As a small business owner, your success depends on having enough cash on hand to pay all bills when they come due. Your success also depends on being able to read financial statements as they contain a wealth of information about your business.
When used wisely, financial statements provide:
- hard data for strategic and operating decisions to successfully run and grow your business; and
- an early warning to make mid-course corrections when necessary.
Let us begin this series of three blogs with a few definitions to understand the difference between Finance and Accounting:
Finance is the task of providing the funds for a company's activities. It involves balancing risk and profitability, while attempting to maximize owner’s wealth. This entails three interrelated decisions:
- Investment decision - which "projects" (if any) to undertake.
- Financing decision - how these investments are to be funded.
- Dividend decision - whether any profit is to be distributed to shareholders, and if so, in what form.
We will not be addressing Finance in this series of blogs.
Accounting, on the other hand, is called "the language of business” because it is the vehicle for reporting financial information about a business entity to many different groups of people.
- Management accounting is for people inside the business. It is concerned primarily with providing a basis for making management or operating decisions.
- Financial accounting is for people outside the business, such as creditors, potential and actual shareholders, analysts, government agencies and credit reporting agencies. Their needs are diverse and so the presentation of financial accounts is very structured and subject to many more rules than management accounting.
In this post, we will focus on Managerial Accounting as this is the most important tool for a small, privately-owned company. The next blog will address Financial Accounting and the third will focus on Score Card (also known as Key Performance Indicators).
Managerial Accounting is forward-looking and model-based to support decision making. It is usually confidential and used by management, instead of the public. In the story Alice in Wonderland, the Cheshire cat tells Alice: “If you don’t know where you are going... any road will take you there.” Managerial Accounting not only looks at the history in a specific way but uses it to show the destination and the best way to get there. The most important management report is
Cash Flow Forecasting. Cash flow is the life-blood of all businesses – particularly for the start-ups and small enterprises. As my colleague Ed McMahon in his book Understanding Small Business said: “When you are out of cash, you are out of business.” Given this great importance, every small business must build a model to forecast cash flows by month for at least the next six months (preferably 12 months). The level of details should be just enough to capture major variables affecting profitability and significantly less than that in a Financial Accounting report. Here are the key reasons why cash flow forecasting is so important:
- It identifies potential shortfalls in cash balances in advance and gives you time to take corrective action. Suppliers who don't get paid will soon stop supplying the business; it is even worse if employees are not paid on time. And you could go to jail if you fail to pay the Government.
It acts as an "early warning system" when combined with other management reports; e.g., it could let you know if
- Sales and costs are off the trend line (higher or lower), then you can drill down to find out why
- Inventory is turning over at the right rate (if not, you have too much obsolete, out of fashion items on your shelf or warehouse)
- Customers are paying on time
In addition to the Cash Flow Forecast, Managerial Accounting consists of various reports tailored to individual business needs, such as
- Sales forecasting
- Product profitability
- Client profitability analysis
- Geographic vs. industry or client segment reporting
- Sales management scorecards
- Rate and volume analysis
- Price modeling
- Cost analysis
- Cost–benefit analysis
- Cost-volume-profit analysis
- Life cycle cost analysis
You can find a simple cash flow forecasting template at: http://scorehouston.org/eControl_repository//12-Month_Cashflow.xls You can find other useful templates for building or updating a business plan at: http://scorehouston.org/resources/SCORE-TEMPLATES In summary, to run a business successfully,
Forecast cash flows
- Determine cash needs
- Control inventory, receivables and payables
- Flag out of line revenues and expenses
- against industry (ratio analysis)
- against another period of time (trend analysis)
- against the budget
- Create a Score Card (Key Performance Indicators) and set red flags for action
In the next post, we will discuss Financial Accounting. In my 3rd blogpost, we will focus on the Score Card (Key Performance Indicators).