Intro to Finance

Money Intro to Finance

CONTENTS

Cash vs. Accrual Accounting Matching Operating vs. Capital Expenditures Cash Still Rules Financial Statements ‣ Income Statement

If you’re like many people, numbers can make you a little nervous. We get it.

But having a grasp on the fundamentals will pay off.

‣ Balance Sheet ‣ Cash Flow Statement Resources

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You only need to understand a few key ideas to get the basics.

And if you learn how the three main financial statements work, you’re already ahead of the game.

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Money Intro to Finance

CONTENTS

Cash vs. Accrual Accounting

Cash vs. Accrual Accounting

Think of cash-based accounting as the way you balance your checkbook every month. Money comes in, and money goes out. If you bring in more than you spend, great. Otherwise, watch out.

Matching Operating vs. Capital Expenditures Cash Still Rules Financial Statements ‣ Income Statement ‣ Balance Sheet ‣ Cash Flow Statement Resources

That works well for people, but for most businesses it’s not enough.

That’s because businesses do a lot of different things to make and sell a lot of different products and services to a lot of different customers. Understanding if and how all that stuff is generating profit means having a more detailed picture.

Accrual accounting gives us that detailed picture. It does that by linking revenues with costs more accurately than cash accounting can.

But that accuracy comes with an important caveat: most numbers in accrual accounting are estimates that are not equal to cash.

So for example: Profit ≠ Cash That’s a very big deal. It’s how people go broke while “making money.” The profit is there, but the business doesn’t survive long enough to see it. We’ll get to cash again later.

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Money Intro to Finance

CONTENTS

Matching

Cash vs. Accrual Accounting

The heart of accrual accounting is the matching principle. This is how accountants are able to link the cost of making or delivering a product or service to the time the revenue is earned.

Matching Operating vs. Capital Expenditures Cash Still Rules Financial Statements ‣ Income Statement ‣ Balance Sheet

Note: this is not when the sale is made or even when payment is received.

This concept can be a little tricky at first, but seeing some examples will help.

‣ Cash Flow Statement

A consulting firm signs a $20,000 contract on January 15.

Resources

The project starts February 1 and runs to April 1.

The client pays $10,000 on March 1 and $10,000 on May 1.

Revenues are recorded when the services are delivered: February and March.

$20,000 contract signed

Client pays $10,000

Client pays $10,000

Project Jan 1

Feb 1

Mar 1

Revenue

Apr 1

May 1

Jun 1

Revenue

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Money Intro to Finance

CONTENTS

Operating vs. Capital Expenditures

Cash vs. Accrual Accounting

Businesses incur many different kinds of expenses. For each expense they determine if it is a normal part of operations or a longer-term capital investment.*

Matching Operating vs. Capital Expenditures Cash Still Rules Financial Statements ‣ Income Statement ‣ Balance Sheet ‣ Cash Flow Statement Resources

Operating expenses are all of the day-to-day costs associated with running your business. These include things like rent, the salaries and benefits you pay your employees and the electricity required to “keep the lights on.” Some of these operating expenses will be fixed, meaning they remain constant no matter how much business you do. Others, such as the raw materials needed to create a product, will be variable—rising with the volume of business you do.

Capital expenses are longer-term, higher-cost investments you make in the business. No matter when you actually pay for these investments, they are recorded as expenses over the life of the asset. The process of spreading out these expenses is called amortization (in the case of intangible assets like software or patents) or depreciation (in the case of tangible assets like machinery). Let’s look at an example.

A restaurant buys an oven for $200,000. They pay $20,000 upfront with $180,000 financed over 3 years at 0% interest.

CASH

$20,000 on purchase + $5,000/mo $5,000/mo $5,000/mo Y1

ACCOUNTING EXPENSES

Y2

Y3

Y4

Y5

Y6

Y7

Y8

Y9

Y10

Oven’s expense is recognized over its 10-yr lifespan at $1,666.67/mo

*This is the kind of decision for which you will want to consult an accountant.

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Money Intro to Finance

CONTENTS

Cash Still Rules

Cash vs. Accrual Accounting

We started out this chapter explaining that accrual accounting was a more accurate measure of profit than cash-based accounting.

That’s true, but you have to remember an important point: profit is not enough.

Matching Operating vs. Capital Expenditures Cash Still Rules

Remember, Profit ≠ Cash. That’s where trouble can start.

Financial Statements ‣ Income Statement ‣ Balance Sheet ‣ Cash Flow Statement Resources

Let’s say your business is humming along. Customers love the new product and orders are coming in up to 3 years in advance. Your team’s in place and everything seems to be going great.

Then you get a call from your accountant: there’s a problem. You have a cash crunch coming and if you don’t do something about it, you’ll be out of business.

You’re lucky you have such a good accountant.

While accrual accounting is a powerful tool, you always have to keep your eye on liquidity and cash flow. We’ll get back to this when we cover the cash flow statement.

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Money Intro to Finance

CONTENTS

Financial Statements

Cash vs. Accrual Accounting

There are three main types of financial statements that you should know about. The first one that we’ll cover is an income statement.

Matching Operating vs. Capital Expenditures Cash Still Rules Financial Statements

Income Statement What it does

It measures profit.

How much money are you making on the money customers are paying you?

‣ Income Statement ‣ Balance Sheet ‣ Cash Flow Statement

What it tells you

Are we making or losing money?

What trends do we see in our business?

Resources

How could we increase our profits?

Time range

Measured over a range of time—usually a month, a quarter (3 months) or a year.

Often, income statements will show trends over time. (e.g. Year 1, Year 2…)

On the next page, we’ll go over the formula to calculate an income statement.

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Money Intro to Finance

CONTENTS

Cash vs. Accrual Accounting

To put it simply, Revenue − Cost = Profit. But let’s break that down into some more detail.

Matching Operating vs. Capital Expenditures

Income Statement

Cash Still Rules Financial Statements ‣ Income Statement

Total value of products or services that you sell.

Revenue

Recorded when you deliver, not when you are paid.

Cost of goods sold

‣ Balance Sheet ‣ Cash Flow Statement Resources

Money made selling, not including the cost of running the business.

The best picture you have of your business’s financial health.

Gross profit Operating expenses

The actual “bottom line.”

Recorded when finished product is sold, not when costs are paid.

Cost of running things day-to-day, including expenses that are spread out (amortized) over several periods.

Operating profit Interest and taxes

The magic number.

How much it costs you to make the product or service.

Well, you know what they say about death and taxes…

Net profit

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Money Intro to Finance

CONTENTS

Cash vs. Accrual Accounting

The second financial statement you should know about is a balance sheet.

Matching Operating vs. Capital Expenditures Cash Still Rules

Balance Sheet What it does

It measures the value of a business.

How much is the business worth and why?

Financial Statements ‣ Income Statement

What it tells you

Are our assets greater than our liabilities?

‣ Balance Sheet

Have we been growing over time?

‣ Cash Flow Statement Resources

Where is the value in the business?

Time range

Measured at a specific moment in time.

Often balance statements will show previous year for comparison (e.g. Year 1, Year 2…).

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Money Intro to Finance

CONTENTS

Cash vs. Accrual Accounting Matching Operating vs. Capital Expenditures Cash Still Rules

The value of a business is calculated using this formula: Net Worth = Owned − Owed.

Balance Sheet

Assets (things you own)

Financial Statements

Cash and cash equivalents Money in the bank, stocks, bonds, etc.

‣ Income Statement

Accounts receivable Money customers owe you

‣ Balance Sheet

Inventory Finished products that you have made or bought but not yet sold

‣ Cash Flow Statement Resources

Property and equipment Buildings, machines, vehicles, tools (minus accumulated depreciation*) Goodwill, intellectual property, intangibles Assets that have value but not physical form Accruals and prepaid assets Stuff you have paid for but not yet received

Liabilities (things you owe) Accounts payable Money you owe other people Money currently owed on debt Money you currently owe to pay back debts Payroll and accrued expenses Salaries and everything else that you owe in this period Long term liabilities Money you will owe in the future that is not yet due for repayment, including mortgage

Owner’s equity (who owns you) Shares Investors’ ownership stakes in a business Retained earnings Profits that have been reinvested in the business (minus accumulated depreciation*)

*All deductibles that have been taken to date against the value of a piece of property or equipment

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Money Intro to Finance

CONTENTS

Cash vs. Accrual Accounting

The third and final financial statement that we’ll cover is called a cash flow statement.

Matching Operating vs. Capital Expenditures Cash Still Rules

Cash Flow Statement What it does

It measures cash on hand.

Does the business have enough cash to continue operating?

Financial Statements ‣ Income Statement ‣ Balance Sheet

What it tells you

Do we have enough cash on hand to run our business?

‣ Cash Flow Statement

Where is our cash coming from and where is it going?

Resources

Are our customers paying us on time?

Time range

Measured for a specific moment in time at the end of a specified period.

It shows the difference in cash between the beginning and end of the time period.

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Money Intro to Finance

CONTENTS

Cash vs. Accrual Accounting Matching Operating vs. Capital Expenditures Cash Still Rules Financial Statements ‣ Income Statement

A business’s cash flow is calculated using this formula: Cash = Cash Held + Cash Earned − Cash Paid.

Cash Flow Statement

Cash from operations or cash used in operations All the cash received or paid running the business. Includes payments made by customers as well as those made on salaries, supplies, rent, etc.

‣ Balance Sheet ‣ Cash Flow Statement Resources

Cash from investing or cash used in investing Cash received or spent in investments, including capital expenditures on new assets for the business

Cash from financing or cash used in financing Cash received or spent borrowing or paying back loans or through investor contributions

Current cash All the cash held by the company at the end of a specified period

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Money Intro to Finance

CONTENTS

Resources

Cash vs. Accrual Accounting

That covers the basics. If you want to learn more, be sure to check out Khan Academy’s videos on accounting and financial statements.

You may also want to pick up Karen Berman and Joe Knight’s book Financial Intelligence for Entrepreneurs, which is really a must-read.

Matching Operating vs. Capital Expenditures Cash Still Rules Financial Statements ‣ Income Statement ‣ Balance Sheet ‣ Cash Flow Statement Resources

Also check out: Buyers’ Guide to Accounting Software What does accounting software do? What’s the difference between Xero, QuickBooks, FreshBooks, Zoho? How much should you expect to pay?

Hiring Bookkeepers and Accountants Getting help with the books can be critical. Why does having good advisors matter? Determining what you need. Where should you look for help?

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