For owners of small businesses, financial management is a key survival skill. Without sound financial management, no amount of marketing, product development or customer service acumen will be enough to keep your business afloat. Good financial management practices give small business owners the tools they need to efficiently and effectively collect, keep track of and invest their money properly.
Poor financial management is a major reason why many small businesses fail. Even if you entrust your bookkeeping and accounting work to a professional, as the owner of a business you still need to understand the basics of financial management in order to make sound decisions.
The Basics of Bookkeeping
Good financial management starts with keeping good financial records. Even if you hire a bookkeeper, it’s important to understand the fundamentals of bookkeeping in order to supervise your bookkeeper properly, as well as being able to make well-informed decisions about budgeting, borrowing and other important choices.
For bookkeeping purposes, every business transaction you make should be documented by a check, receipt or sales invoice. These transactions should be entered into a journal, which can be a chronological record of sales and cash receipts, cash disbursements or other special entries.
Information entered into the journal should also be entered into a ledger. While journals provide documentation of transactions on a chronological basis, the ledger categorizes transactions according to which accounts they impact. Your company’s general ledger reflects your business’ balance sheet, revenues and expense accounts. The general ledger is completed at the end of each accounting period, when the information from your journals are categorized and posted into your general ledger.
In the double-entry accounting method used by most businesses, each transaction will impact two accounts, as every transaction will consist of a debit and a credit. One account will likely be a balance sheet account, while the other will be made into an income or expense account.
As an example, if you ran a plumbing business and charged $1,000 for a service, the service would be entered twice, once as a $1,000 invoice in the debit section, and once as $1,000 as income in the credit section. Once the fee was paid, you’d write up the $1,000 in your accounts receivable in the credit section, and $1,000 in the cash section of your balance sheet, a debit section.
When an accounting period ends, all of the account balances are added up and entered into the general ledger to produce a trial balance. In the trial balance, the debit balances in your ledger sum should be equal to the sum of the credit balances. If they don’t balance out, you’ll need to investigate to see where the errors lie.
When you or your bookkeeper are done with the journals and ledgers, and you’ve come to the end of a financial period, you will need to close the books for that period.
Basically, this occurs when all entries have been posted to the general ledger and a trial balance has been prepared and checked and necessary adjustments have been made.
You’ll need to prepare a balance sheet, a summary of your company’s financial balances, and/or an income statement. Also, after all this is complete, you’ll then need to prepare closing entries for your general ledger by reflecting the profit or loss of the business in relation to the owner’s equity in the company. After that, you’ll start a new financial period with books set back to zero.
The Income Statement
The income statement, also called the profit and loss statement, summarizes your company’s profit or loss over a time period, such as a quarter or year. The statement reflects all revenue and expenditures over the time period.
Businesses typically use income statements to keep track of how much they make and how much they spend to help them gauge the business’ operating performance. A small business owner can use their income statement to see where cost overruns may be in their business, such as excessive phone, utilities or other bills. They can also help business owners see what products or services are hot, and what percentage of sales they account for, as well as help business owners determine their income tax liability.
Most income statements have three basic sections, the heading, revenues and expenses. The heading gives basic information about the business, such as name and address. The revenues section lists the money made by the business over the pertinent time period. The statement can lump all revenues into one, or break down revenues into a number of categories such as a line by line reflection of revenue from each store or product. The expenses section works the same way. Small business owners may want to use a very detailed income statement, as it can guide them to where their profits lie and what aspects of the business need help.
The Balance Statement
The balance statement is a good bit more comprehensive than the income statement. It may be the most complete reflection of the health of your business, showing all of the assets and liabilities of your business, such as property owned by the business, debts owed by the business etc.
There are many software applications that can help business owners do their books and create income and balance statements. It’s advisable for business owners who want to handle their own books to invest in these applications, as they can make the process less confusing and easier. Having good income statements and balance sheets are important, because they’re often looked at by banks when they’re deciding whether to approve a loan or line of credit.
Once you have a detailed income statement and balance sheet, you can use these informational tools to cut costs, identify areas in your business that need support and create long term plans based on your knowledge of the historical performance of your company.
For example, if your income statement reveals that you’re spending an exorbitant amount of money on utilities, you could use that information to start an energy savings program in your business. Or, if you see that one product line is generating most of your sales, you could beef up promotion of that product.
Bookkeeping and basic financial management provide essential informational tools to small business owners playing the profit and loss game. Be sure to understand the rudiments of bookkeeping to help put these tools at your disposal.