The importance of accounting for small businesses

Diluxshy MARIYAN Eastern University, Sri Lanka

Accounting is a crucial part of running a business. Many people mistakenly believe that if you are starting a small business, you really do not need accounting. However, this is not true. If you want your business to reach its full potential, you have to follow basic accounting practices. You might find accounting boring, but you cannot avoid it.

Importance of accounting

When you start a small business, you need an accounting system in place. This could help you create a record of all the revenue and the expenditure of your business on a daily basis. Maintaining this data is crucial because you will need it when you file for tax returns. You might also need it for legal purposes. If, in the future, you apply for a loan to expand your business, this data can help you get one.

Another important purpose of maintaining an accounting system is that it provides you with a tool to assess your business's performance. An accounting system provides you with information about your business that will help you analyze the weak and the strong points of your business. You will realize what is helping your business and what is not.

Once you realize how important accounting is, you will be more than eager to put in that extra effort. Moreover, accounting is not that hard for small businesses. All you need to do is ensure that your financial records accurately reflect your business's income and expenditure.

Ledger

Most small businesses maintain their records in a ledger, which is a record of sales, receipts and expenditure. You need to transfer all your receipts and expenditures to this ledger. You can do this on a daily, weekly, or a monthly basis. Basically, this will depend on your business.

Three financial measures

Accounting for small businesses usually consists of three financial measures: Balance Sheet, Profit and Loss Statement, and Cash Flow Statement.

The Balance Sheet portrays how much your business is worth. This statement will list all your assets (building, machineries, investments, cash, inventories, account receivables, etc) and liabilities (loans, accounts payable, and debts).

If done in a proper manner, the Balance Sheet can show you exactly where your business stands. Your ledger will not show accounts payables and receivables; however, your balance sheet will.

The Profit and Loss Statement shows how your business is performing. This statement covers a time period, which could be monthly or quarterly.

The Cash Flow Statement provides an assessment of future cash needs of your business.

Among these three financial measures cash flow statement is important, because it generates and assesses the cash flows, so this is the time for considering what is cash management, components of cash flow and its importance.

Cash Management

Business analysts report that poor management is the main reason for business failure. Poor cash management is probably the most frequent stumbling block for entrepreneurs. Understanding the basic concepts of cash flow will help you plan for the unforeseen eventualities that nearly every business faces.

Cash vs. Cash Flow

Cash is ready money in the bank or in the business. It is not inventory, it is not accounts receivable (what you owed), and it is not property. These can potentially be converted to cash, but cannot be used to pay suppliers, rent, or employees.

Profit growth does not necessarily mean more cash on hand. Profit is the amount of money you expect to make over a given period of time, while cash is what you must have in hand to keep your business running. Overtime, a company's profits are of little value if they are not accompanied by positive net cash flow. You can't spend profit; you can only spend cash.

Cash flow refers to the movement of cash into and out of a business. Watching the cash inflows and outflows is one of the most pressing management tasks for any business. The outflow of cash includes those cheques you write each month to pay salaries, suppliers, and creditors. The inflow includes the cash you receive from customers, lenders, and investors.

Positive Cash Flow

If its cash inflow exceeds the outflow, a company has a positive cash flow. A positive cash flow is a good sign of financial health, but is by no means the only one.

Negative Cash Flow

If its cash outflow exceeds the inflow, a company has a negative cash flow. Reasons for negative cash flow include too much or obsolete inventory and poor collections on accounts receivable (what your customers owe you). If the company can't borrow additional cash at this point, it may be in serious trouble.

What are the components of Cash Flow?

A 'Cash Flow Statement' shows the sources and uses of cash and is typically divided into three components:

Operating cash flow: Operating cash flow, often referred to as working capital, is the cash flow generated from internal operations. It comes from sales of the product or service of your business, and because it is generated internally, it is under your control.

Investing cash flow: Investing cash flow is generated internally from non-operating activities. This includes investments in plant and equipment or other fixed assets, non recurring gains or losses, or other sources and uses of cash outside of normal operations.

Financing cash flow: Financing cash flow is the cash to and from external sources, such as lenders, investors and shareholders. A new loan, the repayment of a loan, the issuance of stock, and the payment of dividend are some of the activities that would be included in this section of the cash flow statement.

How to practise good cash flow management?

Good cash management is simple. It involves:

1. Knowing when, where, and how your cash needs will occur

2. Knowing the best sources for meeting additional cash needs

3. Being prepared to meet these needs when they occur, by keeping good relationships with bankers and other creditors

The starting point for good cash flow management is developing a cash flow projection.

Smart business owners know how to develop both short-term (weekly, monthly) cash flow projections to help them manage daily cash, and long-term (annual, 3-5 year) cash flow projections to help them develop the necessary capital strategy to meet their business needs.

They also prepare and use historical cash flow statements to understand how they used money in the past.

So now you understand how important accounting is for your business. If you have been educated in the field of commerce, you might be able to do the accounting yourself. However, if you do not know much about accounting, you can consult an accountant to help you set up your accounting system. Consulting an accountant is cheaper than hiring a bookkeeper.

Another thing you can do is purchase accounting software.

It will not only help you keep track of all the receipts and expenditures, but will also help you create quality financial reports.

The bottom-line is that as long as you make the commitment to setting some time for your accounting needs and start maintaining your accounting system, you will realize how easy it is!