If you’re a sports lover, you may be looking forward to a summer of watching, or taking part in, your favourite sports. There are so many different types of sports, each with their own unique scoring systems. Obviously, competitors need to understand how their chosen sport is scored in order to play well and improve their performance.
If you look upon business as a game, it follows that we need a scoring system in business to assess our performance, just as our sports stars do. So how do you know what scoring system to use in your business? Well, you must first get the basics right, and that means understanding your accounts. All other measurements relate to your financials, because the object of the game we are playing is generally to make as much profit as we can, irrespective of the business we are in.
The history of accounting
Accounting has been around for a long time. In fact, the earliest records of accounting date back to around 5000 BC in Babylon, Mesopotamia and Egypt, where temple priests kept track of loans to merchants and goods traded. The Greeks invented the banking system so they didn’t need to carry coinage while on a journey. The Romans calculated a system for charging interest on loans and the Jews became masters of money lending and rent collection.
However, it was the Merchants of Venice who developed the modern day accounting methods. A Monk wrote the first accounting manual and coined the phrase ‘double entry bookkeeping’ because of the simple fact that every entry must have an equal and opposite entry for the books to balance. From this, the common phrase, ‘balancing the books’ originates.
So if accounting has been with us as long as money, it really should not be that difficult to understand! However, many business owners seem to view it as a foreign language that they will never get to grips with. But when you think about it simply, it all makes sense. Money flows in and out of your business like a stream. All accounting does is monitor the progress of that money, in the form of credits and debits.
Credits – where the money is from
A business first starts with a zero cash position, and the first transaction is always money coming into it, normally from the business owner or as a loan from somebody else (creditor). Then you start trading and you receive more money for the goods and services you provide (income). All this money into the business is recorded as a credit in the accounts. But then you need to do something with the money you have collected.
Debits – where the money has gone
If the flow of money inwards is a credit, then the outflow is a debit. Money flows out to buy goods that are used to make what you sell (cost of sales), pay rent, wages and other running costs (expenses). Or you may spend that money on equipment that will last a few years, stock that you will eventually sell or if you have a bit left over you will put it into a bank account for safe keeping. Stock, equipment and the bank balance are all referred to as the assets of the business.
When you make something you are converting one debit into another, e.g. materials and labour into stock, and when the stock is sold, that debit becomes cash again. Even when things get a little more complicated and you start buying and selling on credit, this simple system works. If you give your customers time to pay, the money has changed from stock to a debtor (money owed to you), while suppliers are in effect lending you money, so are creditors.
Because there can be many types of transaction and accountants are very clever people, accounts can get very complicated, but underneath this is a very simple system of money in and money out.
So how do we keep track of the inflow and outflow? Well, that is where the financial reports – the Profit and Loss Account and Balance Sheet, come in.
Profit & Loss Account (P&L)
The P&L is a record of all the ins and outs during trading in a particular period, be that a month, quarter, or year. Simply stated, this records all the income (credits) less all the expenses associated with those sales (debits). The resulting balance is the net profit or loss for the period. If there is a profit, this is surplus money coming into the business, so it will be a credit. If it is a loss, it is extra money gone from the business, so it is a debit.
Balance Sheet (B/S)
While the P&L is for a period, the B/S is a ‘snap shot’ at one particular moment in time, so you can see where all the money at that date. Some funds will be tied up in assets and your customers will owe you money. In turn, you will owe money to your suppliers and those that have loaned you money to buy things. The balance between money in and money out will probably be in the bank. Finally, the profit or loss figure from the P&L will appear on the B/S.
So if you have taken care to ensure that every in has an out, then your double entry will be correct and your books will balance. Simple!
Assessing your performance
So now you have your figures, but these don’t mean much on their own. You need to look at them in comparison to something – last year’s results, last month’s figures or your budget. After all, every sporting score board will have a comparison with your opposition. This will show you how your business is performing and also give you an idea of where you need to focus to improve performance. As the saying goes, “What gets measured gets improved!”
If you need help, talk to your bookkeeper, accountant or coach, but you need to take ownership of your financial statements and get to understand what they’re telling you. Accounting needn’t be a foreign language, it just takes a bit of time and study to get to grips with the terminology!
So go on, get hold of those accounts that have been sitting on your desk for the last year, take ACTION and learn the language of business!