Understanding Business Accounting For Dummies, 2nd Edition (120 page)

Our question is this:
Where is that £600,000 of profit?
Can you find and locate the profit earned by your business? Is it in cash? If not, where is it? If you can't answer this question, aren't you a little embarrassed? Quick - go and read Chapter 5!

Profit accounting is more complicated than simple cash-in, cash-out bookkeeping. Sales for cash increase cash, of course, but sales on credit initially increase an asset called debtors. So
two
assets are used in recording sales revenue. Usually, a minimum of four assets and two liabilities are used in recording a business's expenses. To locate profit, you have to look at all the assets and liabilities that are changed by revenue and expenses. The
measure
of profit is found in the profit and loss account. But the
substance
of profit is found in assets and liabilities, which are reported in the
balance sheet
.

Your accountant will have determined that your £600,000 net income consists of the following three components:

£600,000 profit = £420,000 cash + £290,000 net increase in other assets - £110,000 increase in liabilities

This is a typical scenario for the makeup of profit - we don't mean the pound amounts but rather the three components of profit. The pound amounts of the increases or decreases in assets and liabilities vary from business to business, of course, and from year to year. But rarely would the profit equation be

£600,000 profit = £600,000 cash

Cash is only one piece of the profit pie. Business managers need accounting to sort out how profit is divided among the three components - in particular, you need to know the cash flow generated from profit.

Govern Cash Flow Better

A business wants to make profit, of course, but equally important, a business must convert its profit into
usable cash flow
.
Profit that is never turned into cash or is not turned into cash for a long time is not very helpful. A business needs cash flow from profit to provide money for three critical uses:

To distribute some of its profit to its equity (owner) sources of capital - to provide a cash income to them as compensation for their capital investment in the business.

To grow the business - to invest in new fixed (long-term) operating assets and to increase its stock and other short-term operating assets.

To meet its debt payment obligations and to maintain the general liquidity and solvency of the business.

One expense, depreciation, is not a cash outlay in the period it's recorded as an expense. Rather, depreciation expense for a period is an allocated amount of the original cost of the business's fixed assets that were bought and paid for in previous years. More importantly, the sales revenue collected by the business includes money for its depreciation expense. Thus the business converts back into cash some of the money that it put in its fixed assets years ago. Understanding how depreciation works in cash flow analysis is very important.

In one sense, you can say that depreciation generates cash flow. But please be careful here. This does
not
mean that if you had recorded more depreciation expense, you would have had more cash flow. What it means is that through making sales at prices that include recovery of some of the cost of fixed assets, your sales revenue (to the extent that it is collected by year-end) includes cash flow to offset the depreciation expense.

To illustrate this critical point, suppose a business did not make a profit for the year but did manage to break even. In this zero-profit situation, there is cash flow from profit because of depreciation. The company would realise cash flow equal to its depreciation for the year - assuming that it collected its sales revenue. Depreciation is a process of recycling fixed assets back into cash during the year, whether or not the business makes a profit.

In the example in the preceding section, the business earned £600,000 net income (profit). But its cash increased only £420,000. Why? The
cash flow statement
provides the details. In addition to reporting the depreciation for the year, the first section of the cash flow statement reports the short-term operating asset and liability changes caused by the business's sales and expenses. These changes either help or hurt cash flow from profit (from operating activities, to use the correct technical accounting term).

An increase in debtors hurts cash flow from profit because the business did not collect all its sales on credit for the year. An increase in stock hurts cash flow from profit because the business replaces the products sold and spends more money to increase its stock of products. On the other hand, an increase in creditors or accrued expenses payable helps cash flow from profit. These two liabilities are, basically, unpaid expenses. When these liabilities increase, the business did not pay all its expenses for the year - and its cash outflows for expenses were less than its expenses.

Generally speaking, growth hurts cash flow from profit. To grow its sales and profit, a business usually has to increase its debtors and stock. Some of this total increase is offset by increases in the business's short-term operating liabilities. Usually, the increase in assets is more than the increase in liabilities, particularly when growth is faster than usual, and therefore cash flow from profit suffers. When a business suffers a decline in sales revenue, its bottom-line profit usually goes down - but its cash flow from profit may not drop as much as net profit, or perhaps not at all. A business should decrease its debtors and stock at the lower sales level; these decreases help cash flow from profit. Even if a business reported a loss for the year, its cash flow from profit could be positive because of the depreciation factor and because the business may have reduced its debtors and stock.

Call the Shots on Your Management Accounting Methods

Business managers too often defer to their accountants in choosing accounting methods for measuring sales revenue and expenses. You should get involved in making these decisions. The best accounting method is the one that best fits the operating methods and strategies of your business. As a business manager, you know these operating methods and strategies better than your accountant. Chapter 13 gives you the details on various accounting methods.

For example, consider sales prices. How do you set your sales prices? Many factors affect your sales prices, of course. What we're asking here concerns your general sales pricing policy relative to product cost changes. For example, if your product cost goes up, do you allow your ‘old' stock of these products to sell out before you raise the sales price? In other words, do you generally wait until you start selling the more recently acquired, higher-cost products before you raise your sales price? If so, you're using the first-in, first-out (FIFO) method. You might prefer to keep your cost-of-goods-sold expense method consistent with your sales pricing method. But the accountant may choose the last-in, first-out (LIFO) expense method, which would mismatch the higher-cost products with the lower-sales-price products.

The point is this: Business managers formulate a basic strategy regarding expense recovery. Sales revenue has to recoup your expenses to make a profit. How do you pass along your expenses to your customers in the sales prices you charge them? Do you attempt to recover the cost of your fixed assets as quickly as possible and set your sales prices on this basis? Then you should use a fast, or
accelerated
,
depreciation method. On the other hand, if you take longer to recover the cost of your fixed assets through sales revenue, then you should probably use the longer-life
straight-line
depreciation method.