For any business cash is important, many people even say that “cash is king.” So when a business owner is looking at their cash position are they referring to their bank balance or are they looking at their statement of cash flows? Many small business owners do not use the statement of cash flows and, instead rely on the balance in their checking account. I recently asked my students this question: “What information are you missing by not reviewing the statement of cash flows. How could the use of the Statement of Cash Flows help a business owner run their business more effectively and efficiently?”

One of my students, Mark, stated that, “relying on a checking account balance is very dangerous.” He mentioned that by looking only at the bank account a business owner isn’t preparing himself for liabilities that may come due, such as sales taxes. In many states the business is a collection agent for sales taxes on behalf of the state. The business will collect sales taxes upon recording a sale. The cash will sit in their bank account for about 30 days (give or take depending on their submission due dates). This is false cash in the bank. Even if you know a portion of the cash in the bank it isn’t yours, you might not be considering all of your debt and accounts payable items along with account receivables to determine your true cash position.

Another students, Craig, summarized that the statement of cash flows allows you to view the cash on hand in tandem with the items due to you and payable by you. This is because the statement of cash flows presents the flow of cash in three different categories: operating, investing and financing. In the operating section you can see how much cash is being generated from the daily sale of products and services as well as the payment for operational items.

Most accounting software providers offer the option to generate a statement of cash flows at a point in time. If you are currently reviewing your income statement and balance sheet each month or each quarter consider adding the statement of cash flows to analyze. Knowing how much cash you have in the bank is important, but planning for both the receipt and use of cash can be accomplished easier with the statement of cash flows at your fingertips.

In the Arizona Republic, the Phoenix Metro area newspaper, there was an article in the business section about how math literacy is directly related to wealth accumulation. According to the article, if a couple can answer three questions correctly they are more likely to accumulate wealth than couples that do not get all three questions correct. The difference in wealth was significant.

I think this logic can apply to accounting as well. Business owners with an understand, not necessarily expertise, in accounting are more likely to be successful than those that do not have a basic understand. This is a generalization as many business owners can hire an accountant or bookkeeper to help them use their accounting information effectively.

A tip that is easy to implement and use in your business is a regular review of the Statement of Cash Flows in addition to your bank balance or check register. Most accounting software, such as Quickbooks, will calculate a Statement of Cash Flows for you so you don’t even need to really know how to do the math. The Statement of Cash Flows will show you how you are using your cash, including any increase in your Accounts Payable or other debt related accounts. It will also show changes in your Accounts Receivable account.

Managing your cash by solely using your bank account will not tell you everything that is going on in your business. Knowing how much cash is on hand is important, but it is just as valuable to know what items are due to you and are due from you.

A really good summary of what the Statement of Cash Flows is, what it includes and what it looks like is found on Wikipedia-Cash flow statement. While I do not use Wikipedia as a primary source, it often makes difficult topics easy to understand.

Hopefully you’ll use the Statement of Cash Flows in your business for the new year. You’ll be glad you did.

This time of year we are busy scurrying to complete holiday shopping, which could include gifts for your employees. The decision to pay bonuses or provide a gift requires careful analysis of the year-to-date results, promises/expectations of employees, and your cash position. Unlike the purchase of machinery or equipment, these payments do not return a tangible benefit. We hope that such bonuses or gifts provide an intangible benefit as happy employees are productive employees.

Did you plan for year-end bonuses? Or was it a last minute decision? What about purchases for automobiles, machinery, equipment, furniture, etc.? If you want to expand your business you will need to buy new equipment. If you want to maintain your business you will need to replace old or outdated equipment. The best way to prepare for the purchase of these large items is to prepare a capital budget.

Summarize the items you think you will need and in what month you plan on purchasing them. Compare the cost of these items to your cash budget. Will you have enough cash in the bank? If not, consider building a relationship with a banker if you do not already have one.

Next, determine the net cost or benefit of your purchase. There are a couple of ways to do this, but the easiest and most commonly used method is Net Present Value (NPV). You will need to know:

1) the cost of the item or project,
2) the life of the item or project,
3) annual cost savings or maintenance expenses,
4) the savage value, if any, and
5) the required rate of return.

Using the data listed above, you’ll drop the data into a table that includes some of the following pieces of information:

• Initial Investment (this is the amount you are paying for the new equipment or project. Show as a negative number)
• Annual cost savings (this is how much the new equipment is expected to save you over its useful life. Show as a positive number)
• Annual costs, if any (this is if the new equipment will have maintenance or other costs to operate in addition to what you pay now. Show as a negative number)
• Salvage Value (If the equipment will have value at the end of its useful life, show as a positive number)
• Net Present Value (this is the result of the figures above summed together)

For an example calculation of NPV visit NPV Example. The best way to decide when to buy, refurbish or scrap equipment/machinery is with a capital budget. Estimate the amount you will need to spend and when you plan on buying the item. Then conduct a NPV analysis to make sure the purchase is a good decision for our business.

As we approach the last month of the year many businesses are in the middle of planning and preparing for a new year. One of the most common planning tools is a budget. For some tips about how to create a budget refer to Budgeting: Are You Doing It? and Year End Budgets. These posts will help you start planning for the next 12 months.

A budget is a great planning tool, but it is generally a static document – meaning it usually doesn’t change after it has been created. When you compare the January budget to the January actual results the differences may be significant. To reduce the wide gaps between budgeted figures and actual results you can create a flexible budget. There are many different types of flexible budgets, but the academic version of flexible budget is a budget that uses the “static” budget estimates using a per unit rate to estimate a “revised” budget for actual production or sales.

For example, assume that you had budgeted to sell 1,000 units (or hours) in January but you only sold (or billed) 900. Comparing a static budget to actual results will show you variances in quantity. However, creating a flexible budget at 900 units will allow you to compare a budget at 900 to the actual results at 900. When comparing the same number of units you can then see inefficiencies instead of just quantity differences. This information can be helpful in determining why you had higher than expected labor or materials costs.

As you sit down to prepare your 2011 budget, reflect on what worked and what didn’t work in 2010. What are some areas that you can cut costs and others that should be allocated additional dollars? Has the marketplace changed, for better or worse, since you prepared your last budget? What changes, if any, do you anticipate for sales, labor costs, and other operating expenses? Remember that you can always change the data later if you need too. A budget is a tool helpful too, create one that it is relevant to your business.

I love this time of year. It forces us to spend time with our extended family, even when we sometimes might not want to. Thankfully, I am in a good place with most of my family members, including my in-laws. My children are really looking forward to seeing their grandparents and I am looking forward to a lot of yummy food and a relaxing day.

As I reflect on the past year, I am thankful for right where I am in my life and my career. I enjoy my work, especially teaching, and more opportunities are abundant this year than one year ago. I am thankful I have been lead down this path as it is not one I would have consciously chosen. Never would I have imagined myself in the classroom year after year and still loving it.

Where are you at in your business? Are you where you thought you would be? If not, what can you do in the new year to get on track? If you are, give yourself a pat on the back to congratulate yourself for your achievements.

Have a wonderful holiday weekend.
Kelly

The term relevance is considered a characteristic of useful accounting information. From an accounting perspective, relevance is when information has the potential to make a difference in your decision making.

Students who are completing an MBA program often ask me why they need to take accounting courses when it is not their major or concentration. In my response I communicate that one day they will be in a management position and they will need to know how to create a budget or read one, read and analyze their departmental financial results, and make decisions for the company that will impact profitability.

The accounting data is relevant to business. If an entrepreneur does not have skill in accounting they should outsource the preparation of the profit and loss statement along with the balance sheet. And while cash is king, it is important to understand what is happening in the daily operations to make good cash flow decisions. The profit and loss statement provides a wealth of information.

But it is not just accounting data that is relevant. Marketing efforts play a big role in the success or failure of businesses. Are you analyzing where you spend your advertising dollars? A few years ago I hired an advertising agency to help me with an ad campaign. They did not guarantee results, but they came highly recommended so I moved forward. In hindsight, it was a waste of time and money. I discounted the value of an ad agency that offered a partial refund if the results I wanted were not achieved because they were not highly recommended. Oops. Since I am not a marketing expert I didn’t know the questions to ask or what expectations I should have of the ad agency. I used the referral as a relevant item to my decision rather than the results of the campaign. My mistake and one I will not make again.

All aspects of our business are important and help us make good business decisions. While they are not equally important, they all play a role that determines how successful we will be.

At a time when many small businesses are cutting or spending very little for marketing, Gnosis Arts Multimedia Communications is coming to the rescue by offering a Your Market Research Scholarship Program. Gnosis Arts will select one business per month – that is 12 scholarships per year! The winner receives a $200 scholarship toward Gnosis Arts market research services. The result is a summary of what online efforts would be best for your business, which means you will know exactly where to focus your time and money.

You must apply for the scholarship and the process is fairly easy. You have to determine four questions you want answered regarding marketing as well as write a paragraph as to why you deserve the scholarship. To read more about or apply for the scholarship click Your Market Research Scholarship Program.

If you are selected as a winner for the scholarship Gnosis Arts will also submit a press release on your behalf. If you are looking for a little boost to help your marketing efforts, I recommend you apply. Even if you are not selecte, the effort of creating the four marketing questions you have about your target market will give you greater clarity as to where to focus your time and money.

Good luck!

Supply and demand are two keys that drive business. While these are more economic principles than accounting topics, we use these concepts in budgeting and planning. Even if a small business owner doesn’t prepare a yearly budget, they most likely have calculated the break-even point. The break-even point tells us how many units we need to sell or the total dollar of revenues we need to generate to cover our costs.

The formula for the break-even point is simple, but can be more complicated if you have multiple products. First you need to determine your selling price per unit as well as the variable costs per unit. The difference between the selling price and the variable costs is call Contribution Margin per unit. Next determine your fixed costs. The formula is:

Fixed Costs / Contribution Margin per unit = Break-Even Point in units

For example, your fixed costs are $90,000. You sell your product for $150 per unit (or you charge $150 per hour for your services). The variable costs associated with your product are $90 per unit (or per hour). The contribution margin per unit (or per hour) would be $60. Using the break-even formula the break-even point in units would be 1,500. ($90,000/$60=1,500 units)

Assume you want to know what your revenue will be at the break-even point. We can convert the contribution margin into a percentage. Take the contribution margin per unit and divide by the selling price. The result is a percentage. Then you use the following formula:

Fixed Costs / Contribution Margin ratio = Break-Even Point in dollars

Using the same example as above, we know our contribution margin per unit is $60. So the contribution margin ratio is 40% (solved by taking: $60/$150). When we put these figures into the formula we get $225,000 as the amount of revenue we need to generate to break-even. ($90,000 fixed costs/40% contribution margin ratio)

When you have multiple products or services you can still calculate the break-even point using a couple of different methods. The easiest is to determine the proportion of each product to the whole. Then multiply the number of units needed to break-even by the prorated allocation. It’s not a perfect methodology, but it can give you insight as to how many of each units you need to sell to break-even.

When you are considering different options for your business, such as should I buy that new truck or laptop computer, how do you determine what factors play into your final decision? Do you crunch the numbers before making the purchase or do you just buy what you need/want? Hopefully you crunch at least a few numbers before making a big purchase. But what numbers should you be using?

As we continue with accounting terminology (see Types of Cost Behaviors), a couple of items to consider when making a new purchase are opportunity costs and sunk costs. An opportunity cost is a foregone benefit. For example, do you rent the extra office on your floor to generate some additional revenue or do you use it as a storage room? The “lost” benefit would be the rental income. A sunk cost is a cost that has already been incurred and is irrelevant for the current decision. For example, the original price for a new car 4 years ago is irrelevant to your decision to purchase a new car today.

Why do opportunity and sunk costs matter? Because we need to account for any lost benefit if we choose one option over another. And the sunk costs are often mistaken for relevant costs and can skew a decision. Therefore, it is important to categorize items before you crunch the numbers.

Here is a common example: You want to buy a new truck for your business. The new truck will cost $36,500. The truck you have is 4 years old. You bought it for $32,000 and the outstanding loan value is $13,000. You wish to sell the auto, but the Kelley Blue Book value is only $12,000. The annual depreciation on the new truck is $7,300 per year. Depreciation on the old truck was $6,400.

In this example the relevant costs are the cost of the new truck at $36,500, the market value of the old truck of $12,000 and the $900 difference in depreciation between the old and new truck. The original cost of the old truck is irrelevant because it is a sunk cost as is the outstanding loan amount.

The next time you consider buying a new vehicle or equipment for your business, look at what items are relevant to the decision. You can use similar logic when analyzing if a cost is avoidable or unavoidable.

Accounting is like a foreign language. The terminology is sometime intuitive and other times very challenging. My students spend the first few classes learning the differences between an asset and a liability as well as debits and credits. They are almost always confused why a debit increases cash and a credit decreases cash because the average consumer is familiar with these terms in the reverse. From a literal standpoint debit means left and credit means right.

As you start to plan for the new year, I will be posting about various accounting terms and other accounting tools. First let’s discuss types of cost behavior. There are two main categories of cost behavior; variable costs and fixed cost. Each of these two categories have subcategories of costs.

The definition of a variable cost is an item (i.e., expense) that varies in direct proportion to the level of activity. For example, a consultant may have to pay an independent contractor $15 per hour to complete a project. The independent contractor is only paid for the hours they work on the project.

With variable costs sometimes the amount can change when their are large blocks of activity, this is called a step-variable cost. For example, let’s say that you are ordering 1,000 brochures. If you order and additional 250 brochures the cost may decrease by $.15 for the additional brochures only. Note the original 1,000 brochures are offered at the original price.

When an cost is considered fixed it means that it does not fluctuate with changes in activity. The amount we pay each month for a car loan will be the same regardless of how many miles we drive. Fixed costs can be considered committed or discretionary. A committed fixed cost is one that cannot be changed over a period of time. An example is the rent on a 5 year lease. The rent payments will be the same each month and we do not expect to be able to break the lease without penalty. A discretionary fixed cost is one that we can choose not to incur, such as the cost for an advertising campaign.

As you analyze your performance over the past year and plan for the next one, consider how your costs are classified. Which ones are variable costs and which are fixed, either committed or discretionary? Once you know your variable costs you can estimate the amount for the new year based on activity levels. For the discretionary fixed costs, determine if those items helped you generate revenue in the past year. If not, can you get rid of them and improve your bottom line?