Understanding Your Business: Keeping the Books II

I’m frequently asked why it is important for small businesses to keep their books in good order. Some of my clients run their businesses with nothing more than a checkbook and a notepad. If you are a small business owner and you can keep track of everything that way, great. However, businesses grow, and when they grow they tend to become more complex. Many business owners discover that the simple checkbook is no longer sufficient. Keeping track of receivables and payables and inventory becomes increasingly difficult with a notepad and a spreadsheet. As a business owner, you use many tools to manage and grow your business. Those tools might include advertising and marketing, staffing, and bookkeeping. Your business toolkit should grow as your business grows. Whatever stage of business you are in, you need to be able to keep track of your activities and summarize your results.

You need to keep books your books organized and produce financial statements for two reasons. The first reason is that you need them to manage your business. The three financial statements give you a complete picture of the financial health of your business.

  • An income statement summarizes your revenue and expenses. It is a picture of the activity that took place over time. Some people call this a profit and loss statement.
  • A balance sheet summarizes your assets and liabilities. The balance sheet is a snapshot of what you own and what you owe.
  • A statement of cash flows summarizes your sources and uses of cash. If you want to know if you made or spent cash in operations, investing in your business, or financing your business, the cash flow statement is the place to look. The statement of cash flows is very important if you are using accrual accounting.

The second reason is that you may need to provide financial statements to other people such as lenders or your tax preparer. If you want to borrow money, your lender will want to have some assurance that you will have enough profit and cash flow to cover the debt service and that you will ultimately be able to repay the loan. Your tax preparer will need to be able categorize all your transactions to be able to prepare your return. Your business may be small enough that your tax return does not require a balance sheet, but you will still have to summarize your revenue and expenses.

Here’s a sad but true story that makes the point. Several years ago, I had a client with a small manufacturing business. He produced limited runs of very high quality goods on contract. In the beginning, he was the only employee. He made the sales to customers. He purchased the raw materials and made the goods. He ran his entire business with just a checkbook and he kept invoices, receipts, and records in a shoebox. As time went by, he grew. He had enough volume with his suppliers that they began offering him trade credit. He began expanding and started adding customers, including some large accounts. Some of his newer accounts took longer to pay. He wasn’t worried about the slow pay, because his vendors were giving him terms, and he was making a lot of money. Unfortunately, he was still managing his business using a checkbook and a shoebox. By the time I met him, he had lost track of what was going on in his business. The slow pay by some of his accounts could have been managed, but he did not know how. He could not keep up with his payables and his vendors began demanding cash on delivery. He was running a cash basis business and trying to manage receivables and payables, but he did not have a way to account for them. He started writing checks to pay vendors so that they would stop complaining that he was past due, and then his checks bounced. When I asked why he did not hire a bookkeeper or at least purchase bookkeeping software and learn to keep his own books, he told me that it cost too much. It is true that he saved money by sticking to his checkbook and shoebox. But the money he saved was more than offset by the cost of losing control of what was happening in his business. Losing access to trade credit meant that he needed more cash to run his business.  He had to turn away business because he could not always purchase raw materials. Not having a robust bookkeeping system meant that he could not keep track of his slow paying accounts and he was unable to do anything to speed up collections. Finally, once he started losing control of his checkbook, the fees for overdrawing his account quickly added up. To make matters even worse, while he may have avoided paying bookkeeping fees, before his tax preparer could prepare his tax returns, he had to turn the shoebox full of receipts and invoices and the checkbook and bank statements into a set of financial statements. In effect, the tax preparer did a year’s worth of bookkeeping in two weeks. It turned out that he paid for bookkeeping after all. Unfortunately, it was too late to do him any good.

This example is a cautionary tale. As your business grows more complex, so should your accounting processes. The business owner above managed just fine with his checkbook and shoebox until his business began to grow.

My colleagues in the accounting world have similar stories of small businesses that outgrew checkbook and shoebox accounting. Savvy business owners realize that the processes they use in their business need to grow along with their business. Whether you hire a bookkeeper or do your books yourself, as your business grows, make sure that your management toolkit grows as well. However you manage your books, keep them in good order and make sure that you can summarize your results.

 

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