Small Business Finances - Cash or Accrual?

In the April 19th post I discussed the difference between cash and accrual accounting.  In this post I'll go over why you might want to choose one over the other.  My objective for this blog is to always portray the topics from the business owner's perspective.  In this case I'll start with a strong belief that your financials are the tool by which you measure your success if implementing your business plan and of course the success of your business.

Your financials should try, as closely as possible, to report the sales in a given month with all the expenses that were incurred in that SAME month to generate that revenue.  For businesses that don't give terms to their customers that create receivables or receive terms from their vendors that create payables, the cash basis is probably appropriate.  A lot of small B to C (business to consumer) businesses fall in that category.  As B to C businesses grow and for almost all B to B (business to business) businesses, the accrual basis is necessary.

If you review the April 19th post you'll see that timing is everything and that only the accrual basis of accounting will meet our objective to have the revenue and expenses for each sale aligned in the same month.

Choosing accrual accounting is not the only decision we need to make to make sure we have our revenue and the corresponding expenses aligned in the same month.  In the next post we'll look at some GAAP (Generally Accepted Accounting Principles) that may be appropriate for small business to increase the accuracy of their financials.

Accounts Receivable and Collections

Oh boy - those are scary topics for any entrepreneur.  We'd all like to operate in a COD business (oh yeah, cash in advance is even better) but if we have have any amount of business-to-business sales, at some point we're going to have to give terms to a customer.  Keeping on top of who owes you money and COLLECTING that is very important to your cash flow.  Many small-business owners feel like they're going to insult their customer or make them unhappy if they try to collect money owed.  Don't feel that way!  You're providing them credit so you're doing them a favor. Make sure you review your accounts receivable at least weekly - and take action!

Before we jump to the point where you need to call them about what is owed, let's consider some other steps.  First off, make sure you invoice in a timely manner.  Depending on your type of business, invoice when the product or service is delivered or at the end of the period (e.g. month) if you're on some periodic billing cycle.  Remember that if your invoice arrives late, it's late getting into your customer's payment cycle.  These will seem like obvious points but:

1. Make sure you have their correct address.
2. See if they accept invoices via email and use that if possible for faster delivery.
3. For larger customers, understand their payment cycles so you make sure you work hard to get your invoices in before the cut-off for a given checkrun.
4. Use statements for late payers and be prompt in issuing them.
5. Try follow-up emails ("Just checking to make sure you received our statement").

If all that fails then you should have no compunction about making the call.  Start it soft, "I just want to see where you are with our payment for invoice 123".  Listen to their answer and be prepared to work with them.  If they say they can't pay it, look for alternatives: partial payments or converting a cash pay account to credit card or a schedule of payments if they can't pay today.  A customer with cash flow problems will be much more likely to work with you if you seem tuned in to their problems.  Empathy goes a long way, particularly if you're both small business owners. Play on their sympathy for you, "I've already paid my employees who performed this service for you".

Don't be tempted to keep selling to someone who isn't paying you under the mistaken impression that you need those sales.  Watch out that your salespeople don't get you in this position.  Sales and collections need to part of the same team.  More sales can't happen if you don't have the money to support the sale and you get that money through collecting your A/R.  Remember - it's your money!

Demystifying Cash and Accrual Basis Accounting

Today I’ll cover the difference between cash and accrual accounting.  You must choose one or the other method for tax reporting and consistently use it from year-to-year but it doesn’t mean you can’t use the other, or even both, for your internal reports.  Remember I’m writing this from a business owner’s perspective.  So while you definitely want to work with your accountant to determine which method he or she recommends for tax purposes, you should use everything you need to make timely and informed business decisions.

Cash Basis

Let’s look at cash basis from both a revenue and expense perspective.  From a revenue perspective you recognize the income from the sale in the month that you receive the payment from the customer.  So if you sell something for $150 this month and are paid next month you have $0.00 in revenue this month and $150.00 in revenue next month.  From an expense perspective you recognize the expense in the month you actually pay the invoice.  So if you buy something this month for $75.00 but pay for it next month, you have $0.00 in expenses this month and $75.00 next month.

Unfortunately for a business just starting out they may have to give terms to a customer so that they can pay next month but the small business may have to pay its expenses in the current month, perhaps even COD.   So, our revenue would be the same as the example above of $0.00 this month and $150.00 next month.  BUT, the expense would be $75.00 this month and $0.00 next month.  So, we’d have a loss of $75.00 this month ($0.00 in revenue minus $75.00 in expense) this month and a profit of $150.00 ($150 in revenue minus $0.00 in expense) next month.

Accrual Basis

Again, we’ll look at accrual basis from both a revenue and expense perspective.  From a revenue perspective you recognize the income from the sale in the month that you deliver the goods to the customer.  So if you sell something for $150 this month and are paid next month you have $150.00 in revenue this month and $0.00 in revenue next month.  From an expense perspective you recognize the expense in the month you actually receive the goods from your vendor.  So if you buy something this month for $75.00 but pay for it next month, you have $75.00 in expenses this month and $0.00 next month.

So, continuing with our example from above we’d now have a profit of $75.00 this month ($150.00 in revenue minus $75.00 in expenses) and a break-even of $0.00 next month ($0.00 in revenue minus $0.00 in expenses).

Timing

So the difference between cash and accrual is all in the timing – when do you recognize the revenue and expenses?  It may not be apparent at first but (at least in my opinion) the accrual method is more accurate.  I say that because the revenue from the sale of the product now occurs in the same month as the expenses you incurred to deliver the product.  CAVEAT 1 – before someone takes me to task over the flow of inventory we’ll cover that in another session (consider for this example that your expenses relevant to the sale occur in the month of the sale).  CAVEAT  2 – this applies to most distribution or retail type businesses, manufacturing has its own set of guidelines (more in a later blog).

Cash Vs. Accrual and Your Business Model

I like to think of the accrual method as validating your business model.  By the way, we also have some additional topics (like prepaid expenses) to cover before we have a complete and accurate view of our business model.  Our objective in developing how we record expenses and revenue is to align as accurately as possible the revenue we receive in a month with all the costs related to that specific revenue.

Danger of Accrual Method

You can go broke making money.  What the &$%@?  How can that be?  This is admittedly a very simplistic example of only two months and some ridiculous assumptions but believe me, this happens over and over because folks don’t understand accrual versus cash basis.

Here’s our report on an accrual basis for the first two months of business:

	1	2	YTD
Revenue	150.00	300.00	450.00
Expenses	127.50	255.00	382.50
Profit	22.50	45.00	67.50

It looks like we’re off to a great start.  We doubled sales in the second month and made a YTD profit of $67.50.  Looks like a big bonus of $67.50 for our budding entrepreneur.

Oops!  We forgot to look at our cash which we can see if we look at our books from a cash basis (this uses the same assumptions as above with the payment from the customer coming in the month after the sale but we’re paying our vendors in the month we receive their goods):

	1	2	YTD
Revenue	0.00	150.00	150.00
Expenses	127.50	255.00	382.50
Profit	-127.50	-105.00	-232.50

 It looks like we won’t be taking that bonus yet.  I’ve ignored starting cash balance and made crazy assumptions but I think you get the idea.  The business model is good because the accrual method shows us making money but if we’re not adequately funded and we continue to grow at this rate we’re quickly bankrupt.  There are other ways to look at this but we’ll cover that in a later blog.

It's the Little Things that Get You

This could be subtitled "What You Can't See Can Hurt You." In our quest for profitability we often overlook small expense items in our P&L, particularly if they're set up on autopay through our bank or directly with the vendor. Various web-based products and services come immediately to mind. It's easy to forget about these once we set up the auto-payment and we think, "Well, it's only $19.95 per month after all." But if we have enough of these they add up and even if there is just one, we're looking to drive as much profit to the bottom line as possible.

So, dig into you P&L and root out products and services that you're no longer using - or that you could take a less expensive option on. Many service companies offer an al a carte menu of services. Even if you still need the main course, make sure you really need all the options.