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A Cautionery Tale for Business Owners

Most business owners manage cash well. They know how much they have and shuffle the cash around to keep going - Peter's regularly getting robbed for Paul's sake.

But it's possible to be going broke and not know about it until the cash squeeze becomes too tight and someone (probably a creditor) closes you down.

This nearly happened to a smart, successful business owner I know who came to me and asked why he always seemed to be running short of cash. He had a business selling online goods which were paid for upfront, had a large warehouse full of stock, and he imported his stock from overseas by ship.

An accountant was doing cash flow projections for him and advising to take on more debt as they were warning him of cash shortfalls coming if he didn’t.

But he wasn’t comfortable with continuing to take on additional debt. He wanted a better understanding of what was going on in his business. The first thing I looked at was his profit and loss report, but there was no correction for stock arriving or leaving. Also, given that he was paid up front, the income was being over-stated months before it was properly earned. The business was cash-rich while sales were growing, making it look profitable, but now that sales had levelled off, the cash was running down.

Now while you do have to watch your cash very carefully, the problem is that it’s a bit like waves on the shore. Cash comes in and goes out but it’s very hard to tell whether the tide is coming in (you’re profitable) or going out (losses).

So here's the lesson: Most small to medium business owners don't understand Profit - and by that I mean an accountant's definition of Profit. SME owners often think that profit is the excess cash you generate and take out as a dividend. That's one kind of profit, but I'm taking about accounting Profit.

Accountants have invented this clever way of working out if a business is Profitable or not taking the cash movements out which are confusing the scene in the short and even medium term. It's part of "accrual accounting". Profit is how much money you earned today, this week, this month as opposed to how much of it has actually turned up as cash in your bank account.

The poster child is the P&L (profit and loss) report. I believe the formal name is "statement of income" but no-one I know calls it that. It's easy enough to print one off from your system, you're already keeping accounts for tax purposes, right?

But here’s the thing, your accounts have been maintained to keep the ATO happy, and the ATO doesn’t really care about your business survival. All they really want to know is how much profit you make (as defined by them) and therefore if you've paid all the tax you owe. Furthermore they get you to do the hard yards of working this out and collecting the tax.

Because the vast majority of small business bookkeeping and accounting is done for tax purposes, the reports just don’t give you a proper indication of Profit until the end of the financial year (and probably many months after).

Beyond keeping Mr Taxman off your back, most small business owners simply watch the bank account as their prime indicator of how their business is going. Now while this is important, it is simply not enough; and as you know, business failure rate is shockingly high. Somewhere between 15 and 25% of small businesses fail every year. Compounded over five years this means only about 24% are left in tough times.

The answer is to prepare monthly management report. It's a completely different mindset and approach to accounting than tax accounting. It’s the accounting you do to understand your business, how it makes money, and predict your profit (and even dividend). It's accounting for the Management of the business.

Now if you were to find out that you, in fact, lost money last month, even though your bank account looked healthy, you would be taking rapid action to find out why and fix it. So how could your bank account look healthy despite your business going backwards? Simply because of timing. For example you may have :

  • collected GST but not yet remitted it to the ATO

  • purchased stock and sold it but not yet paid the suppliers

  • collected pre-payments from clients (such as on-line sales) and the goods need to be back-ordered

  • run down your stock by selling it but not replaced it to the same value

  • progress billed a large project ahead of your costs (builders do this a lot)

  • been profitable up until recently and the cash is still rolling in from invoices sent out, but business conditions and costs have changed and you're actually now losing money

Further, your bookkeeper may not have remitted tax or superannuation contributions (yes it happens). Your business could be shrinking and the working capital is coming back to the bank. All of these and other timing events could give you a healthy looking bank account in an unprofitable business. Unfortunately, a very hard landing is not far down the track. Things to consider on your P&L report :

  • not showing unearned income - ie money received or invoiced that you haven't earned and/or haven't incurred all the costs of earning it yet

  • not showing purchases that were put into stock

  • not showing GST (becasue it's just in and out)

  • reversing out expenses which are part of WIP (work in progress) and haven't been invoiced yet

  • showing the cost of stock when it's taken off the shelf and shipped to the customer

  • showing depreciation calculated monthly

  • showing pre-payments as income only once the goods are delivered

  • and so on.

This givens the business owner are much clearer understanding of whether or not they are making a profit. By doing this, the business owner gets a much clearer idea of when their profit was made. They find out whether last month was profitable or not without waiting many months for the cash to play out.

Back to my business owner: I showed him how to correct the accounts for stock. He went back and re-calculated his last 12 monthly stock balances from his stock system and put them into his P&L. The result was that he had actually been in losses for five out of the past six months! If he had kept going that way, ultimately his business would be forced to close. Naturally this came as a huge shock - especially as he had been growing steadily for 7 years.

So we locked ourselves away with the numbers, a whiteboard and plenty of coffee. At the end we had an action plan which included price increases, integrating freight costs into the cost of each item, and overhead cost reductions (it's amazing how much money you can blow on on-line advertising). I'm happy to say he is now doing much better and the business has a great chance of future success with its better reporting of Profit.

So what do SME owners need to do to increase their chances of survival? Management Accounting is what they need to do. Management Accounting is different from tax accounting. A big part of Management Accounting is the reports that are generated every month which tell you whether or not you are Profitable, where your cash is, and how much Profit you are likely to make by the end of the year if things keep going the way they are. Having these reports prepared for you will make all the difference to your chances of survival in business.

Find yourself an accountant who can prepare management reports for you each month and help you interpret them. Then fully engage with the insights gained and you'll reap the benefits.

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