For many small business owners, managing finances is the most difficult part of running a company. Part of it stems from anxiety. Think about the number of people in life you have met who say, “I’m not good at math.” The reality is that you don’t have to be able to do complicated algebraic formulas to be able to figure out your profitability. It’s actually quite simple; your profit is equal to your revenues minus your expenses. If you generate more than you spend, your company is running profitably.
Doctors, restaurateurs, nail salon owners, really anyone who goes into business, should have at least a rudimentary knowledge of business finance – even if you hire someone to do the books for you. A certified public accountant (CPA) is a well-trained professional who can offer a tailored service for your business needs. Many business owners find their accountants through referrals from their business colleagues, their attorneys or their friends. Hiring a good accountant is one of the most important decisions a small owner can make.
On the other hand, a bookkeeper won’t have the formal accounting training of a CPA, but can handle basic day-to-day functions at a lower cost. Whether you try to do the accounting yourself or hire someone to do it for you, there are the basic concepts that every business owner – especially aspiring entrepreneurs – must understand:
- Accounts receivable: Money that is expected by the business that is derived from its operations
- Accounts payable: Expenses owed to vendors and others
- Payroll: The amount of money you are paying your employees
- Available cash: How much money is in the bank
Now let’s take a look at the documents that report on these important factors:
The balance sheet is the bedrock tool of small business accounting. It provides a snapshot of your company’s financial health and allows you to keep track of your current cash flow situation and help provide projections for the future.
A balance sheet tracks assets, liabilities, and equity. It enables small business owners to analyze revenues and costs, including fixed (rent, insurance, utilities) and marginal (staff hours, inventory, etc.) costs that may change from week-to-week or month-to-month. Work with your accountant to identify recurring and periodic costs, and then properly categorize those expenses on your balance sheet.
Profit and Loss Statement (P&L)
A profit and loss statement summarizes the revenues and expenses a business incurs during a specified period of time, usually a fiscal quarter or year. The difference between a P&L statement and a balance sheet is related to the period of time that is being examined. A balance sheet summarizes a company’s financial situation at a specific point in time (ex: last day of the month). Meanwhile, P&L statement shows revenues and expenses during a set period of time, such as a quarter or an entire year.
A cost-benefit analysis enables a small business owner to look at the money spent by the company and derive whether certain expenses are generating enough revenue to be worthwhile. For instance, a trucking company owner who is deciding whether or not to add a new vehicle will have to consider all the costs of increasing his fleet: purchase price, insurance, maintenance and the expense of hiring a new employee to drive it. If the incoming revenue does not meet or exceed the projected additional revenue that would be generated by the new vehicle in the long-term, the purchase may not be a wise one.
Having a firm grasp of the money coming in and the money going out can mean the difference between profit and loss for any business. Use your cost-benefit analysis to make an informed business decision.
Once you understand these basic documents, you can better manage your finances and improve your creditworthiness if, at some point, your business needs to secure working capital or the funding for growth and expansion. Having a solid track record of repaying debts is important not only for obtaining credit but also in getting it at reasonable rates and terms.
Knowing your cash on hand and your accounts payable will let you know how many of your bills you can pay at a given time. Paying bills on time and in full, if possible, helps establish a good credit history for your business. Doing so will improve the credit rating of your company and thereby increase your chances of securing small business financing.
Currently, big banks are approving about one-quarter of the business loan applications they receive, while community and regional banks are granting almost half (49.1 percent) of funding requests, according to the latest Biz2Credit Small Business Lending Index (January 2018). Banks typically offer the lowest interest rates and the longest payback periods. Lending institutions that are approved partners of the Small Business Administration offer SBA loans, backed by government guarantees against default that incentivize lenders to provide capital to small business owners.
Borrowers that have less than stellar credit ratings may have to approach non-bank lenders (factors, cash advance companies, and others) that will provide credit, but at high interest rates and short payback periods. Improving your creditworthiness will make you a more attractive borrower to traditional lenders. Understanding basic accounting concepts is the first step towards improving your financial situation and credit rating.