For those not inclined to be organized, the idea of doing your own accounting beyond balancing your checkbook may make you a little queasy. However, you’ve managed to keep your lunch this far, and guess what? You’re almost done! Over the past three weeks, we’ve discussed balance sheets, income statements, and cash flow statements; today, we will be discussing the linchpin that allows the financial statements to communicate in a clear and logical manner… the chart of accounts.
Week 4: Do You Have the Right Chart of Accounts?
Well if you don’t, then you should, and hopefully after this, you will. Your business life has the chance to become incredibly more coherent once you implement the right one. In layman’s terms, a chart of accounts (COA) is just that — a chart, made by you, listing each of your General Ledger account names that describe the nature of the account; all your financial transactions get recorded by coding the transaction following the COA . SmallBusiness.com refers to it as “an accounting term that describes a list of common ways money is used by a business so that its owners and managers can organize revenues, costs, and assets into categories.” It is, for any business, an invaluable tool. Remember, the coherency of financial statements is all in the coding.
Below is a basic format for setting up the COA.
|Income Tax Expense||900-999||9000-9999|
The 3-digit coding can accommodate two product lines; if you have more than two, use 4-digit coding which considerably expands the coding universe. Please note that service lines may be substituted for product lines.
Direct Costs may be defined as costs directly associated with the cost to manufacture, warehouse, distribute, deliver, or to consult, for a “line of business”. Direct Costs exclude selling, general and administrative expenses. These are Operating Expenses, or Overhead.
A chart of accounts is made to be adaptable to each business’ unique needs, so go ahead and tailor it! This is a system made to make your life and the running of your business easier, not to add more stress. Keep it simple. That is the best way to keep it focused, and keeping yourself focused means that you allow yourself more time to explore opportunities that will grow your business profitably by having coherent financial statements.
To reiterate, there are four main types of financial statements: the balance sheet, the income statement, the cash flow statement, and the statement of shareholder’s equity. Balance sheets were our first topic of discussion this month; last week we covered income statements; now it’s on to cash flow statements.
There is a difference between profit — what your company actually makes — and cash. Profit is the overall money your company earned for a given time period, which, as we discussed in our last blog, is what the income statement tracks. Cash is the money you actually have immediately available to you, which is what the cash flow statement tracks. It records the inflow (money coming in) and outflow (money going out, e.g., expenses, purchasing, etc.) of cash in your business and how it’s being used. The SEC states, “A cash flow statement shows changes over time rather than absolute dollar amounts at a point in time. It uses and reorders the information from a company’s balance sheet and income statement.”
Now you may be asking yourself why is it useful to have a cash flow statement, or why to bother going over it. For you and your investors, it’s the most informative financial statement there is–for the simple reason that having one of these allows you to pinpoint exactly from whence your cash surplus, or deficit, is coming, giving you the immediate opportunity to adjust your business as necessary. Or, as financial writer Reem Heakal succinctly put it: it tells you how your company’s cash flow is performing, where your money is coming from, and how it’s being spent. You should review this statement carefully. If you don’t understand what’s going on, pose questions to one who knows.
Generally, there are three different types of activities that cash is involved in and tracked: operating activities, investing activities, and financing activities. Reviews of these show an increase or decrease of your cash over a set period of time. Below is a very, very basic outline of what each of these terms refers to:
This is the most important of the three activities, documenting where your money goes in the operations of the business. This is where you can follow what happens to your profits as changes occur in accounts receivable, inventory and accounts payable.
Follow these two rules to find the cash:
- An increase in any asset other than cash has a negative impact on cash and a decrease in any asset other than cash has a positive impact on cash.
- An increase in any liability has a positive impact on cash and a decrease in any liability has a negative impact on cash.
Investment activities is as it sounds, monitoring the purchase and sale of permanent assets in your business. The same two rules above also apply to investing activities.
Financing activities show the changes to cash flow by owner decisions, such as borrowing money, equity capital transactions and dividends paid out to owners. The same two rules above also apply to financing activities.
For more information, check out the SEC’s brochure on A Beginner’s Guide to Financial Statements: http://www.sec.gov/investor/pubs/begfinstmtguide.htm
Understanding these three activities together gives you a strong hold over the running of your business, and in combination with your balance sheets and income statements, begin to give you an advantage in whatever field your business exists by illustrating where you have the opportunities to strengthen, contract, or grow your business to your best advantage. Don’t underestimate the power of your financial statements; understanding them fully will give you the tools to give your business its best shot for success.
How about you? Has your cash flow statement revealed opportunities to you that you might otherwise have missed? Opportunities to grow, or to improve cash flow?
By accounting standards cash-flow cycle is defined as the number of days from a decision to produce a product (or render a service) to the date money is actually received from selling the product or service.
During the cash-flow cycle, the company’s bank account fluctuates from a deficit to a surplus level.
The cycle starts when materials, labor and overhead are purchased. The purchase creates a simultaneous accounts payable and inventory. The next step turns inventory into finished goods which are sold to customers. If the sale is on credit, an account receivable will be generated. The final step of the cycle is collecting the receivable and receiving the funds.
If money is paid out on the tenth day and money is collected on the fortieth day, the cash flow cycle is 30 days. Typically, a bank credit line is established to finance this 30 day time factor. As production continues, the cash-flow cycle repeats over and over again.
Management actions may change the time factor. For example, granting more lenient credit terms and paying bills sooner can increase the time factor. A growing time factor could be a danger signal if not properly managed. In contrast, if management creates more stringent terms by requiring cash, cash deposits or installment terms cash flow can be increased.
The cash-flow cycle is intensified if a company’s business is seasonal. During slow periods, firms in seasonal businesses try to control costs and limit losses. However, fixed costs must be paid.
The cycle can be further disturbed if the profitable months do not outweigh the loss months. If lenders lose confidence in management’s abilities, credit lines will be cancelled.
Cash-flow cycles are a business reality. They lead to trouble only when sales are highly seasonal or when annual cash flow is negative.
The first step in effective cash flow management is to schedule out, on a monthly or weekly basis, anticipated cash receipts and cash disbursements. The difference between receipts and disbursements equals cash flow. When cash flow is positive, funds are flowing into the company; when cash flow is negative, funds flow out.
Cash flow and profit are not the same. Profit is the difference between sales and cost. The one major difference is this: cash flow considers only money actually entering or leaving the company, while profit is calculated without considering whether funds have actually been received or disbursed.
More businesses fail because they have lost sight of their cash-flow challenge or because they have lost the faith of their lenders than for any other single cause. In the current economy with a tighter credit market, failures are even more likely.
The confidence of lenders or investors can be regained by establishing a sound cash flow management process. If you are interested in evaluating your business’ cash flow management process to determine if there are opportunities to increase cash flow please contact me directly at firstname.lastname@example.org or 630-269-7646.
The Wisdom of Henry Hazlitt (1894 – 1993)
There are always any number of schemes for saving the X industry (The X industry is one that is obsolete, for example the Horse and Buggy trade). One such contention is that the X industry is already “overcrowded”, and to try to prevent other firms or workers from getting into it. Another proposal is to argue that the X industry needs to be supported by a direct subsidy from the government.
Now if the X industry is really overcrowded as compared with other industries it will not need any coercive legislation to keep out new capital or new workers. New capital does not rush into industries that are obviously dying. Investors do not eagerly seek the industries that present the highest risks of loss combined with the lowest returns. Nor do workers, when they have any better alternative, go into industries where the prospects for steady employment are least promising.
Similar results would follow any attempt to save the X industry by a direct subsidy out of the public till. This would be nothing more than a transfer of wealth or income to the X industry. Taxpayers would lose precisely as much as the people in the X industry gained.
It is equally clear that other industries must lose what the X industry gains. They must pay part of the taxes that are used to support the X industry.
The result is also that capital and labor are driven out of industries in which they are more efficiently employed to be diverted to an industry in which they are less efficiently employed.
If the X industry is shrinking or dying by the contention of its friends, why should it be kept alive by artificial respiration? In order that new industries may grow fast enough it is usually necessary that some old industries should be allowed to shrink or die. In doing this they help to release the necessary capital and labor for the new industries. If we had tried to keep the horse-and-buggy trade artificially alive we should have slowed down the growth of the automobile industry and all the trades dependent on it.
Paradoxical as it may seem to some, it is just as necessary to the health of a dynamic economy that dying industries be allowed to die as that growing industries be allowed to grow. The first process is essential to the second.
— Paraphrased From Economics in One Lesson (1946)