Basic Business Cents
by Lou Schultz, SCORE counselor
Original publish date 05/20/2009 (#9)
As an engineer, I found accounting dull and boring. As a business owner I find it interesting and very useful, in fact a tool that I enjoy.
Software is available to do all the reports for you, but I believe like most things, it is best to do them by hand until you understand what is going on. Just like you don't want to automate a bad process in manufacturing, you don't want to automate a bad process in accounting. It is deadly for the leader to not understand the finances of the organization.
Accounting is defined as "The art of recording, classifying, and summarizing in terms of transactions and events of a financial character and interpreting the results thereof." There are Generally Accepted Accounting Principles (GAAP), which cover the Income Statement (Profit and Loss Statement), Balance Sheet, and Cash Flow Statement.
The Income Statement is a tabulation of the revenue received over a period of time, the expenses over the same time, and the difference between them, which defines the profit or loss over that time frame. It includes noncash items such as accounts receivable, accounts payable, and depreciation. The expenses are listed by major category so as to provide more information as to where the money is going.
The Balance Sheet has three parts: assets, liabilities, and ownership equity. Where the Income Statement is over a period of time, the Balance Sheet is at one point in time. By definition, the net worth must equal assets minus liabilities.
The Cash Flow Statement is a listing of when revenue is actually coming in and when expenses are actually being paid. It tells you where your money is coming from-operations, financing, or investments, and where it is going-operations, financing, or investments. It is an analytical tool that is useful in determining the ability of the organization to meet its obligations. Always a necessary aid for management, its importance is great in this economic climate.
As useful as these three tools are, they are a reflection of what has happened in the past. Management must predict the future. The Pro Forma Financial Projection shows potential of expected income, costs, assets, or liabilities in relation to some planned or expected act or situation. By taking the information on the Income Statement and then predicting results for the next year by month and the following two years by quarter, I have a tool that is extremely useful in making management decisions. It is a prediction that is fine-tuned each month as it is updated. Like any theory that is supported or disproved with data, it improves with use.
Myron Tribus once said, "Making management decisions by looking at the financial numbers alone is like driving a car by looking in the rear-view mirror." The Pro Forma Financial Projection allows us to look forward and see the impact of our decisions.