lies in their interpretation for business decision making and financial planning, and for most businesses, this is Accrual Accounting.  So when might you need this kind of information?

Ask yourself these questions:

  1. “I seem to be making a decent profit, but where did the cash go?” This is a matter of understanding the difference between “profit” and “cash flow.”   A company can be very profitable, but its funds are tied up in accounts receivable, inventory, fixed asset purchases, etc., all of which are balance sheet items and reflected on the Cash Flow Statement, NOT the Profit & Loss Statement.
  1. “How much profit do I need to make in order to pay myself what I’d really like to make, and how do I get there?” When a product or service is sold, the Gross Profit is the difference between what it was sold for and what was paid for it.  For financial reporting purposes, this relationship is referred to as “matching” of costs and revenues, and for most businesses, is accomplished only through “accrual accounting.”        
  1. “What do my sales need to be in order to produce the kind of income I’m looking for?” Initially, this is a “breakeven sales” question, and in order to calculate it, fixed operating expenses are divided by the “Gross Profit Margin” (Gross Profit divided by Sales).  But first, one must know that the Gross Profit Margin is accurate (see # 2 above), as the slightest difference in the assumed Gross Profit Margin (i.e., denominator) can make a huge difference in the final sales number you come up with.         
  1. “How much money do I need to produce that level of sales?” As a business grows, its accounts receivable, inventory, and sometimes its investment in plant and equipment also grow.  To the extent that the business cannot fund the growth in these assets from internally generated profit and cash flow (see # 1 above and #6 below), it must borrow from outside of the business.  Here again, accrual accounting is critical, otherwise receivables and inventory will not even appear on the balance sheet.        
  1. “Where does that money come from?” The real question here is, can growth in the above assets be funded internally, or does it need to be sought outside of the business somewhere, and if so, where, the owner’s personal cash reserves, a lender of some kind, or an investor?   The answer to this question in turn then depends on exactly what kind of asset is being financed (i.e. accounts receivable, inventory, plant and equipment), and the perceived financial strength of the business as indicated by its financials, as the types of lenders and investors vary in terms of the type of assets they will finance, and their appetite for risk.
  1. How much debt can I afford? This is the same question prospective lenders and investors will have, and in a word, the answer is “Profit” (which by the way, is also an extremely important component of “Cash Flow” that all lenders and investors say they are looking at.)  A Loss, is instead a cash drain which, over time, threatens not only a default on the loan, but the very survival of the business itself.  It is also important to be able to demonstrate a historical trend of profitability, so using accrual accounting consistently from the start is just as important.
  1. “Where do I want my business to be a few years down the road, and how do I get there?” Of course, this is first more of a marketing question, but assuming the goal is to sell the business, its value is usually based on some multiple of historical “earnings”(profit).  So in financial terms, the “how” part of this question is by doing all of the above.  

Just some things to keep in mind if you ever start thinking about where you want to take your company few years down the road, and the kind of information you will need for both you and outside professionals to get a true picture of your business (good or bad).

 


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