Hide Notes 

Slide 1: 55 January04 1ACCOUNTING CONCEPTS FOR ENTREPRENEURS There are three essential accounting statements that apply to all businesses, regardless of size. They are the Balance Sheet, the Income Statement (which may also be called an Operating Statement or an Income and Expense Statement or a Profit or Loss Statement) and the Cash Flow Statement. Each displays a different facet of a business’ financial health, but they are interrelated. Even though the small business owner delegates the preparation of these statements to a bookkeeper, accountant or CPA he or she must be intimately familiar with both the makeup and the conclusions of these statements. We hope that this summary review of accounting concepts will be helpful to small business owners or those just beginning the planning process with the goal of starting a small business. The Balance Sheet, so called because it presents a balance of Assets versus Liabilities +Net Worth, is familiar to almost everyone (certainly anyone who has ever had to borrow money from a bank or mortgage lender) and is a very important tool in the planning of your business money matters. As an aside, every household should prepare a personal Balance Sheet every year, usually at year end, a snapshot of your overall financial status as the clock strikes twelve on New Year’s Eve. This is as good a time as any to introduce the concept of Accrual Accounting and how it differs from Cash Accounting, which acknowledges nothing until cash has been given or received. As individuals we pay our taxes using Cash Accounting and a business structured under a “sole proprietor” arrangement will account for its activity through a cash-basis “Schedule C” attached to the 1040 form. It is clear, however, that accrual accounting is far superior to cash accounting in presenting an accurate picture of a business’s financial status. We do not mean to thumb our nose at cash since, “When you’re out of cash you’re out of business!” So, we do suggest that new small businesses (or in planning to open a new business) attention focus on cash flow, at least until it is clear that the business has passed the Breakeven Point and is generating a consistently positive cash flow. Mature businesses continue to watch cash flow, particularly how cash positions change from one year to the next. These statements differentiate cash flow from operations, investing and financing activities (see attached sample) since each of the three categories either raises cash or spends cash in quite different ways. Back to the Balance Sheet. (See attached sample.) One of the first things you will notice is a division between Current Assets and Other Assets and between Current Liabilities and Other Liabilities. An older definition of Current Assets are those assets that are cash, Cash Equivalents or similar assets that can be converted to cash within one year. The newer definition of Current Assets includes those assets that ‘circulate’ and change from day to day as opposed to Fixed Assets like plant and equipment. The comparison of Current Assets to Current Liabilities, where Current Assets is the numerator (the top number) and Current Liabilities is the denominator (the bottom number), develops a ratio that is very helpful in evaluating the health of your business. This is called the Current Ratio. If both current assets and current liabilities are the same the resultant number is 1.00. It is obvious that ratios above 1.00 are good and numbers below 1.00 are not so good. This is a rule of thumb, and like all such rules there are exceptions. For example, the largest non-governmental oil company in the world had a current ratio of .82 in 1999, meaningless in the context of their huge fixed asset base of petroleum properties. The material in this document is presented solely as a public service by SCORE® Chapter 72 and has been obtained from one or more Public or private sources. No opinions, findings, conclusions or recommendations expressed herein necessarily reflect the views of SCORE.
Slide 2: 5-2 Contractors who require surety bonding will be faced with a slightly different variation of current assets and current liabilities. They will be asked, “What is your “Net Quick?” (Net-quickly-convertible-to-cashcurrent-assets after subtracting current liabilities.) As we have said, the difference between total assets and total liabilities is the business’ net assets (same as net worth), the two principal components of which are the Capital that has been invested in the business and Retained Earnings (the accumulation of prior profits of the business which have not been expended or withdrawn). We have said that the Balance Sheet is a snapshot. The Income Statement (see attached sample) is more of a movie, which is stopped at various intervals, called accounting periods, to look backward to analyze the profit result of the business. The shortest interval is usually a month and the longest a Fiscal Year. Then you can do neat things like comparing one month against the one before and against the same month in the prior year or simply comparing year to year as you usually do with all three of the financial statements. When more than one year is presented the statement is called a Comparative Statement. The Income Statement (keep in mind we’re talking accrual accounting here, not cash accounting) will introduce several new terms. Revenue, for instance, which is the total amount taken in by the business for the sale of merchandise or the rendering of services during the selected interval. When your banker talks about the “top line” he or she is referring to Revenue, that is a long way from net profit or net income, the “bottom line”. First, part of the revenue may be Accounts Receivable, which are sales made and earned but not yet collected. If it is determined that certain accounts receivable may become a Bad Debt then that amount must be deducted from revenue and the resultant figure becomes Net Revenue. Similar offsets to the Gross Sales component of revenue are Sales Returns, Sales Discounts and Sales Allowances and, of course, Cost of Goods Sold. The remaining deductions to Revenue and or Net Sales are the various expenses that are necessarily incurred in running the business. Once these expenses, usually presented in some detail, are deducted you have reached that income level which is called EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization.) Once you add these further deductions (if they are required) you finally reach Net Income. A further display on the Income Statement usually shows the amount of retained earnings being carried forward from prior periods and the new total going forward. The final of the three statements is the Statement of Cash Flows (see attached sample) that, as we have said, details and segregates the cash flow from Operating Activities, from Investing Activities and from Financing Activities. In addition the display will show the total cash gained from these activities, added to the cash and equivalents at the beginning of the year, resulting in the amount of cash and equivalents at the end of the year. Like the income statement this statement covers an accounting period, usually a fiscal year. One of the neat things displayed in this statement is the process whereby net income from operations (an accrual calculation) is converted to net cash by various additions or deletions. You may be confused since this cash flow statement looks nothing (or very little) like the monthly (first year) and quarterly (second and third year) statements of cash flow that are called for in a formal Business Plan or by potential lenders for a new, or proposed, small business. There are two reasons for this. One, the statement here starts from net income, a figure that already incorporates all the expense items and two, it represents real results not projections which are the numbers you may be struggling with. It might help if you labeled your work “Projections of Future Cash Flows” or “Cash Flow Budgets” which may be more accurately descriptive of what you are attempting than the term Pro Forma Statements of Cash Flows. The material in this document is presented solely as a public service by SCORE® Chapter 72 and has been obtained from one or more Public or private sources. No opinions, findings, conclusions or recommendations expressed herein necessarily reflect the views of SCORE.
Slide 3: 5-3 We mentioned the Current Assets/Current Liability ratio that is a test for solvency. Here are some other helpful ratios: Total Debt/Net Worth Working Capital/Sales Cost of Sales/Inventory Net Profit/Sales Cost of Sales/Sales Too much debt could indicate insufficient capital and weaken your competitive position. A handy ratio that you should compare with industry averages to see where you stand. Shows the number of times your inventory turns over. Again, a comparison with industry averages could be enlightening. This measures Profit Margin. This is an indicator of what is available to defray expenses. If the margin is too thin compared with industry averages the business may be headed for trouble. One of the problems with accounting terms is that many of the common terms used by accountants and others are different, but mean the same thing, or very much the same thing. Rather than worry too much about nomenclature just try to get the basic concepts. The critical thing is to understand what the statements furnished you by your bookkeeper, accountant or CPA mean and that you then take any action the figures suggest. It is obviously not possible to distill the complex subject of accounting into a summary of a couple of pages. But it is hoped that this brief exposition along with the attached definitions and the samples of the three types of statements discussed will make you more comfortable with the subject. By the way, if you don’t have a computer with good accounting software, you will be doing yourself a great favor by putting that next on your business shopping list! The material in this document is presented solely as a public service by SCORE® Chapter 72 and has been obtained from one or more Public or private sources. No opinions, findings, conclusions or recommendations expressed herein necessarily reflect the views of SCORE.
Slide 4: 5-4 DEFINITIONS Accounts Receivable Accrual Accounting Amortization Bad Debts In accrual accounting, represents the amount of money for sales made but where the cash has not yet been received. The accounting standard for business where assets, liabilities, sales and expenses are recognized when they are known, even before cash has been received or expended. Similar to depreciation, the non-cash deduction from earnings to represent the declining value over time of certain intangible assets, such as ‘goodwill.’ A deduction that is applied to accounts receivable for that portion which is uncollectible. This item in a year-end Balance Sheet may be an estimate, based on the past history of the business. One of the three basic accounting statements. Assets are ‘balanced’ with liabilities, the difference between them being net worth. That point in a new business’ history when revenue, less all expenses and other deductions begins to generate positive cash flow. Money invested in a business by owners, partners or shareholders. The form of accounting in which nothing is acknowledged formally until cash is received or expended. Individuals pay their taxes using cash accounting. CD’s, Money Market Funds and other such highly liquid investments that do not fluctuate in value and may be converted to cash quickly. A form of Income Statement using cash accounting that is often used in the form of monthly or annual projections or budgets for planning purposes. For mature businesses a different type of cash flow statement analyzes changes in cash flow from operations, financing and investing activities. The actual cost to the business of products that are re-sold by the business. Those assets that change and ‘circulate’ from one day to the next, e.g., cash, accounts receivable and inventory. Under earlier definitions those assets that are most easily convertible to cash. Obligations that must be retired within one year, e.g. accounts payable, taxes, interest and a portion of long term debt among other things. Current Assets divided by Current Liabilities to develop a number either more or less than 1.00. Numbers less than one usually indicate an ‘unbalanced’ financial condition. Balance Sheet Breakeven Point Capital Cash Accounting Cash Equivalents Cash Flow Statement Cost of Goods Sold Current Assets Current Liabilities Current Ratio The material in this document is presented solely as a public service by SCORE® Chapter 72 and has been obtained from one or more Public or private sources. No opinions, findings, conclusions or recommendations expressed herein necessarily reflect the views of SCORE.
Slide 5: 5-5 Depreciation Depreciation is the exhaustion of the useful service potential of an asset through the combined effects of utilization, wear and tear, aging and obsolescence. Applies to tangible assets like buildings and equipment and is applied against the asset side of the Balance Sheet in a structured formula year by year. Earnings before interest, taxes, depreciation and amortization. It is a useful figure that gives an indication of the validity of the enterprise’s sales plan. But, it’s just an interim number in the Income Statement, not something you can ‘take to the bank’. Corporations and business structures other than sole proprietorships may elect to use an accounting period other than calendar year (January 1 to December 31) for tax and record purposes. This generally happens because businesses are not always started on January 1. A fiscal year can, and often does, coincide with the calendar year. Occasionally you will hear the expression ‘physical year’. This is simply a mispronunciation of fiscal. EBITDA Fiscal Year Financing Activities Fixed Assets Goodwill Gross Sales Income Statement Part of the modern Cash Flow Statement that relates to issuance or repayment of debt or issuance or purchase of the stock of the company. Also referred to as ‘Other Assets’ or other than ‘Current Assets’. Is the amount paid for a business that exceeds the fair market value of the assets less assumed liabilities. This amount must be amortized over time. The total sales figure for an accounting period, before deductions for returns, discounts and allowances. One of the three basic financial statements along with the Balance Sheet and the Cash Flow Statement. This statement, like the Balance Sheet, is calculated on an ‘accrual’ basis and shows how the net assets of the enterprise have changed during the accounting period displayed. The products held for sale by the business. A part of the modern cash flow statement that relates to the purchases and sales of assets, expending or adding to the company’s capital. The very ‘bottom line’. What is available for distribution to owners or shareholders or, alternatively, carried forward to the next accounting period. Revenue less bad debts. Gross sales less deductions for returns, discounts or allowances. Total assets less total liabilities. Can be a positive or a negative number. Negative numbers are not good. The key part of the modern Cash Flow Statement demonstrating the cash generated or Inventory Investing Activities Net Income Net Revenue Net Sales Net Worth Operating Activities The material in this document is presented solely as a public service by SCORE® Chapter 72 and has been obtained from one or more Public or private sources. No opinions, findings, conclusions or recommendations expressed herein necessarily reflect the views of SCORE.
Slide 6: used up in the actual operation of the business. 5-6 Other Assets Other Liabilities Pro Forma See ‘Fixed Assets’. Other than Current Liabilities, principally long term debt. A Latin phrase. In an accounting context it means that a furnished financial statement is correct as to form, but that the actual numbers are likely to change. In short, an advance copy or a first draft. A ratio of Net Profit divided by Sales. This will always be a percentage less than 100%, but the higher the better. Earnings that are carried forward from one accounting period to the next. Retained earnings give the business a cushion for hard times and the wherewithal for growth. The ‘top line’. In addition to gross sales it will include such things as interest income. A deduction in a sales price after the sale has been recorded, usually done to keep a disgruntled customer happy. A discount allowed for prompt payment of an accounts receivable item, e.g., a 2% discount for payment in 10 days. Merchandise returned by the customer for full credit. The IRS form attached to a 1040 tax return that reports the business profit or loss on a cash accounting basis for a sole proprietorship. The wherewithal to run the business. Calculated as the difference between Current Assets and Current Liabilities. The bigger the number, the better, up to a point. For instance, too much cash in a business may mean missed opportunities for growth. Profit Margin Retained Earnings Revenue Sales Allowance Sales Discount Sales Return Schedule “C” Working Capital The material in this document is presented solely as a public service by SCORE® Chapter 72 and has been obtained from one or more Public or private sources. No opinions, findings, conclusions or recommendations expressed herein necessarily reflect the views of SCORE.
Slide 7: 5-7 FLORA’S LANDSCAPE CENTER, INC BALANCE SHEET Year ending December 31, 2003 (Initial Year of Operation) ASSETS Current Assets Cash & Eq. Accts. Rec. Inventory Equipment ,net of depreciation Tot. Current Assets Other Assets Real Property,net of depreciation Tot. Other Assets Total Assets 172900 12500 25000 25000 235400 190000 190000 425400 LIABILITIES Current Liabilities Accts. Pay. Debt due in 1 yYr. Taxes Due Total Current Liabilities Other Liabilities Long Term debt Total Other Liabilities Total Liabilities 12600 12500 5000 30100 100000 100000 130100 STOCKHOLDERS EQUITY Capital Paid In Additional Capital Accrued Earnings-Prior Earnings-Current Year Total Accrued Earnings 10000 265000 -3900 -3900 295300 425400 NET WORTH TOTAL LIABILITIES & NET WORTH The material in this document is presented solely as a public service by SCORE® Chapter 72 and has been obtained from one or more Public or private sources. No opinions, findings, conclusions or recommendations expressed herein necessarily reflect the views of SCORE.
Slide 8: 5-8 FLORA’S LANDSCAPE CENTER, INC. INCOME STATEMENT Calendar Year Ending December 31, 2003 (Initial Year of Operation) REVENUE Gross Sales Allowances, Discounts, Returns Cost of Goods Sold Other Income 290000 -7000 -115000 7700 175700 Net Revenue EXPENSES & DEDUCTIONS Labor & Benefits Legal Office Advertising T& E Utilities & Phone Insurance Interest LOC Contract Expense Executive Salaries Depreciation Taxes Miscellaneous Exp. 47000 1000 11000 13500 11000 5500 5500 15000 1100 34500 14000 10000 5000 5500 179600 -3900 TOTAL EXPENSES & DEDUCTIONS Net Income 5-9 The material in this document is presented solely as a public service by SCORE® Chapter 72 and has been obtained from one or more Public or private sources. No opinions, findings, conclusions or recommendations expressed herein necessarily reflect the views of SCORE.
Slide 9: FLORA’S LANDSCAPE CENTER, INC. STATEMENT OF CASH FLOWS Calendar Year Ending December 31, 2003 (Initial Year of Operation) The material in this document is presented solely as a public service by SCORE® Chapter 72 and has been obtained from one or more Public or private sources. No opinions, findings, conclusions or recommendations expressed herein necessarily reflect the views of SCORE.