CFO Consulting Topics: Accrual Basis Accounting for Small Business

CFO Consulting and Accrual Basis Accounting

Ready for a round of CFO Consulting Topics? This month, we’re tackling a key question for small business owners everywhere:

What’s the difference between Cash Basis Accounting and Accrual Basis Accounting?

Both the cash basis and accrual basis of accounting are acceptable approaches to bookkeeping, and in many instances, cash basis is the preferred way to record transactions for tax purposes, especially for small business owners.

But…

The accrual method is the proper Generally Accepted Accounting Principles or “GAAP” way to record your books and is required for publicly held organizations.

If you are a small business owner currently employing the Cash Basis Accounting method, below are a few key CFO consulting insights on how Accrual Basis Accounting can be applied in small business situations.

About Cash Basis Accounting

Cash basis accounting is the methodology of tracking your business receipts and expenses as you pay for them. If you receive money for your goods or services, you record revenue when the money is received regardless of when the services were delivered to your customers.

Likewise, you record expenses when you pay them, regardless of when you incurred those expenses.

How to Approach Accrual Basis Accounting

With accrual basis accounting, you record revenue when the service is delivered. You may have customers that you perform services for on a subscription basis (monthly retainer). These customers are typically billed monthly and that is when the revenue is booked, regardless if your customer has paid for the service.

Accrual accounting also records expenses in the period incurred, regardless of when they have been paid. If a company has received a service from a vendor, the expense associated with that service is recorded as accounts payable or accrued liabilities in the period the obligation was incurred.

That’s not all.

Taking the accrual accounting concept even further, if something is paid for in full, like an annual insurance policy for liability insurance, the proper way to account for this is to record the entire payment in a prepaid asset account when paid and expense the monthly portion and reduce the asset each month of the year.

Other items that should be recorded as an asset — or potentially recorded as a deferred liability account — and amortized monthly would be customers who have prepaid for a service or who have been required to make a deposit.

For example,

If a customer pays for a three-month service in full when the contract is signed, the proper way to record this is to establish a deferred revenue liability account or customer deposit asset account for the entire amount and reduce the balance each month while recording the appropriate revenue.

Here is how it would be recorded (customer prepays for 3 months of service for a total of $6,000 or $2,000 per month):

  • At contract signing and receipt of 3 months of service: Debit cash $6,000 and Credit $6,000 deferred revenue liability
  • When the first month of service has been provided to the customer: Debit deferred revenue liability $2,000 and credit customer revenue $2,000

When Should Small Businesses Use Accrual Basis Accounting?

There are many more complex transactions that require analysis and estimates (bad debt reserves, warranty liability reserves and tax estimates to name a few).

However…

If you record obligations as expenses and liabilities when incurred, record revenue and accounts receivables when the service has been delivered and the value has been determined, you will be well on your way to properly recording your books on the accrual method of accounting.

If you have a business that is growing, and you are thinking about bringing on investors or potentially thinking about selling your business then the accrual method of accounting is the proper method to use. ChoiceFinance’s CFO Consulting services can prepare your business for these next steps.

Three KPI’s for Small Business Success

Here are three KPI’s that are important to understand when running a small business and managing its finances along with a brief description of each:

Current Ratio

This KPI is a measure of the liquidity of your business. It will show you if your business can cover its immediate obligations. The current ratio is defined as the current assets of your business (most usually cash and accounts receivable) divided by the current liabilities of your business (vendor accounts payable, credit cards payable, short term balance on any loans, payroll liabilities).

What does this mean?

At a minimum you want this ratio to be 1:1 which indicates you have adequate current assets to meet your short-term liabilities. In an ideal world, your current ratio would be 2:1 or better. This would indicate that you have double the current assets (cash and accounts receivable) to cover your current obligations.

Building a cushion here shows that you can successfully build your business by turning your operations into much-needed cash. After all, Cash is King!

Gross Profit Margin

Measures the percentage of revenue that is left over after deducting all expenses associated with creating and delivering your product or service for your customers.

For example…

If your revenue is $5,000 and the cost to create, and deliver your product is $3,000 then your Gross Profit is $2,000 and your Gross Profit Margin is 40% ($2,000/$5,000).

Your target Gross Margin will depend upon the type of business. Many software companies can have gross margins in excess of 60% while many labor-intensive service companies have Gross Margins from 35% – 55%. You want to make sure that regardless of your company that the Gross Profits you are generating will cover the remaining operating expenses of your business.

The higher the Gross Margin, generally the more profitable the organization. Many sophisticated companies understand the Gross Margins by individual product or service line. This will allow you to try and maximize the sale of the most profitable products and examine the less profitable products for potential improvements in production or delivery to enhance overall profits to the company.

Cash on Hand

This KPI measures the amount of cash at a snapshot in time. This might seem obvious; however, turning your company’s revenue and profits into cash and growing the cash balance over time isn’t always easy.

Once you have customers and a steady flow of revenue, you need to establish a targeted cash balance that you can keep on hand. I am not talking about having just enough cash to cover your current needs as we talked about in the current ratio section, rather creating a goal of having 2-3 months of operating expenses on hand at any time.

Converting your services or products into cash is the real measure of success.

Most people want to talk about the revenue of their business invoices or the profits that it generates. Converting your services or products into cash is the real measure of success. It is hard to spend revenue or profits, but it is easy to spend, or better yet, to save cash!

Let ChoiceFinance help you with understand the KPI’s and the financial strategy of your business and ultimately help you improve your profits and grow your cash!

How Small Business Owners Can Maximize Cash Flow

Cash flow

Cash.

It is a word that signifies something we all like to have in our hands. You can never have too much of it and it is responsible for helping you keep your business up and running. Without cash, you may find that you cannot afford inventory, or you cannot meet payroll, which can be scary for you as a business owner. Fortunately, there are ways for you to maximize your cash flow, even as a small business owner.

Your business is a game of expenditures, revenue, and profit. If any of those three metrics are not in line, your business will find itself in a tough spot. Maximizing your cash flow can help you balance those three metrics. Here are some tips to help you out:

Replace Your Old Inventory and Equipment

You cannot be efficient if your warehouse is stocked with old inventory and equipment that is useless to you. In addition, it takes up space, which could be used for other processes. Old equipment can lead to a slowdown in selling your product or reaching your customers, which will decrease your revenue and cause you to spend more to make it happen.

Replacing old equipment with newer equipment is a great way to minimize overhead costs and see to it that you can maximize your cash flow and process. If you are not able to purchase new equipment, consider leasing it.

Also, if you have excess inventory on hand that cannot be used, sell it off. You can sell it at a discounted price and still make money while clearing out room to be used for your business.

Create Incentives for Early Payments

You never know when a client will pay their invoice, but you can help maximize your cash flow by offering incentives for them to pay early as opposed to when it is due or late. Of course, you should have penalties in place for late payments to discourage them.

One of the many incentives you can offer for early payment is a slight discount. You want the discount to make sense for your business’s final line and your client too, so do think about how you can incorporate it to incentivize without coming too close to your bottom line.

Outsource to a Financial Management Company

Managing your finances can be tough, especially as a small business owner. It is something you NEED to do but not something you always HAVE the time to do. This is where you can turn to financial experts such as the ones at ChoiceFinance. They can assist you in managing your business’s finances and provide you with easy to read and understand charts to show you how your business is doing in a quick snapshot.

Fortunately for you, ChoiceFinance is affordable and costs much less than hiring an accountant to do it for you. This way, you can focus more on maximizing your cash flow without going broke in the process.

Start Maximizing Cash Flow Today

Maximizing your cash flow is about balancing out your budget, revenue, profit, and expenditures. Companies such as ChoiceFinance can help you do this while you focus on selling and bringing in the money. The above tips are just a start and there are more ways you can maximize your cash flow such as reevaluating the cost of your product or services, offering discounts to new or returning clients, and improving your marketing strategy and campaign.

Remember, maximize your cash flow today and enjoy every bit of tomorrow!