When performing your due diligence on the financial statements of a business you must first identify what method is utilized for their preparation. There are two generally accepted methods of accounting practices in businesses: Cash and Accrual. (Cash accounting can be utilized in any business in the US that is a private company and has less than $10M in sales). Although they are both acceptable methods they provide you with completely different financial pictures of the business that you are contemplating buying.
If you do not have some financial background or experience the following explanation may be somewhat confusing, and if you have an in-depth financial background you will find the explanation somewhat simplistic. But I have attempted to find a happy median without writing another manual on accounting.
If you require or desire a more in depth accounting education there are usually evening classes held at local community colleges. As well, there are many very good books on the subject.
In cash accounting there really is only one financial statement and that is the "Profit and Loss" statement.
In accrual accounting there are three financial statements. Balance Sheet, Profit and Loss and Utilization of Cash.
Cash Accounting:
A business that utilizes cash accounting methods is basing its finances on the receipt of funds on sales that it has made and expenses that have actually been paid. The two key phrases in the aforementioned statement are; “receipt of funds” and “actually been paid”. Cash accounting ignores invoices that are sent out and bills that have been received by the business if “cash” has not moved from one bank account to another.
As a very simplistic example let us look at a small retail store. The basic assumptions are that it is owned and operated by the owner (no additional staff), does not accept credit cards or checks and that it does not have any credit with its supplier of merchandise for resale (the owner pays cash on delivery for his merchandise for resale). In this example the business does not even have a bank account.
The day the business opens the owner puts $10,000 (his life’s savings) in a bowl behind the sales counter of the business.
On that first day, from his bowl behind the sales counter he removes:
- $1,000 for rent
- • $2,000 for merchandise for resale
As well, on that first day, he has cash sales (which he has put into the bowl) of $1,000. (The business is located in a jurisdiction that does not have sales tax).
At the end of the day he counts the money in the bowl and discovers he has $8,000 in it. As he started with $10,000 according to the cash accounting method he lost $2,000 in his first day in business.
His Profit & Loss statement at the end of the day would look like this:
Profit & Loss statement at the end of the 1st day:
Sales |
$ 1,000 |