Most business owners are in business to make a profit. It stands to reason therefore that as business owners, we need to be able to understand our financial indicators. Otherwise, how do we know if we’re achieving our objective?
We may have bookkeepers and accountants to help us get the numbers right, but we really need to be the ones reviewing the financial performance of the business, and making decisions based on those numbers.
Unfortunately, many business owners seem to view accounting as a foreign language that they will never get to grips with. But actually it can be quite simple if you think about it using the following basic concept – money flows into 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. For every debit there is an associated credit – that is the basis of double entry bookkeeping.
Credits = where the money is from
A new business starts with a zero position. The the first transaction is always money coming in, normally from the business owner or as a loan, or from somebody else, such as the bank (creditor). Loans and creditors are a liability of the business, and are credit entries in your accounting records.
When you start trading, you receive more money for the goods and services you provide (income). All this money coming 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 naturally, the outflow is a debit in the accounts. Money flows out to buy goods that are used to make what you sell (cost of sales), and to pay rent, wages and other running costs (expenses). These expenditure items are debits in your accounting records.
You may also spend the money you’ve earned on equipment that will last a few years, or stock that you will eventually sell. If you have a bit of money left over, you will put it into a bank account for safe keeping. Stock, equipment and the positive bank balance are all referred to as assets of the business, and are all debit entries in your accounting records.
And then it gets more complicated …
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). On the other hand, suppliers are in effect lending you money, so are creditors.
Because there can be many types of transaction and accountants are very clever people, accounting records 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), leaving a balance that 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 is at that date. Some funds will be tied up in assets and your customers will owe you money (debits). In turn, you will owe money to your suppliers and anybody that’s loaned you money to buy things (credits). 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 a corresponding ‘out’, then your double entry will be correct, and your books will balance. Simple!
If you need help interpreting your financial statements, talk to your bookkeeper, accountant or coach, but you need to take ownership of your numbers 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!
For more practical help to enable you to really understand your financial statements, why not come along to our next Finance Mastery Workshop?