The first rule of running a business is, you need to be cash-flow positive.
Running A Business
Welcome to the second part of my series on starting a business online. If you haven’t read the first part, please visit How To Start a New Business Online for information on choosing and forming your new business.
Whatever you’ve heard from the many self-proclaimed gurus of online business and marketing, there is no such thing as easy money in business.
Running a business requires a lot of time, money, patience, commitment, and true grit to weather occasional uncertainty. No matter what your “Amway-selling” neighbor says, there is no magic formula that immediately gets you millions of dollars in revenue overnight.
What you put into your business will be reflected by what you get out of it.
Once you’ve come to realize that to support your business you will be working a lot of long days, you’ll need to understand a few basic principles of what it takes to run your business well.
Cash flow is Life
Once you’ve made the cash commitment to forming your business; getting the website made, business cards, and advertising, you’re going to want to start selling.
Cash flow is the lifeblood of your business and is essential to keep your business in the black.
In terms of balance sheets, positive cash balances are noted in black, and negative cash balances are noted in red. You want to make sure your business is always “in the black.”
Some tricks to getting cash flow out of the gate is how you ask for payment for your services or items.
If you’re a service-based business, you can ask your clients to make an up-front payment and pay balances upon work completion. This is very common in construction and other professional services.
If you’re selling items online, you’ll typically be collecting full payment from your customer at the point of sale. This is extremely important if you are drop-shipping as you want to make sure your up front costs on the item being sold are zero.
One of the first decisions you will need to make is how you plan on tracking your income and expenses. There are two methods that are typically used: Cash Basis and Accrual Basis.
Using the Cash accounting method, accounting records recognize income and expenses according to real-time cash flow. Recording income upon receipt of funds and not based on when it is actually earned. Recording expenses as they’re paid, rather than when they’re actually incurred.
This method is pretty much how anyone handles their personal bank checking account. Of the two methods it is typically the easiest to manage. It provides a more accurate picture of cash flow and income is not subject to taxes if it has not been received.
Disadvantages of this method are that income and expenses are not matched within a given time interval.
For example, if your business provides a service in March, it will likely send an invoice to the customer in April and may not receive payment until May. If your business has employees or other expenses, it will still need to pay them during the months of March and April. Your profit and loss statements for March and April will show high expenses without any corresponding income.
Using the Accrual accounting method, accounting records recognize income and expenses when they are earned or incurred regardless of when the cash associated with the transactions was exchanged. Recording income when it is actually earned and not when it is actually received. Recording expenses when they’re actually incurred and not when they’re paid.
With this method it is possible to defer your taxable income by delaying billing so that payment is not received in the current year. It is also possible to accelerate expenses by paying them as soon as the bills are received before the due date.
This method is used to recognize income and expenses within the period in which they occur. It provides a more accurate picture of how a business is performing within the confines of monthly, quarterly, and annual income review dates.
Using the example above, income and expenses for the service job would be recorded in March and thus show a more accurate picture on the monthly profit and loss statement.
Disadvantages of this method are that it is slightly more complex to manage and taxes can be due on income that hasn’t been received.
Under Generally Accepted Accounting Principals (GAAP), the Accrual method of accounting is required for all businesses that handle inventory. With some exceptions, it is also required for businesses that have gross sales over $5 million per year. If you run multiple businesses of various types, it is permissible to use different accounting methods for each.
Profit & Loss Statements
A profit and loss statement (P&L) is a financial document that summarizes the revenues, costs, and expenses incurred during a given period of time. These can also be called income statements.
This statement should be generated monthly, quarterly, and/or annually.
These documents give you the information necessary to understand your businesses ability to generate profit by increasing revenue, reducing costs, or both.
Your typical profit and loss statement will have a heading containing the period in which the income and expenses are recorded, sales revenue itemized by product and/or service, costs of sales and revenue, gross profit, and then finally operating expenses broken down by sales and marketing, general administrative, and payroll/taxes.
Your Business Requires Accounting
So with all this in mind, you can now understand why so many business owners rely on an accountant to handle their business financials. It really can be a full-time job for a lot of people tracking and ensuring their business is healthy.
Of course, I like to have a complete understanding of all the facets of my businesses and would want to control the accounting aspects early on.
If you’re like me, then I recommend using software like QuickBooks Pro to handle managing income and expenses. The power of these tools will make tracking inventory, customer invoicing and billing, and tax forms a snap for the small business owner.
Fun fact: Back in the 90’s when I took an accounting course in college, the professor actually had us using pencil and graph paper to create P&L spreadsheets. Thank God for Excel!
Interpreting The Data
You have an accounting method chosen, software configured, you’ve made some sales, and you’ve generated your P&L statements. What do you do now?
P&L statements should help you visualize trends with income and expenses in your business month to month, quarter to quarter, year to year. As I mentioned above, your goal is to be cash flow positive each month. It is also important that your positive cash flow increase over time. At what rate is subjective but the goal is that you want your business to grow.
With growth comes more opportunity to expand into new services or product lines.
Your goal is to decrease your costs of goods/services sold and operating expenses while increasing income to maximize your overall profit.