Financial Matters Explained
Accrual Accounting
Accrual accounting measures the periodic performance and position of a business in terms of
the "economic events" that occur in the period, regardless of when their related cash
transactions occur.
For example if, in March, you were to purchase a wad of trading stock through a cooperative
which did not issue a single, consolidated invoice until the first week in April, which you then
settled by a payment in May, your cash-based accounting would show the in-flow of cash from
sales of that stock in March, but no outflow for its purchase until May. In this simple example,
March's profits would be falsely inflated, and May's falsely deflated.
It's not a lot different to the problem you would suffer if the fuel gauge on your car had a twomonth lag in its reading: it would be useless - and, in many respects, an accounting system with
that order of lag is also pretty useless as a tool for measuring real-time performance in a real
live business!
The problem I have outlined above is a real one for those who attempt to run a fast-growing
business via cash accounting, and it's further exaggerated when they attempt to do so solely via
their Profit & Loss Statement, so this might be a good time to revise "Accounting 101" and some
of the basic facts about "the books".
Trading Account
This is often presented as "the top
consists of all Sales Income for a
making those sales (Cost of Sales),
for the period.
bit" of a Profit & Loss Account and
period, less the costs associated with
and its bottom line is your Gross Profit
Cost of Sales, by the way, obviously
includes the purchase price of the stock
sold but, less obviously for many
people, also includes any other costs
associated with getting that stock
to the point of sale (transport,
insurance, duties, other services),
and all labour costs associated with its
preparation,
transformation
or
delivery.
These
might
include
technicians' or process workers' wages as well as superannuation, work cover insurance, long
service leave accruals (there's that word again!) or, in a service industry, the salary and
associated costs of the service provider.
Key Concept: Gross Profit is all that you have to meet the other expenses associated with
running your business. It must be measured regularly and protected.
Profit & Loss (P&L)
The Profit and Loss Statement (or "Account") starts where the Trading Account ends - with the
Gross Trading Profit - and proceeds to list all of the other expenses (sometimes called "fixed
costs" or "overheads" because they tend to be relatively static regardless of the volume of
sales).
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Gross Profit minus Expenses gives us our Net Trading Profit and, for most businesses, it is this
figure on which the company pays taxes.
A common distortion of Net Profit arises from owners not accounting for their input to the
business by drawing a regular and realistic salary - one that bears some resemblance to what
they would have to pay a person with their skills, knowledge and dedication, to run the business
at least as effectively as they do.
We also see a few examples of owners who own their own premises but draw a low or no rent,
thus subsidising their business with the use of their assets, and distorting their profits.
Non-Trading Financial Transactions
If a business generates some purely financial transactions that are, strictly speaking, not part of
its normal business trading activities (for example, interest earned on cash deposits, or interest
incurred on loans) these are traditionally brought to account after the trading profit, and before
tax liabilities are calculated.
This practice enables the business operator to gain a clear picture of the profits they are
generating purely as a result of their trading, before they account for financial income or
expenses.
Balance Sheet
The Balance Sheet is our record of what the company owns balanced against what it owes, and
will always display an equal figure on both sides for the simple reason that anything "left over",
whether a debt or an asset, is owed to the business by the owners, or is owed by the business
to the owners. This difference is termed Capital and, in a healthy company, will usually be owed
to the owners (shareholders).
The major items of interest when using a Balance Sheet to provide part of the picture in relation
to the trading performance of the business, are: the balance of any loan (including overdraft)
accounts to and from the business, and the total value of Trade Debtors (this is an asset "something owned by or owed to the business") and Trade Creditors (a liability - "something
owed by the business").
A common rule of thumb for Debtors and Creditors is to attempt to balance them (make sure
that we are using as much of other people's money as other people are using of ours) - then
add a "fudge factor" of around 10% on the Debtors' side, because we know we will always pay
100% of our Creditors' bills for the goods and services they provide, while we don't enjoy the
same certainty that we will collect 100% from our Debtors for the goods and services that we
have provided to them.
The relevance of the Balance Sheet when it comes to judging our trading performance, centers
mainly around shifts in the balance of what is owed to us and what we owe to others (except for
the Shareholders). Regardless of our Net Profit, any shift that lessens our Assets relative to our
Liabilities represents a lessening in the ultimate value of our business.
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Using Your Accounts as a Dashboard
Let's have a quick look at how we might interpret a set
of accounts to determine how we have traded over the
last month.
In a cash model, if we were busy and now have more
money in the bank than at the end of last month, the
tendency is to think that we have had a good month.
But, what won't be obvious without reference to our
Balance Sheet items, is that we may have bought a
large amount of stock on credit (we won't have to pay
for that for a month or more) and sold all of it at such
thin margins that they did not even cover our
expenses. Sure, we feel great with a pile of money in
the bank right now, but wait until the hangover hits
next month when we have to pay our Suppliers!
Working from our Trading Account, P&L and Balance Sheet, however, we would have gained a
different picture of our performance, become aware of the low margins more quickly, and have
been in a better position to correct pricing (or purchasing) to turn the matter around.
Our Trading Account would tell us instantly that despite heavy sales activity, our Gross Profit
was low (the direct result of low margin sales).
Next, our P&L would tell us that our Expenses are now closer to the value of our GP than last
month (i.e: our Net Profit is dropping).
And finally, our Balance Sheet will show us the size of the debt that we have to address, and
how much we have in the bank to do that.
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