Cash is king! You’ve heard that one before, haven’t you? Well, it’s true.
Cash is what keeps your business from closing its doors and it’s also what pays your personal bills, so you can keep on running that business. Cash, in this case, means currency, checks, credit cards, any way you get paid right now. The alternative is selling things on credit by doing the work and then sending an invoice for payment later. That might be a formal term of payment in 30, 60, 90 days or it may be a bill that is due immediately but gets paid whenever the client gets around to it.
You can just feel how important cash flow is because you have bills (personal and business) to pay and you need cash to pay them. Most won’t like it if you pay the bill with a note that says “I worked really hard this month and sent out a lot of invoices.” You need the cash. Without cash, you end up on the floor, in the fetal position, softly sobbing… also it’s dark (did I mention it’s dark?) because the power has been cut off.
So, cash flow is a really big deal in the present.
How much money comes in this month vs. how much goes out this month is the basic definition of cash flow. For many people, this is all that is measured because it’s the easiest to see on a bank statement or calculate from receipts. Most small businesses use cash basis accounting because the IRS allows it for smaller companies. What cash flow and cash basis bookkeeping can’t do is show you how your expenses are connected to your income so you can actually make your cash flow BETTER next month. My fundamental question is always “What am I doing today to make tomorrow better than yesterday?” This is how you know. Don’t worry, you can still do your taxes the simple way, you just have to understand how the money moves to make better decisions.
Accountants use the word “accrual” for the alternative to cash basis accounting. Basically, instead of tracking cash in and out, you track expenses when they are accrued (like when you actually buy the thing or use the electricity) and revenue when it is accrued (when you’ve delivered the goods or performed the work). Doing it that way lets you harness what accountants call the matching principle. In other words, you make sure to match the expenses with the income they helped generate, regardless of when you slipped someone a Benjamin.
A little example may be in order. Let’s say you offer web services and have to pay for a SAAS you use to do client work. You pay for it all at once for the entire year and you do projects all year long using that software. If you just track when payments are made, it will look like January was a rough month, because you paid a big subscription fee for your software. All the other months, though, look just a little rosier. Does that reflect what really happened? No, not at all. We need to know how much of the software cost was “used up” for each project so we can see how profitable we are and if we’re on the right track.
Let’s say that software is $600 a year/$50 a month. You do one project each month using that software. If you compare the way you look at cash or accrual numbers, each project (except for January) would be $50 less profitable than before. Well, not really, but you would be aware that it was $50 less profitable than you thought it was. What might that do? It might make you charge $50 more to meet your profit goals. It might make you reconsider which projects are worth taking and which are not. It might even make you reevaluate that software and decide if it’s bringing in enough profitable business to be worth the cost each year. Maybe dropping it would be the smarter move.