Page 94 - Finance for Non-Financial Managers

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Profit vs. Cash Flow
Cash basis accounting A method of accounting in which
financial transactions are recorded only when cash is
involved. Similar to keeping a checkbook, a sale is recorded 75
only when the cash is received, and an expense is recorded only when
a check is written to pay for it.
Accrual basis accounting The more common method of accounting
in which financial transactions are recorded when they actually happen,
even if the payment is made later. A sale on credit is recorded when the
customer is invoiced, and a purchase on credit is recorded when the
goods are received, even if the supplier’s bill is paid much later.
sultant who sells her time to clients. She’s not very concerned
about gross margins, because her operating costs are relatively
low. But she’s very concerned about cash flow, because without
it there’s no paycheck for her.
On the other side, far more small businesses (and all large
ones) keep their books on the accrual basis, usually for one or
more of three reasons:
• They’re concerned about gross margin on products they
sell.
• They want to really know when they’re making money
and when they’re not.
• They’re required by lenders, investors, or government
authorities to report their activities that way.
These are all good reasons to use accrual basis accounting,
and most experts would commend that choice. But many of
these same companies look only at their income statements
and often don’t even prepare cash flow reports. Instead they
rely on good old rule-of-thumb methods to manage the cash so
that they don’t run short or let unused cash sit idle.
Our purpose here is not to tell you which accounting
method is best for you—although like most professionals we
prefer accrual accounting because it gives most business own-
ers so much more useful information. Rather, we want to help
you understand the differences between accounting methods so
you can make the better choice. But regardless of which