Understanding Business Accounting For Dummies, 2nd Edition (121 page)

In short, we encourage you to take charge and choose the accounting methods that best fit your strategic profit plan. You need to speak some of the accounting language and know which accounting methods are available. In short, business managers should take charge of the accounting function just like they take charge of marketing and other key functions of the business.

This applies only to management accounting. Your accountants and auditors will call the shots when preparing accounts for the outside world.

Build Better Budgets

Budgeting (explained in Chapter 10) provides important advantages - first, for understanding the profit dynamics and financial structure of your business, and second, for planning for changes in the coming period. Budgeting forces you to focus on the factors that have to improve in order to increase profit and helps you prepare for the future. The basic profit model provides the framework for the profit budget. A good profit model is the essential starting point for budgeting. To develop your profit plan for the coming year, focus on

Margins

Sales volume

Fixed expenses

The profit budget, in turn, lays the foundation for changes in your operating assets and liabilities that are driven by sales revenue and expenses. Suppose you project a 10 per cent rise in sales revenue. How much will your debtors asset increase? Suppose your sales volume target for next year is 15 per cent higher than this year. How much will your stock increase? The budgeted changes in sales revenue and expenses for next year lead directly to the budgeted changes in operating assets and operating liabilities. These changes, in turn, direct attention to two other key issues.

First, if things go according to plan, how much cash flow from profit will be generated? Second, will you need more capital, and where will you get this money? You need the budgeted cash flow from profit (operating activities) for the coming year for three basic financial planning decisions:

Cash distributions from profit to owners
(cash dividends to shareholders of companies and cash distributions to partners).

Capital expenditures
(purchases of new fixed assets to replace and upgrade old fixed assets and to expand the business's capacity).

Raising capital
from borrowing on debt and, possibly, raising new equity capital from owners.

The higher your budgeted cash flow from profit, the more flexibility you have in having money available for cash distributions from profit and for capital expenditures, and the less pressure to go out and raise new capital from debt and equity sources of capital.

To sum up, your profit budget is dovetailed with the assets and liabilities budget and the cash flow budget. Your accountant takes your profit budget (your strategic plan for improving profit) and builds the budgeted balance sheet and the budgeted cash flow statement. This information is essential for good planning - focusing in particular on how much cash flow from profit will be realised and how much capital expenditures will be required, which in turn lead to how much additional capital you have to raise and how much cash distribution from profit you will be able to make.

Optimise Capital Structure and Financial Leverage

Our friend Ron, a florist, made this point one night: ‘To make profit, you must make sales.' We quickly added that you also must invest in operating assets, which means that you must raise capital. Where do you get this money? Debt and equity are the two basic sources.
Equity
refers to the money that owners invest in a business with the hopes that the business will turn a profit. Profit builds the value of owners' equity; profit fundamentally is an increase in assets that accrues to the benefit of the owners. Chapter 11 discusses ownership structures; Chapter 6 covers debt and equity.

The return on the owners' equity interest in the business consists of two quite distinct parts:

Cash distributions from profit to the owners