ACCOUNTING

 What is Accounting?

Quite simply, accounting is collection of financial records concerning your business. Records are kept for a variety of reasons. Needed to raise money from bankers and investors. They are required by government for tax purposes. But Most importantly, you need to keep financial records to help you manage your business. They assist you in evaluation of current operations and are crucial for planning future operations.

The terms bookkeeping and accounting are often used interchangeably, but there is a considerable difference. Bookkeeping is simply the recording of business data. Accounting is the preparation of reports based on the recorded data. In other words, accounting is the analysis of the meaning of the financial data in these reports is the basis of management decisions.

Don't let ACCOUNTING scare you. It really isn't all that hard. At its heart, accounting is really pretty simple:

Sound a lot like keeping your checkbook? Well it is. If you keep an accurate check book and balance it at the end of the month, you have the skills you need to do the books for your start-up business. Almost. All you have to remember is that the above formula deals in CASH not SALES. If you run strictly a cash business, this presents no problem at all. However, if you offer credit in any form, and few business today can survive without offering some sort of terms, suddenly you have a whole new set of problems. That you must be aware of at all times. When you make the sale is irrelevant. When you get the payment is crucial.

In the early 1990's a study was done on industry receivables turnover. That's a fancy way of saying how long it took them to collect the money owed by their customers. In that study, the average receivable was 45 days old. (Remember that was the AVERAGE meaning half were older!) In the mid-1990's, Microsoft Corporation was experiencing a receivable turnover of 59 days! Can you afford to become your customer's banker and basically loan them money for 45 days?

So, to complicate your lives and to help assure your success, the formula must be modified:

The lack of understanding of the element of time between the sale and the actual receiving of payment is perhaps the major killer of new businesses. Failure to plan for the operational shortfalls this lag can create is perhaps the single most common error of start-ups. Your bills go on, no matter how long the lag. You have to meet payrolls, pay the utility bills, the rent, your vendors and your bank note while your customer uses your money for 30, 45, or 60 days.
 

GETTING STARTED

Your financial projections for your start-up business are the last thing you prepare when doing your business plan, not the first. Why? Simply because all the other elements of the business plan contain research and financial information you need before you can generate meaningful financial projections. You have to have a handle on you production cost, employee cost, operational structure cost (rent and office overhead) and your marketing cost, among other things. If you don't have a marketing plan developed and know how much its going to cost you, how can you factor it into your projections? Same goes for all your cost factors. Once you have completed all the other elements you are ready to begin.

Start-Up Budget

The start-up budget is simply a listing of all the money you need to get the doors open for business. That means any and all expenses prior to the first sale. It includes things like legal fees, patent fees, utility deposits, rent deposits, initial equipment, furniture and fixtures, initial inventory and any pre-opening marketing, market research, r&d and anything else you spend preparing for starting the business. Write them all down, add them up and you have your start up cost.
 

Warning: This is NOT the same thing as the initial capitalization you will need to start your business. That is a completely different figure. Attempting to start a business capitalized solely on your start-up budget will cause you to fail!

Financial Projections and Pro Forma

"Pro Forma" is simply an accounting term meaning projections. There are three key documents for a start-up business.   Pro forma income statement, usually in a spreadsheet format.

The whole purpose is to let you see if the proposed business will work, using reasonable estimates of sales and cost backed up by sufficient market research data to give you confidence.

These pro-forma are necessary if you intend to raise funds from a bank or investor. They are also essential as "scorecard" for your first year's operation. They you an estimate on what you think you will do in sales and how much capital it will take to do it. They will give you some idea of whether the business, as you have conceived it, will provide a profit and when it might do so.

Although three year projections are the minimum requirement of most banks or investors, spend most of your time being as accurate as you can on the first year projection. Quite simply, if you don't make it through the first year, there will be no year two and three to worry about. And if you succeed in getting through the first year, you will have actual numbers to revise your year two and three projections.

Numbers used in the creation of Pro Forma must be as accurate as you can possibly make them. Wishful thinking, wild guesses, and "forcing" the figures tell you what you or other people want to see - makes the whole projection worthless. It is very tempting, especially when working with electronic spreadsheets, to simply change the sales numbers to make the bottom line look better without any justification for those sales numbers. You are only lying to yourself and setting yourself up to fail. Bankers and competent investors will be able to see right through this dishonesty.

The working model created by the projections must meet your stated objectives or the proposed business will fail. Market Research already conducted should supply you with most of the figures you need for realistic projection. From your research on your industry you should have developed numbers on industry sales, cost and operating information, inventory cost, space cost and Personnel cost. Knowing the industry "averages", you have something to compar your numbers against. If your numbers differ significantly from the industry numbers, it should raise a "red flag" in your mind, especially if your numbers on production cost and so on are significantly lower than the industry averages. The industry has economy of scale and experience. You are the new kid on the block...what makes you think you can do it better than the pros? Maybe you can, but be prepared to back it up.

Where do you start? Begin with the Opening Balance Sheet. This is simply a statement of what your business will own and what it will owe on the first day of operation. Use a standard balance sheet format. List assets (current, fixed and others) EXCEPT CASH and total them. (CASH will be determined last.) List all liabilities (current and long-term) and total them. List how much money you plan to put in the business, your partners put in, or how much will come from sale of stock and place in the Equity or Net Worth line.

Add up Liabilities and Net Worth and subtract the Assets you have listed up to this point. The number you arrive at will be the amount you enter on the CASH line of Assets.

Now your Pro Forma opening statement should balance according to the

Assets = Liabilities + Net Worth formula. This is your starting financial position.
 

The First Year Income Statement will determine what you are going to do with your initial financial projections. Use the standard format of an income statement work sheet. Basic formula for an income statement work sheet is:
 

• Net Sales - Cost of Goods SOLD = Gross profit
• Gross profit - total of all expenses = Net pre-tax income
• Net pre-tax income - federal taxes = net after-tax income

For manufacturing, you are more interested in manufacturing capacity. You should start with industry averages on asset turnover or fixed asset turnover. Both consider output in sales for a given asset.

Once you arrive at a sales estimate, compare that to the target market you isolated during market research. What percentage of your estimated target market is your sales? Does this percentage of the market seem reasonable? (Remember, after 100 years, even Coca-Cola has only a 21% market share, so don't overstate your market share.)

Market research should have also made you aware of industry literature which may have long- and short-term forecasts of economic factors which will affect your industry. How will they affect your business? In reality, it is extremely unlikely that you will achieve sales that are average for your industry in your first year of operation.

Perhaps the best approach is to prepare THREE estimated income statements. The first is based on what you have estimated your sales to be. The second estimates sales based on what you MUST have just to break even. The third is the mid-point between the previous two. If your concept is sound and all other considerations are realistic, this will probably be the most accurate of the three projections.

When you have arrived at a reasonable figure for your first year of operation, extend your estimates for two more years. No matter what percentage increase you choose to increase your sales by annually, be sure to increase the appropriate expenses by a realistic amount so your net income reflects realistic cost.

Remember the purpose of these estimates is to judge if you can succeed in this venture. Do not pad the figures to make them look good. It is poor management and is bound to result in failure.

Other estimates used on the income statement should be readily available. Cost of goods sold includes all materials, direct labor cost, and overhead used to sell your product. Salaries and other expenses should be easily estimated. Find out the actual current tax rate for your estimated net profit to make the projection as accurate as possible.

The First Year Budget/Cash Flow Statement is a document is prepared to estimate your cash flow for the first year. It will let you know how deep a "hole" you will get into before breakeven. It will let you plan your purchases, labor and equipment expansion and your payments. Basically, it tells you how much money you will have and when you will have it and when you can spend it. It's your budget.

It is a month-by-month breakdown of the first year income statement but it is NOT simply dividing the first year income by 12. Every business has seasonal fluctuations which will affect sales on a MONTHLY basis, thereby affecting your monthly cash flow. Industry data should give you insight into this flux. Many retail sales businesses do as much as 40% of their annual sales during the last 2 months of the year. However, these are perhaps the worst months of the year for Lawn and Garden stores. Most manufacturing concerns are on a different timetable. Whatever your business, you must be aware of and take seasonality into account.

Once you have estimated your monthly sales, you must take your credit policy into account. In retail, American Express can take up to 6 weeks to pay you off. So, if half of your pre-Christmas sales were charged on American Express , you are not likely to have it in your account until February of the following year! If you have accounts receivable, you must take into account your terms. When will they be paid? This whole exercise is to figure out what cash you will have and when you will have it.

Next you must figure the cash outflow. You can estimate your fixed expenses fairly easily, remembering to take into account seasonal flux in things like heating and air conditioning costs. Don't forget marketing and advertising .

The hardest problem is figuring purchases of inventory and materials. You must know the terms of trade for your industry to estimate how soon after you receive the inventory you will have to pay for it. Your sales projections must be as accurate as possible to avoid over or under ordering, both of which are a serious drain on your cash flow.

Next you must figure in your start-up cost in order for the cash flow statement to be accurate at the end of the year.

Now you have a set of numbers concerning your proposed business which you can use to make some serious decisions. Look at the bottom line and consider if the numbers look good or fall far short of expectation.

If they fall short, can something be adjusted in the way the business was to be conducted to make it look better? This does not mean padding the sales figures, rather things like adjusting product mix; reducing rent by reducing planned floor-space needs; renting or leasing some equipment rather than buying new equipment; starting off with used equipment or other ways to reduce overhead.

Using ratio analysis you should be able to pinpoint the area that is out of line. Can something steps be taken to bring them back into line and still keep within the original objectives you set for your business?
 

Initial Capitalization

Now you are ready you figure out your initial capitalization, that is how much cash you are going to need to start your business. You have already figured out your start-up budget and your cash flow pro-forma. In all likely hood there is a period of time in the early months that your expenses are greater than your income, leaving you with an operational shortfall. This may be the case for two, three or four months or even longer. This is not untypical for a new business. But that money that you are short has to come from somewhere. As stated earlier, you do have ongoing bills that must be paid.

You add up your operational shortfalls and get the total. You add this to the amount needed for your start up budget and you have your initial capitalization, the amount of money you have to raise to get the business started and keep it operation until you reach a breakeven and the income exceeds your expenses.

So, to recap:

START-UP COST

+ TOTAL OPERATIONAL SHORTFALL

INITIAL CAPITAL NEED

This sounds like a lot of work, and it is. But it must be done, and done honestly. If you are going to go broke, what better time or place than to go broke at the kitchen table with a calculator and a yellow pad....BEFORE you take out a second mortgage, cash in your life insurance cash value, pawn the title to the car and basically put your and your family's future at risk.

Basic terms.

• Business transaction. This is simply the occurrence of any event that must be recorded. It is any transaction of money or something of value in lieu of money, such as a purchase, a sale, a loan, a receivable, or payment.
• Asset is any property owned by a business. It could be the furniture in the office, the computer, the inventor, account receivables and the cash in the bank.
• Liability is any debt of a business. In other word, anything you owe.
• Capital is the owner's equity in the business.
• Balance Sheet is simply the listing of all assets, liabilities and capital.
• Financial Statement is a summary of revenue and expenses for a specific period of time.
• Capital Statement is a summary of changes in capital for a specific period of time.
• Accounts Receivable are the monies owed to you by your customer.
• Accounts Payable are monies you owe to your vendors.

An accounting cycle is simply the flow of day-to-day transactions that are used to prepare periodic financial statements. Transactions are recorded individually in a JOURNAL. This is simply a record of daily debits and credits. Journal entries are totaled and recorded in a LEDGER. At the end of the accounting period, the debits and credits in the ledger are totaled and, if done properly, these totals must match exactly i.e. BALANCE.

The figures that form the balanced ledgers are used to prepare financial statements, that is, the balance sheet, the income statement and the capital statement.

The ledger totals are carried forward to the next accounting period and the books are said to be CLOSED for the previous period.
Setting Up the Books
 

General Ledger
 

Financial information and transactions are organized into various accounts. The accounts are classified by common characteristics.
 

Assets - Anything owned by the business. Assets are of several types. First are Current Assets which is cash or other assets used within a year or less. Then there are Fixed Assets, those items such as permanent fixtures such as land, buildings, equipment and machinery. Finally there are Intangibles - long-lived asset useful in the operation of a business that is not held for sale and is without physical qualities such as patents, trademarks, corporation expenses.
 

Liabilities are the debts of the business. These are of two types: Current which are payable within a year and Long-term which will not become due before 12 months

Capital which is the owner's equity in the business.

Revenues which include sales, interest income and any other sources of income coming into the business.

Expenses which are the cost incurred from the day-to-day operations of the business
 

A simplified chart of the above accounts might look like this:
 

1000 Assets
2000 Liabilities
3000 Capital
4000 Revenues
5000 Expenses

1010 CASH IN BANKS
1015 CHECKING ACCOUNT
2010 NOTES PAYABLE
2030 PAYROLL TAXES
3010 CAPITAL STOCK
4010 SALES
4011 SALES - DEPARTMENT 1
4012 SALES - DEPARTMENT 2
4050 INTEREST EARNED
5010 UTILITIES
5011 ELECTRICITY
5012 WATER

JOURNALS

As you would expect there are also different types of Journals.

• Purchase and Cash Disbursements
• Cash Receipts i.e. Cash Sales, Checks Received on Account
• Accounts Receivable - sales made on credit
• Payroll
• General Journal - for entries which don't fit into any specific journal

Posting to GENERAL LEDGER.

Once all the journal entries are posted and totaled, you transfer or "POST" JOURNAL balances to GENERAL LEDGER by account number. Then you run a trial balance by listing each GENERAL LEDGER account and its ending balance. Total of the DEBITS and CREDITS must be zero or books are out of balance i.e., you've made a mistake.
 

Basic financial statements

The Balance Sheet reflects the financial condition of a business at a specific point in time. It can provide comparative data for the same DATE of the preceding year. The basic formula: Assets = liabilities + net worth

The Income statement, also called the statement of profit and loss or P&L. It Provides comparative results for the preceding year or the same period of the proceeding year ie. the same quarter of the proceeding year. It reflects the results of operations over a period of time. In other words, it shows how much money was bought into the company and how it was used.

Using Financial Statements

The numbers in your financial statements are tools for determining how the business is doing. The raw numbers are not particularly informative by themselves. Even comparing single line items from period to period can be misleading. A difference in a line item only tells you that SOMETHING happened but not WHY it happened or if the change is good or bad or what you need to do about it.

For example a company shows a net profit of $10,000 last year and $11,000 this year. In absolute dollars it is making more money but is this performance good? This number must be compared to other numbers in the financial statement to be able to make any meaningful judgment.

If you compare the net profit figure to the sales figures for the two years, you begin to develop some meaningful information by developing a relationship between the two pieces of data that can be compared from year to year in absolute terms.

Suppose the company had sales of $100,000 the first year and $150,000 the second year. The RATIO of profit to sales was 10% for the first year and only 7.5% for the second year. This indicates that something isn't going quite as well as the increase in net profit would indicate. The company has made relative less profit for every dollar made in sales. They are not doing better as the raw numbers would indicate.

In order to obtain useable information from financial statements, you must focus on the relationships between them and compare the resulting ratios. Although any two numbers can yield a mathematical ratio, a number of standard ratios have been developed that are common to all businesses.

Some standard ratios include:
 

Profitability Ratios: how much did a business make in relation to what it took to make that amount.
 

Return on sales = profit

sales

total assets

net worth or equity

Liquidity Ratios: the ability of a business to meet its short-term obligations, given its short-term assets.
 

Current ratio = current assets

current liabilities

Current liabilities

Acid Test ratio = cash and securities

current liabilities

Activity Ratios: generally relate an INCOME STATEMENT item with an ASSET item to find out if the level of investment is adequate or excessive.
 

Asset Turnover =    sales

total assets

Inventory Turnover =   cost of goods sold

average inventory

Receivable turnover = net accounts receivable

(sales/360)

Once you develop a set of pertinent ratios to use, you compare them to prior results or results from other companies to find areas of significant differences. When significant difference is found, you can focus your attention on what can or should be done for corrective action, if anything.

Ratios for comparable businesses are available from a number of sources available in the library. Look for books such as Annual Statement Studies by Robert Morris Associates, Key Business Ratios by Dunn and Bradstreet, Inc., Cost of Doing Business, Dunn and Bradstreet, Inc., Almanac of Business and Industrial Financial Ratios, Leo Troy. Also various Trade and Industrial Association annual reports can be helpful.