Accounting For Dummies
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How can accounting help make you a better business manager? That’s the bottom-line question, and the bottom line is the best place to start. Accounting provides the financial information you need for making good profit decisions — and it stops you from plunging ahead with gut-level decisions that feel right but don’t hold water after due-diligence analysis. Accounting also provides the cash flow and financial condition information you need.

Reach breakeven and then rake in profit

Virtually every business has fixed expenses. These are operating costs that are locked in for the year and remain the same whether annual sales are at 100 percent or below half your capacity. Fixed expenses are a dead weight on a business. To make profit, you first have to get over your fixed-costs hurdle. How do you do this? Obviously, you have to make sales. Each sale brings in a certain amount of margin, which equals the revenue minus the variable expenses of the sale. (If your sales don’t generate margin, you’re in deep trouble.)

Say you sell a product for $100. Your purchase (or manufacturing) cost per unit is $60, which accountants call cost of goods sold expense. Your variable costs of selling the item add up to $15, including sales commission and delivery cost. Thus, your margin on the sale is $25: $100 sales price – $60 product cost – $15 variable costs = $25 margin. Margin is before interest and income tax expenses and before fixed expenses for the period are considered.

The next step is to determine your annual breakeven point. Breakeven refers to the sales revenue you need just to recoup your fixed operating costs. These costs provide the space, facilities, and people necessary to make sales and earn profit. Say your annual total fixed operating expenses are $2.5 million. If you earn 25 percent average margin on sales, then in order to break even, you need $10 million in annual sales: $10 million × 25 percent margin = $2.5 million margin. At this sales level, margin equals fixed costs, and your profit is zero (you break even).

Until sales reach $10 million, you’re in the loss zone. After you cross over the breakeven point, you enter the profit zone. Each additional $1 million of sales over breakeven yields $250,000 profit. Suppose your annual sales revenue is $4 million in excess of your breakeven point. Your profit (earnings before interest and income tax) is $1.0 million: $4 million sales over breakeven × 25 percent margin ratio = $1 million profit). The main lesson is that after you cross over the breakeven threshold, your margin goes entirely toward profit.

Set sales prices right

Of course, a business manager should control expenses — that goes without saying. But the secret to making profit is both making sales and earning an adequate margin on the sales revenue. (Remember, margin equals sales price less all variable costs of the sale. Internal P&L reports to managers should separate variable and fixed costs so the manager can focus on margin (although they generally don’t, unfortunately).

In the example above, your sales prices earn 25 percent margin on sales. In other words, $100 of sales revenue generates $25 margin (after deducting the cost of product sold and variable costs of making the sale). Therefore, $16 million in sales revenue, for example, generates $4 million margin. The $4 million margin covers your $2.5 million in fixed costs and provides $1.5 million profit (before interest and income tax).

An alternative scenario illustrates the importance of setting sales prices high enough to earn an adequate margin. Suppose you had set sales prices 5 percent lower. Your margin would therefore be $5 lower per $100 of sales. Instead of 25 percent margin on sales, you would earn only 20 percent margin on sales. How badly would the lower margin ratio hurt profit?

On $16 million annual sales, your margin would be $3.2 million ($16 million sales × 20 percent margin ratio = $3.2 million margin). Deducting $2.5 million fixed costs for the year leaves only $700,000 profit. Compared with your $1.5 million profit at the 25 percent margin ratio, the $700,000 profit at the lower sales prices is less than half. The point of this story is that here, a 5 percent lower sales price causes 53 percent lower profit!

Don’t confuse profit and cash flow

To find out whether you made a profit or had a loss for the year, you look at the bottom line in your P&L report. But you must understand that the bottom line does not tell you cash flow. Don’t ever assume that making profit increases cash the same amount. Making such an assumption reveals that you’re a rank amateur.

Cash flow can be considerably higher than bottom-line profit or considerably lower. Cash flow can be negative even when you earn a profit, and cash flow can be positive even when you have a loss. There’s no natural correlation between profit and cash flow.

Accountants do a lousy job of explaining and reporting cash flow from profit. They don’t even call it cash flow from profit; rather, they refer to it as cash flow from operating activities. So how do you get from the profit bottom line in the income statement (P&L report) to the cash flow from profit? You could try reading the first section of the statement of cash flows. Good luck with that. The first part of the cash flow statement is written by accountants for accountants.

If you’re a busy manager, boil down your cash flow analysis to three main factors that cause cash flow to be higher or lower than net income for the period:

  • Depreciation (plus amortization) expense is not a cash outlay in the period it is recorded, so add this amount to bottom-line net income.
  • Group the three current assets: accounts receivable, inventory, and prepaid expenses. If the total change in these three assets is an increase, deduct the amount from bottom-line net income. If it’s a decrease, add the amount.
  • Group the current operating liabilities: accounts payable, accrued expenses payable, and income tax payable. If the total change in these three assets is an increase, add the amount to bottom-line net income. If it’s a decrease, deduct the amount.

Call the shots on accounting policies

Measuring profit and putting values on assets and liabilities boils down to choosing between conservative accounting methods and more optimistic methods. Conservative methods record profit later rather than sooner; optimistic methods record profit sooner rather than later. It’s a “pay me now or pay me later” choice.

Get involved in setting your company’s accounting policies. Business managers should take charge of accounting decisions just like they take charge of marketing and other key activities of the business. Don’t defer to your accountant in choosing accounting methods for measuring sales revenue and expenses. The best accounting methods are the ones that best fit with your operating methods and strategies of your business.

Budget well and wisely

Budgeting forces you to focus on the factors for improving profit and cash flow. It’s always a good idea to look ahead to the coming year; if nothing else, at least plug the numbers in your profit report for sales volume, sales prices, product costs, and other expenses, and see how your projected profit looks for the coming year. It may not look too good, in which case you need to plan how you’ll do better.

The P&L budget, in turn, lays the foundation for changes in your assets and liabilities that are driven by sales revenue and expenses. Your profit budget should dovetail with your assets and liabilities budget and with your cash flow budget. This information is very helpful in planning for the coming year — focusing in particular on how much cash flow from profit will be realized and how much capital expenditures will be required, which in turn lead to how much additional capital you have to raise and how much cash distribution from profit you’ll be able to make.

Demand the accounting information you want

You should identify the handful of critical factors that you need to keep a close eye on. Insist that your internal accounting reports highlight these factors. Only you, the business manager, can identify the most important numbers that you must closely watch to know how things are going.

Your accountant can’t read your mind. If your regular accounting reports don’t include the exact types of information you need, sit down with your accountant and spell out in detail what you want to know. Don’t take no for an answer.

Here are some types of accounting information that should always be on your radar:

  • Sales volumes
  • Margins
  • Fixed expenses
  • Overdue accounts receivable
  • Slow-moving inventory items

Tap into your CPA’s expertise

As you know, a CPA will perform an audit of your financial report; this is the CPA’s traditional claim to fame. And the CPA will assist in preparing your income tax returns.

In doing the audit, your CPA may find serious problems with your accounting methods and call these to your attention. Also, the CPA auditor will point out any serious deficiencies in your internal controls. And it goes without saying that your CPA can give you valuable income tax advice and guide you through the labyrinth of federal and state income tax laws and regulations.

You should also consider taking advantage of other services a CPA has to offer. A CPA can help you select, implement, and update a computer-based accounting system best suited for your business and can give expert advice on many accounting issues, such as cost allocation methods. A CPA can do a critical analysis of the internal accounting reports to managers in your business and suggest improvements in these reports.

A CPA has experience with a wide range of businesses and can recommend best practices for your business. If necessary, the CPA can serve as an expert witness on your behalf in lawsuits. A CPA may also be accredited in business valuation, financial advising, and forensic methods, which are specializations sponsored by the American Institute of Certified Public Accountants (AICPA).

You have to be careful that the consulting services provided by your CPA do not conflict with the CPA’s independence required for auditing your financial report. If there’s a conflict, you should use one CPA for auditing your financial report and another CPA for consulting services.

Critically review your controls over employee dishonesty and fraud

Every business faces threats from dishonesty and fraud — from within and from without. Your knee-jerk reaction may be that this sort of stuff couldn’t possibly be going on under your nose in your own business.

Preventing fraud starts with establishing and enforcing good internal controls. In the course of auditing your financial report, the CPA evaluates your internal controls. The CPA will report to you any serious deficiencies. Even with good internal controls and having regular audits, you should consider calling in an expert to assess your vulnerability to fraud and to determine whether there is evidence of any fraud going on.

Lend a hand in preparing your financial reports

Many business managers look at preparing the annual financial report of the business like they look at its annual income tax return — it’s a task best left to the accountant. This is a mistake. You should take an active part in preparing the annual financial report. You should carefully think of what to say in the letter to stockholders that accompanies the financial statements. You should also help craft the footnotes to the financial statements. The annual report is a good opportunity to tell a compelling story about the business.

The owner/manager, president, or chief executive of the business has the ultimate responsibility for the financial report. Of course your financial report should not be fraudulent and deliberately misleading; if it is, you can and probably will be sued. But beyond that, lenders and investors appreciate a frank and honest discussion of how the business did, including its problems as well as its successes.

Speak about your financial statements as a pro

On many occasions, a business manager has to discuss his her financial statements with others. You should come across as very knowledgeable and be very persuasive in what you say. Not understanding your own financial statements does not inspire confidence. On many occasions, including the following, your financial statements are the center of attention and you’re expected to talk about them convincingly:
  • Applying for a loan
  • Talking with individuals or other businesses that may be interested in buying your business
  • Dealing with the press
  • Dealing with unions or other employee groups in setting wages and benefit packages
  • Explaining the profit-sharing plan to your employees
  • Putting a value on an ownership interest for divorce or estate tax purposes
  • Reporting financial statement data to national trade associations
  • Presenting the annual financial report before the annual meeting of owners

About This Article

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About the book authors:

John A. Tracy is a former accountant and professor of accounting. He is also the author of Accounting For Dummies. John A. Tracy is a former accountant and professor of accounting. He is also the author of Accounting For Dummies.

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