When I first contemplated writing this manual I promised myself that I would not create another manual on basic accounting, there are more than enough of those around.
However, in order to ensure that you as a potential buyer of a business do not over extend your financial resources I have been forced into venturing into some basic accounting subjects.
Insufficient cash flow is one of the leading reasons for failures in businesses. |
Many business books will state that the single biggest reason for a business failing is that it was undercapitalized. Being under capitalized basically means that you did not have enough cash to pay your bills when you bought or created the business. Capital is nothing more than the replacement of cash flow. If you have sufficient cash flow to cover your business expenses you would not have been short of capital. If you have negative cash flow you will remain in business until you run out of your capital.
It is important that you understand the difference between profit and cash flow. I have found that many individuals have a great deal of difficulty understanding the difference between the two terms. A company can be profitable each and every day and still be forced out of business because it has run out of money to pay its bills! A company with a day-to-day positive cash flow can never be forced out of business, at least not for financial reasons. One other important item of note is that a company can show negative profits or losses for years, and yet at the same time have a very positive cash flow. A company can also survive in business for years showing continue losses if it has enough capital to cover the shortfall in profits.
Profit:
The definition of profit is: The excess of total income over total costs. If your total costs in any given period of time was one dollar and your total income over the same period was two dollars then your profit is $1.00.
Cash Flow:
The definition of cash flow is: The measure of an organization's liquidity that usually consists of net income after taxes plus non-cash charges against income.
That being said it is very important for you to prepare a cash flow forecast or budget prior to consummating the acquisition of any business, large or small.
Before you can create your cash flow budget or forecast you must determine the cash flow period. This is a very important and basic ingredient to a cash flow forecast that will have some meaning to both you and a bank or other financial institution and I have found that it is ignored in most basic accounting books as they automatically set the cash flow period at 1 month and even worse they do not take into account the number of days in any specific month or the number of pay days in any specific month.
The cash flow period for your forecast will vary depending on the type of business that is being considered, although it is unlikely that any business would have use for a cash flow period that would extend past 30 days. The primary item that defines the cash flow period is the period of time between payments of your largest operating expenses.
To try and explain this further, let us create a simplistic situation. You have just purchased the assets of a plumbing contractor. You did not purchase any of the receivables. The plumbing contractor has a staff of 25 individuals who each earn $1K per week (gross), hence you have a weekly payroll of $25K (this is your only expense). The average weekly billings are $50K and the average collection of accounts receivable is two weeks and you do all of the invoicing each Friday afternoon.
Lets utilize the standard cash flow period of 30 days. At the end of the first month you would have invoiced $200K, collected $100K and paid out $100K in payroll costs. Hence, your cash flow is break even. Quite acceptable for the first month in business, or is it?