People often say that they don’t need to understand Finance, including my husband who said he would make enough money to hire an Accountant (lucky for him he married one, not sure it was cheaper though?!). Many of these same people find that they are working long hours & don’t know where the money is going (sometimes it’s because it is walking out the door with that trusted Accountant!) or they now have the Accountant telling them where to spend their money & what they can & can’t afford. Many people develop a negative block towards Maths (read this fascinating article to see the negative impact of verbalising these ideas) & by extension Finance, from an early age and so they gave it up & left it to someone else. But it’s not true! I believe Finance is like another language – the language which explains what is happening in your business – would you do business in a foreign language & trust a translator with all the important business decisions? Why do the same with the numbers?
Let’s start with 3 key areas you should know to start financial understanding & to start to gain back the control of your business;
1) Cash does not equal Profit
A client of mine was horrified, when their Accountant smiled at him & said that the good news was that he hadn’t made a Profit. “How is that good news?” he asked me & even more perplexed, “Why do I have money in the bank if I’m not making Profit?”
The simple answer is that Cash in the Bank does not equal Profit. But why? And why was it good news not to make a profit? Let’s answer the second question first… for tax reasons it’s better to make no or minimal profit so that you pay little tax. However the down side is that Banks are usually fairly short-sighted when it comes to reading small business financials & they read no profit as no money & it becomes an uphill battle to get financing from them for anything! You therefore need to look at the impact on the full picture & not in isolation.
To answer why cash doesn’t equal profit, let’s first understand what defines the two. Cash is simple – it’s the money in the bank. Profit is an Accounting term & is the result of taking all the Income made in a period less all the costs incurred in the period. The trick is that not all the money needs to have actually been received in the bank to go into “Income”, people may still owe you for the goods or services (hence they are your Debtors) & the same with your costs – you may still owe money for the costs incurred but not yet have paid them (Creditors). And then you get Accounting entries such as depreciation which is a cost but money doesn’t come out of your bank account to pay for it & finally you may have used cash to pay for things like Assets or Liabilities which don’t form part of the Profit calculation either. The key is basically that they are defining different things & though are commonly confused they are not the same thing!
If you didn’t understand all those Accounting terms – you need to join a Finance for non-Finance Workshop by LDP or let us consult to you for the day to get to grips with your business Finances in a one on one session.
If this was helpful, don’t miss the 2nd building block of Finance – Budgeting – where to start