Thursday, April 21, 2011

Lesson #9: Using Financial Statements As Scorecards, Part 1

I know that most of us have a vague understanding of finances as it relates to your business. Don't despair! Learning a few key components about business finances will go a long way to make sure you're making money. Surprisingly, most people going into business don't know if they're profitable or not! Being financial dumb is a bad excuse for any business failure. 

Making Finance Your Sexy Partner

QuickBooks is the recommended software because it is easy to use, it’s like a mother hen to your inexperience in bookkeeping and if you really screw up, there are more experienced QuickBooks bookkeepers than any other accounting package – by far. Intuit, the makers of QuickBooks, has several levels of sophistication of their QuickBooks product.

The simplest version is simply entitled: “Simple Start” but it’s been converted from the standalone computer version to the online version. Instead of paying a one-time price for the product, you’re required to pay $12.95 per month or $155.00 annually. No doubt, it’s a good product and safe since all your data is on their servers (aka cloud computing) and accessing the info can be done wherever there’s a computer. However, if your budget doesn’t like that monthly fee, your other choice is QuickBooks Pro (Retail: $200 and Street: $150). It’s more sophisticated but quite learnable and frankly, as powerful a program as you’ll need for several years. Your files from Simple Start will also easily move over to Pro.

Of course, if you feel comfortable with cloud computer and its advantages, then there are two other online versions of QuickBooks – Online Essentials ($24.95/month) and Online Plus ($39.95/month) - that can expand your range of sophistication and options –

Learning to enter data accurately and setting up a double-check system are ideal because, in many cases, the person entering the data (most likely you) will need time to get up to speed with QuickBooks, so the possibility of errors is reasonably high. By having an outside bookkeeper check your work, you’ll have greater accuracy. To find a local QuickBooks bookkeeper, you can go to: and if you want one for the web version, you can go to:

How to Learn QuickBooks
Get acquainted with QuickBooks by practicing every day for an hour with your personal financial data. (Don’t worry—QuickBooks can handle multiple companies, so when you’re ready to launch your business, you’ll be able to start from scratch while retaining what you’ve already done in a separate file.)

Use QuickBooks to track your monthly income and expenses. Check out the account categories:     
  • Bank
  • Equity
  • Current assets
  • Long term liability
  • Fixed assets
  • Expense
  • Income

Also check out the “vendor” and “customer” categories. These will be useful when you start to input your business financial data.
As you enter information, the program will require you to categorize the information into different buckets. Examples:
  • PaycheckàIncome
  • Cell phone billàExpense
  • GroceriesàExpense
  • Stock DividendsàIncome
  • Stock PortfolioàCurrent Assets
  • ComputeràFixed Asset (with a value placed to it)
  • Car and monthly paymentsàLong-term Liability
  • Cash in the bankàBank (Later, as you put in money to launch your business, the amount (i.e. $500 should be listed as “equity.”)

These categories are essential for providing an accurate report on your financial health. Pretty soon, you’ll be a darn good money manager. Be diligent and accurate in your bookkeeping, double-check your entries, and remember this simple rule: spend less than you earn. That way, you’ll always be on the sexy side of the ledger.

At this point, let’s define some basic fiscal jargons before you’re introduced to the financial scorecards. And believe me, once you start using scorecards, you’ll have a powerful tool for controlling your finances. It’ll make your life a whole lot easier.

Defining Assets and Liabilities
Assets are positives but they are defined in different ways. When banks are considering you for a loan, they will call your car and boat an asset even though you are still making payments on them. In the most productive use of the term, we can define asset as an income generator - something that will produce income for you such as an interest-bearing checking account and larger entities such as rental property (when the rents surpass your mortgage payments and other liabilities).

Assets include:
·       Cash
·       Bank accounts
·       Stocks, mutual funds and bonds
·       Jewelry made of precious stones
·       Office equipment and furniture
·       Retirement funds
·       Debts owed to you (such as service performed)
·       Net value of your business
·       Net value of income-producing real estate you own

Liabilities include:
Liabilities are negatives. It is money owed and includes:
·       Credit card balances and invoices due
·       Mortgages and lines of credit
·       Car loans
·       School loans
·       Personal loans
·       Taxes owed

Income and Expenses
People who cannot control their cash-flow will always work for others while people who have mastered their cash-flow abilities will have control of their wealth strategy and will define their financial condition as working for themselves.

Income is used to pay your expenses, and unless you have sufficient income over and above your debts, you enter into greater debt in order to make your payments. When you work towards financial security, you can use one of the three forms of income to pay off your debts (defined below). As your asset column increases, the debt side decreases proportionally.

Income is money coming to you. These sources of income include:
·       Wages, tips and salary
·       Interest on investments and dividends
·       Rent from real estate
·       Business profits distributions
·       Capital gains
·       Royalties

Income is classified in three basic types:
·       Earned income
·       Portfolio income
·       Passive income

·       Earned income is wages and salaries from the work you do for others whether in your own company or as an employees.
·       Portfolio income is a type of passive income and it is income derived by stocks, bonds, mutual funds, dividends, royalties and interest earned from savings accounts and loans.
·       Passive income is money generated by a business or real estate holding with minimal effort from its owner. It is also the least taxed.

Expense is the payments you must make on the debts you owe. This is the negative side of cashflow when money is leaving your possession. Expenses include:
·       Credit card payments
·       Home mortgage payments
·       Taxes
·       Loan payments
·       Utility payments
·       Living expenses such as grocery and gas
·       Travel and entertainment
·       All personal expenses

Expense is not only the original amount owed but also the interests accumulated over time. Credit card debt is one of the worst kinds of debts because the interest rates are so high and it is usually used to purchase things that do not create an asset. For many people, credit cards are a seduction to buy because they are so easy to use. The financially literate person will continue to use credit cards for their purchases but pay off the balance each month so as not to incur interest charges. (A quick side note: student loans recently surpassed credit cards as the largest category of debt, according to a federal report issued in April, 2011. In fact, just over 60 percent of college students said they were considering dropping out because their debts had risen so much.)

Debt; however, can be good when used to purchase items that will increase your net worth and/or generate income greater than the expense necessary to purchase the item.

Financial Scorecards
Financial Statements
QuickBooks will generate financial statements based on your data. Financial statements tell you where you stand money-wise. These reports are mandatory to run a successful company and required when applying for bank loans. Usually, the two key reports that most financial institutions are looking for are your Profit and Loss Statement (or Income Statement) and your Balance Sheet (or Statement of Financial Position). There are also two other reports: Statement of Retained Earnings and Statement of Cash Flow. Some banks also may ask to look at these additional statements.

Profit and Loss Statement
The Profit and Loss Statement (or Income Statement, Earnings Statement, Operating Statement) is a company’s record of revenues (money received from sales of products and services, referred to as gross sales or gross revenues) less its expenses (both the costs of the goods and the cost of operating the company). The critical piece of information derived from this statement is called the net income or, in Hollywood language, the bottom line.

The P&L shows the revenues and expenses for a given period of time. Its purpose is simply to show whether the company made money during a certain period of time. In QuickBooks, you can use any set of dates for that period. The most common would be monthly, quarterly, and annually.

The revenues indicated on the P&L is normally written at the top of the statement. Below that is the cost of the goods, if it’s a product, and any returns you may have taken back. If the revenues come from service, there would be no cost of goods. But the cost of providing the service and that would be indicated in salaries, commissions and perhaps, external contract services.

After the revenues, you will see expenses, which is the cost of everything necessary to run the company. The final figure (the bottom line) is exactly in that position—the last figure on the report. It is derived from taking the revenues minus the costs of goods, returns, and all the other expenses to run the company. A simple P&L for a small business looks like the following:

March 1, 2010 to March 31, 2010
 Gross Sales
 Sales Tax Collected
 Less Returns
 Costs of Goods
 Gross Profits


 Commission and Bonus
 Accounting & Bookkeeping
 Microloan Payment (Mthly)
 Insurance (amortized 12mth)
 Equipment Leasing
 Car Lease
 Phones and Internet Svc
 Marketing and Advertising
 Office Supplies
 Travel and Hotel
 Payroll Service
 Employment Taxes        
 Taxes (Sales)
 Total Expenses

(Deduct from Gross Profits)

Net Income (the Bottom Line)  $5,300.00

For nonprofit organizations, the IRS requires a different kind of reporting that essentially does the same thing. However, this report is called the Statement of Activities and includes all of the same categories plus grant revenues and other donor revenues.

A Balance Sheet or Statement of Financial Position is a summary of the money owned and the money owed for your business. The Balance Sheet is a snapshot of a company’s financial condition. It has three components:
  1. Assets
  2. Liabilities
  3. Ownership equity

In a Balance Sheet, the main categories of assets are listed first and in the order of liquidity (meaning assets that are easiest to turn into cash i.e. cash in the bank, outstanding invoices still owed to you by clients, inventory, etc.). Liquidity is a measure of your ability to pay your debts as they fall on their due dates. It is usually expressed as a ratio or a percentage of current liabilities. Following all assets shown, comes a listing of the liabilities. The difference between an asset and a liability is called equity, net worth, or net assets. In an accounting principle called the Accounting Equation, the net worth = assets - liabilities. Another way to look at this equation is as follows: assets = liabilities + owner’s equity (or money). Balance Statements are always shown in two sections: assets and liabilities (plus net worth in the other).

As long as you retain an accurate system of data entry, QuickBooks will provide its own “double-entry” accounting system which is at the heart of the Balance Sheet. It’s not the same as keeping two sets of books like you see you in the old gangster movies where one set goes to the feds and the real set shows all the money from drug deals, offshore accounts, and wild crazy parties.

A double-entry system simply means that for every action, there is a reaction or in accounting terms: debits and credits. So for instance, if you bought ten dollars worth of baseball cards, your debit shows up as $10 spent and your credits would show up as $10 worth of baseball cards. They reside on opposite sides of the Balance Sheet and are double-entered automatically by QuickBooks. The double-entry system is sort of like an error-detection system because if at any point, the debits don’t equal the credits, something is amiss.

The Balance Sheet also shows the various assets and liabilities that a company possesses. If it’s an all cash business with no inventory and no loans, a business could theoretically go to the bank and withdraw all its money to determine the business balance. However, the vast majority of businesses will have outstanding loans, clients will owe them money, rent, equipment, leases, and office furniture. All these values need to be accounted for—assets and liabilities—and the sum total of their values is what the Balance Sheet is all about. Here’s a sample Balance Sheet for a Small Business:

Liabilities and Owner’s Equity
Cash              $5,000.00
Accounts Receivable $7,500.00
 Notes Payable    $10,000.00
Inventory      $9,000.00
 Accounts Payable   $ 5,000.00
Equipment     $7,500.00
 Total Liability    $15,000.00

Owner’s Equity

 Notes Receivable   $12,000.00

 Retained Earnings   $ 2,000.00

 Total Owner’s Equity  $14,000.00
Total      $29,000.00
Total      $29,000.00

The Two Other Reports
There are two other financial statements that are key to understanding the financial health of your company. Besides the Balance Sheet and the Profit and Loss Statement, there is the “Statement of Retained Earnings” and the “Statement of Cash Flow.” All four reports are basic financial statements required under the “Generally Accepted Accounting Principles” or GAAP that is a fundamental standard for the Accounting profession.

Within QuickBooks, you’ll be able to generate any of these four reports as either a general report or a detailed report. Just remember that for the Statement of Retained Earnings, you’ll find that within the Balance Sheet reports.

Statement of Retained Earnings
You’ll recall that in the Balance Sheet, there is a section under Owner’s Equity entitled “Retained Earnings.” Retained earnings refer to income (or profits) that were not distributed to its owners (or stockholders). In this report, these profits are seen over a designated period of time, usually discussed in quarters (three months) and annually. Its role is in showing the changes in net income (and the value in the company which means your financial worth is rising or falling) by first displaying the starting or opening amount of a certain period and the ending amount for that period (such as January 1, 2010 to December 31, 2010). In-between these two numbers are the reasons for the increase or decrease of the ending numbers. These reasons would include profits or losses, dividends paid to owners and stockholders and any other credits and charges (such as employee theft).

Hasta La Vista Dynamite Company
Statement of Retained Earnings
For the Year Ending December 31, 2010

(Opening) Retained Earnings – January 1, 2010                            $120,000.00
Plus Net Income                                                                                  30,000.00
Sub Total                                                                                         $150,000.00

Inventory Loss (Employee Theft)                                                        -5,000.00
Less Dividends                                                                                   -15,000.00
(Ending) Retained Earnings – December 31, 2010                         $130,000.00

As you can see, the income information for the Retained Earnings report comes from the Profit and Loss Statement. The ending figure is provided to the Balance Sheet under Owner’s Equity.

So that in the Owner’s Equity of the Balance Sheet, Retained Earnings would be either the net profits you’ve made or net loss you’ve suffered (which means that your retained earnings would show a lesser number and lower the value of your investment – much like a publicly traded share of stock). Retained earnings are also lowered by “dividends” defined as net profits that are distributed to stockholders rather than returned to the company for its use.

The Statement of Retained Earnings is also called “Equity Statement,” “Statement of Owner’s Equity” for a sole proprietorship, ‘Statement of Partner’s Equity” for a partnership and “Statement of Retained Earnings and Stockholder’s Equity” for a corporation.

Statement of Cash Flow
This statement shows a company’s liquidity and thus, its ability to pay its bills. It is strictly a “cash basis” report on three types of financial activities:
1.     Operating Activities – sales of your products and services, payment to vendors, salaries, interest payments on loans, depreciation, amortization, dividends received by company
2.     Investing Activities – purchase of assets like inventory, land, a building, stocks and bonds, loans made to vendors and clients
3.     Financing Activities – payment of dividends, sale or repurchase of company shares from investor(s), repayment of debt principal

Another key use for this statement is to give you a projection for future cash flow possibilities, a helpful tool for planning ahead.

People who would be most interested in knowing a company’s cash flow would be the owners, its bookkeepers and accountants; lenders and creditors; potential investors and shareholders.

The Statement of Cash Flow only includes the movement of cash - simply called “inflow” for cash or cash equivalents coming into the company and “outflow” for cash or cash equivalents leaving the company. The statement reveals the current operating results and the specific cash movement that created the changes revealed in the Balance Sheet. It does not include depreciation, write-offs of bad debts or credit losses to name a few not affecting cash received and payments made.

(Note: the cash indicated in this report is not the same as the “net income” found in the Profit and Loss Statement because cash flow may be different if you have Accounts Receivable meaning that you’ve given your clients an invoice from which to pay you over a certain period such as 15 or 30 days. This is called “net terms.” In your P&L, your invoices will count as Assets even if you haven’t received your payment. However, in this Cash Flow Statement, nothing gets counted unless you’ve received the money making it truly a cash-only report. If you’re collecting your money from your clients without fail, then the differences should even out over time.)

Hasta La Vista Dynamite Company
Statement of Cash Flow
For the Year Ending December 31, 2010

Operating Activities
     Cash received from customers                                          $140,000.00    (Inflow)
     Cash received from interest/dividends                                    2,000.00    (Inflow)
     Cash paid for salaries                                                           (60,000.00)   (Outflow)
     Cash for rent                                                                         (12,000.00)   (Outflow)
     Cash for Operating Expenses                                               (11,000.00)   (Outflow)
     Cash provided by Operating Activities                                $59,000.00    (What’s left)

Investing Activities
     Inventory                                                                               (17,000.00)   (Outflow)
     Google Stocks                                                                       (10,000.00)   (Outflow)

Financing Activities
     Payment against Owner’s Equity                                          (10,000.00)   (Outflow)

Decrease in Cash During Report Period                                (37,000.00) (Investing & Financing)

Total Cash During Report Period                                            22,000.00

Cash on January 1, 2010                                                           10,000.00
Cash on December 31, 2010                                                      32,000.00

Some Tips on Cash Flow Management
Once you’ve started collecting payments for your services and products, always hold onto as much cash as possible. It’s tough for new companies to keep a secure amount of cash so being frugal and having a plan for savings will serve you well when new business opportunities arise. Keep that in mind even as you grow and the cash conditions improve.

As new business owners, we sometimes have the tendency to mix our credit card buying habits with the same kind of carefree logic as our personal spending habits. Without justifiable evidence we might arbitrarily decide to increase our inventory, add a new employee or purchase office equipment that depletes our cash. Suddenly, when the bills come due and you find yourself with a cash shortage, you’re stunned and babbling like Lt. Colonel Nickelson, who in the World War II movie, “Bridge Over the River Kwai,” utters those famous last words: “Oh my god, what have I done.” (Great movie: see it to find out in what context he spoke that unforgettable phrase.)

So listed below are some ways you’ll control your cash flow:     
Utilize the web. Without a doubt, starting a business today is so much cheaper than just five years ago because many of the business development and marketing tools – many of which are free – are available to you on the Internet. There is no excuse and no way not to be using the Internet to build your business! 
Make financial projections. Forecast both expenses and anticipated revenues for at least the coming year. This will help you predict when you're likely to have cash and when you're likely to need it. You should also maintain a cash reserve if possible. Don’t skimp on this process. You need to think this one through!
Create contingency plans. Just as the GPS asked you the question about what’s the worst thing that could happen to you, you can do the same for your business particularly as it relates to your cash flow. Have several budget projections, including best case and worst case scenarios, and how you might respond. In the event sales don't take off as expected or there's some unforeseen problem, you'll be better prepared.
Keep a lid on spending. One of the most common problems with new businesses is the owners' tendency to spend freely. Do you really need an office or can you work out of your home. You can still take tax write-off on expenses and think like a guerrilla. Remember, you're in this for the long haul: save your money for the future.
Keep inventory low. Stock only what you know you can sell in the short term. Learn to use Just-in-time” inventory buying by building a great relationship with your vendors and assuring quick deliveries.
Lease, don't buy. A good way to conserve cash is to lease equipment instead of buying it. Although leasing can be more expensive in the long run, it helps you avoid laying out a lot of capital all at once for things like office furniture, computers and copiers.
Delay hiring employees.  If the need arises for you to require additional manpower for your business, use independent contractors and consider outsourcing certain nonessential functions. Employees are expensive because you’ll have to pay for employment taxes, social security and worker’s compensation – even with one part time employee. So wait until you’re sure that an additional employee will contribute to the bottomline. 
Pay yourself enough to pay for living expenses. Before you launch your business, get rid of any non-essential luxury items and expenses including that $4.50 latte every morning. Make it yourself. Learn to live (and be happy) without luxuries. Jeff Bezos, founder of Amazon.Com still use plastic folding tables in his conference room. Why? Because it serves its purpose.
Speed up customer payments. Try to get customers to pay on time or early, if possible. Offer incentives like discounts on early payments or cash deals. Adopt effective collection techniques for deadbeat customers.
Don't be wasteful. Recycle and reuse what you can -- for example, boxes, computer discs and file folders. The savings may not be large on any given item, but they can add up over time. 

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