What is Accounting?
Accounting is a process of sorting financial data. Through sorting the data, the accounting process creates products. The products are reports. These reports are useful to the management team, business owners and shareholders or investors. The reports also play a pretty vital role in helping your accountant file your taxes.
The first part of the accounting process is bookkeeping. Bookkeeping is the process of recording the financial transactions. You can have a bookkeeper who isn’t an accountant because you don’t need to have an accounting degree to understand bookkeeping. It’s a data entry that anyone can learn.
It’s like when you go to the dentist and one of the technicians takes your x-rays (the first part of the process). Then the dentist looks at the product (the x-ray) and can analyze the information to figure out what needs to be done.
Here are some important things the accounting process includes:
Preparing adjusting entries. Accounting at it's core is a bunch of journal entries and by the nature of the accounting practices, sometimes it's necessary to enter adjustment journal entries. It's pretty weird sounding if you haven't had any accounting education
Analyzing operational costs.
Preparing financial statements like a balance sheet and profit and loss statement.
Completing income tax returns, sales tax returns and payroll tax returns.
Accountants often help business owner understand the impact of financial decisions. And use the information from the bookkeeping data for tax planning, financial forecasting and strategic planning.
Alright, now that we know what accounting is. The next thing we’ll learn about are specific reports that you should become familiar with.
Financial Reports: The Trifecta
Success is whatever you define success to be. It’s not objective. However, if you want to have an understanding of managing and running a business, from the success perspective of revenue and finances, you have to learn certain numbers and get comfortable with reading certain financial reports.
There are 3 financial reports that you need to become friends with. Good things come in threes. Jordan, Pippen and Rodman. God, Jesus and the Holy Spirit. Harry, Ron and Hermoine. Curly, Larry and Moe. Cory, Shaun and Topanga.
Here is your accounting report trifecta:
The income statement AKA the profit and loss statement
The balance sheet
The cash flow statement
The Income Statement AKA the Profit and Loss Statement
It’s a Narrative
The P+L tells a story. It shows revenue, direct costs and operating expenses over time.
It’s a bit like a bank statement in a few ways: it shows the total deposits and then it shows outflows. And it’s also over time. The difference is the P+L lumps everything into categories instead of seeing each line item.
You can look at your P+L over different periods of time. You can run a monthly P+L. You can run a weekly P+L. You can run a quarterly P+L. You can run a daily P+L.
The Bottom Line
You know the phrase “the bottom line”? This where we get it from. It’s the last line on the income statement. And it shows you if you’re making a profit, breaking even or losing money.
A profit will show a positive number, a loss will show a negative number and goose egg means you’re breaking even.
The bottom line needs to positive more often than it is negative in order for your business to survive.
The Balance Sheet
It’s a Snapshot
A balance sheet is like a photograph of your finances. It's a snapshot that shows what assets your company controls and who owns them. You must give a shit about this statement, because it'll help you understand things like: Is my company on it's way to going bankrupt? How much can we invest in a new line of business? It’ll give you numbers that you can use to analyze your business.
The balance sheet is a complex demonstration of the basic accounting equation:
ASSETS = LIABILITIES + OWNER’S EQUITY
The balance sheet will let you know exactly what assets (things of value) and who owns those assets: someone else (liabilities) or the business owner (owner’s equity).
Here's a few things to note about the balance sheet: The balance sheet is separated with assets on one side and liabilities and owner’s equity on the other. It is so named because the two sides of the balance sheet ALWAYS balance. In other words, both sides add up to the same amount.
What are assets?
An asset is anything of value that your business controls. Here are some examples of assets: Cash, office equipment (computers, chairs, machines, car, etc.) and inventory. Accounts receivable are also assets, this number represents money that is owed to you by customers or clients who haven't yet paid you.
The thing about assets is the financial ownership doesn’t matter. Here's a good rule: if something is in possession of a company, it is considered an asset.
Did you buy a new computer for work? It's an asset. Did you buy a bicycle to make deliveries? It's an asset. Did you buy a new screen printing machine to make prints to sell? It's an asset.
And what about liabilities?
Liabilities are debts you owe to other people. Some examples of common liabilities are credit card balances that are due, an outstanding payment owed to vendor or a long-term small business loan.
If you have to pay debts in the future or have any future financial obligations, these debts are also listed in the liabilities section.
What the heck is owner’s equity?
Owner's equity is the difference between what your company owns as assets and owes as liabilities. In other words, it's the portion of the business assets that you own free and clear.
It’s important to note and that owner’s equity is not necessarily how much the business is worth if it were to be sold. This is because businesses are usually valued based on a multiple of it's earnings.
To recap, the balance sheet will show you what your business owns and what it owes.
The Cash Flow Statement
What is cash flow?
Cash flow is money coming into the business. How does money come into the business? There are three ways:
Operations or sales of your product and/or services.
Bank loans or lines of credit. This has to be paid back because you’re borrowing money.
Funds from investors. Usually investors expect a return on their investment or they are shareholders in your company - who expect a return on their investment.
The cash flow statement shows how cash flows through the business. Just like how the P+L shows numbers over a period of time, so does the cash flow statement. But different from an P+L, the cash flow statements accounts for borrowed money and investor money.
Cash flow from operations is the best kind of cash flow because you earned it. It’s a result of running the business - solving a problem for a customer.
How to have good cash flow?
Invoicing policy
How quickly are clients paying your invoices after you’ve sent them out? If they’re paying right away, you probably feel like cash flow is good. If they’re paying 60 days or later, I know you know what tight cash flow feels like. Feels like you aren’t eating enough fiber, doesn’t it? You can’t invest in your company if you don’t have the cash on hand. Creating and sticking to an invoicing policy is the start to healthy cash flow.
Collections policies
When I was 18, I applied for a job at a big bank. The job was to talk to customers on the phone for 4 hours. I was calling customers who were late on their car payments. At first, I was totally freaked out to ask people for money. But after a while, it got easier. Way, way, way easier. Part of the reason it wasn’t so bad was because the terms were all laid out beforehand.
You need to have policies in place from the beginning and communicate it to your client so everyone’s expectations are managed.
Banks and Credit Card Companies
Know what you’re getting into when you borrow money. The bank sure as hell have policies in place when it comes to them collecting the money you owe them. I know, I used to collect for them. Their policies include late fees, reporting payments that are 30, 60 or 120 days late to the credit bureaus and calling you - a lot.
Extending Credit
If you give your customers products on credit. You’re taking on risk. Understand how and what you can do to protect yourself from being screwed over, holding the bag.
Relationships with Suppliers
If you’re dealing with suppliers, you’ll need to navigate your payment terms in way that it’s favorable to you and your biz.
Figure Out What You Need to Do to Give a Shit About Your Financials
Yeah, I said it. Not looking at your financials is not anyone’s problem but your own. If you’re an entrepreneur, it’s most likely because you chose it. Maybe you’re inheriting your family’s laundromat business, but even a non-choice is ultimately a choice, right?
As a result, parts of the choice you made have crap that isn’t always enjoyable. Parts of this choice will be challenging. If you buy clothes that are dry clean only, you have to take that shit to the dry cleaners. And nobody enjoys that. If you choose to live in a 3,000 square ft loft, you need to figure out how that shit is gonna be cleaned, by you or someone you pay or I guess, you live in filth. If you buy the nice car, you gotta take it in for regular maintenance. See how this works.
So I guess what I’m trying to say is: So, you started a business? Congratulations, you played yourself.
I’m not letting you off the hook because I don’t believe in these weird limiting beliefs that you’ve got going on. You are responsible for your business. A bookkeeper or an accountant or business coach can help you run your business, but you need to learn how to poke the part of your brain that will motivate you to give a shit about the numbers.
So take a deep breath and realize this is part of running a business. And that it’s all nonsense that somebody made up a very long time ago and that not knowing this stuff isn’t serving you.