For example, let’s say Customer A agrees to buy from XYZ a product for $120,000, paid in 12 equal installments over a year. The first payment will be due in 30 days. XYZ will spend $58,000 building and delivering it, and it can do so in 30 days.

Using the Cash method of accounting, XYZ will not record anything upon the signing of the agreement. Assuming XYZ buys its raw materials on terms, the first entry in XYZ’s books (directly associated with the subject transaction) will likely be 30 days hence — a revenue entry for receipt of the initial installment payment ($10,000). Expenses associated with the transaction, such as the purchase of steel, labor, power and freight services — will be recorded as they are paid in cash. As such, someone looking at the financial statements of XYZ 55 days from the date of the sale will see one payment of $10,000 and approximately $48,000 of expenses. The transaction, as of this date, shows a $38,000 loss.

ACCRUAL accounting is quite different. It basically ignores when the cash actually goes in and out. 
Revenue is booked when it’s EARNED, and expenses are booked when the liability is INCURRED. Using our example, the business using ACCRUAL accounting would record, on the date of the transaction, $120,000 of revenue and $62,000 of direct expense. As a result, the bottom line would show a $58,000 profit — all on the day the agreement is signed. The logic is that this is what really happened, economically. The business earned the right to receive $120,000, committed to spend $62,000, and earned $58,000 in profit.

Accrual accounting requires more entries than the cash method. The company that uses accrual will ALSO record actual receipt and payments of cash; they just won’t impact revenue, expense and income.

The knock on accrual accounting is that it can accelerate income and therefore taxes. The knock on cash accounting is that the financials don’t reflect the true financial and economic position of the business.

These examples are simple and attempt to relate only a few of the differences between cash accounting and accrual accounting. An accountant or CPA can explain the details and help you choose and set up the best system for your business.

When a corporation buys common stock from its stockholders, the transaction is referred to as a “corporate stock redemption,” and the stock so acquired is called “treasury stock.”

Corporate stock redemptions are considered by company owners principally for the following reasons:

1. Peace: To silence a troublesome minority stockholder.
2. Obligation: For example, one of your executives is leaving the company and he or she has the legal right to require the company to buy the stock he or she purchased previously under a stock option plan.
3. Mandated Buyout: When a court of law orders the company to buy out a minority owner’s shares.
4. Investment. Management might cause the company to buy the stock from willing sellers because they think it will provide a fair return on investment and raise the value of the shares that remain.
5. Stay below the 500-shareholder threshold. Private firms that have 500 or more shareholders can be required to make public filings similar to public companies.

As principal owner of your business, you have to be concerned with any corporate stock redemption, for the following reasons:

• Many states restrict or prohibit the purchase of stock by the company from its stockholders, principally depending on the availability of cash and capital surplus within the company to effect the stock repurchase. Basically, you cannot “impair” the capital account and solvency of the business by repurchasing “equity” securities.
• Other stockholders may complain because of the effect on the corporation, particularly its balance sheet. The operating agreement of the company may also require that such a transaction be approved by some percentage of the shareholders.
• You may be accused of unfair dealing if you don’t offer all owners the right to sell their stock back to the company at the same time, price and terms.
• Your creditors may object since the stockholders’ equity account drops after a redemption. For this reason, most loan agreements prohibit or restrict a company’s repurchase of equity shares or interest.
• You may be sued by the selling stockholder if you know of certain facts that affect the value of the stock and these facts are unknown to the seller (material insider information) at the time of the stock repurchase.

Effect on the Company

Below is a description of the subject business owner’s analysis, with explanatory remarks. Note that this approach can be applied to companies with other forms of ownership, including S-corporations, partnerships and limited liability corporations (LLCs). Let’s start with the stockholders’ equity account, in which there are 100,000 shares of common stock outstanding.

Let’s also assume that total company debt is $1 million and that of the 100,000 shares outstanding, 20,000 shares are being acquired by the company (20 percent of the outstanding common stock). The agreed-on purchase price is $10 per share (two times the company’s $5 book value per share), which represents a $200,000 total purchase price. Based on these facts, here’s the result:

• Corporate cash declines by $200,000 (20,000 shares times $10).
• Stockholders’ equity decreases from $500,000 to $300,000 — a reduction of 40 percent.
• Leverage increases from 200 percent ($1 million total debt divided by $500,000 equity) to 333 percent ($1 million debt divided by $300,000 equity). This assumes that no additional capital was borrowed to finance the stock repurchase. If that were necessary, the debt-to-equity ratio would have risen even higher.

Effect on Remaining Owners

The remaining stockholders increase their ownership percentages. Since 20,000 shares are in treasury, a stockholder owning 10,000 of the remaining 80,000 shares will now own 12.5 percent of the corporation (10,000 shares divided by 80,000). Before the purchase, this stockholder owned 10 percent (10,000 shares divided by 100,000). The percentage ownership position of all stockholders will increase by 25 percent.

Book value per share declines from $5 to $3.75 – $300,000 pro forma (after repurchase) stockholders’ equity position divided by 80,000 shares. The pro forma decline in book value occurs because the buy-back price of $10 per share was double the previous book value per share of $5 ($500,000 stockholders’ equity divided by 100,000 shares). That’s why other minority stockholders may not be in favor of the transaction – unless they also are given the right to sell shares back to the company on the same terms.

Based on last year’s net income of $75,000, earnings per share would increase from $0.75 to $0.94 ($75,000 net income divided by 80,000 shares). But note that if debt is used to finance the stock purchase, pretax income (and net income) should be adjusted downward to reflect the resulting interest expense. Company cash is being used for nonproductive purposes. This may significantly impact the company’s future growth and its profitability and, as explained below, can negatively impact the company’s borrowing ability.

Finally, the tax basis of each share of stock owned by the remaining shareholders remains unchanged despite the fact that the value of each share has risen due to the lower number of shares outstanding. When the remaining shareholders sell their shares, as if the entire company were sold, the taxable gain will be greater than it would have been had the buyout of the 20 percent owner been effected by a direct purchase from the shareholders. Such a purchase would have required the shareholders to use personal funds to effect the purchase, but a step-up in the basis of the stock would have occurred and the tax owed in a subsequent sale would be less.

Effect on Company’s Value

Since $200,000 is purchasing 20 percent of this company, the value placed on the business is $1 million ($200,000 divided by .20). In terms of fundamental valuation methods, this $1 million value represents:

• A price-earnings multiple (P/E) of 13.3 times last year’s net income of $75,000.
• 2.0 times stockholders’ equity of $500,000 before the stock repurchase.
• 3.3 times stockholders’ equity of $300,000 after the stock repurchase.

This value analysis is presented to give you additional information to help you in deciding whether or not to effect the buyout. You also will have to determine the value of the company going forward. For example, if this company were projecting net income of $150,000 next year, the $1 million value would represent a P/E multiple of only 6.7. This alone could justify the stock repurchase, particularly if the company’s growth continues on course.

Access to Capital

The company redemption/purchase of common stock also has dramatic effects on the company’s creditors, who now have a lower stockholders’ equity account under their debt position, and a debt-to-equity ratio of 3.3 to 1 ($1 million debt divided by $300,000 stockholders’ equity). In addition, the company’s future borrowing capacity is substantially lower. Thus, if you are going to redeem any stock, be sure your overall cash position (today and projected) is more than adequate to finance growth and contractual debt repayments.

What If You, the Owner, Are the Seller?

If you are the owner and your common stock is being purchased by the company, read “Owner Stock Repurchase Tax Traps”. Proceeds of your sale could be taxed to you at ordinary income rates rather than capital gain rates unless you completely sever your relationship with the company. Also, for liability reasons, make sure that the:

• Stock redemption price is at fair market value as established by an independent appraiser.
• Shares are purchased by the company on an arm’s-length basis.
• Acquisition price and terms don’t discriminate against other stockholders.
• Tax impact of the sale/purchase on both you and the company has been reviewed by your accountant.

In any stock purchase by your company, get sound legal and tax advice before moving ahead. In addition, remember this important legal fact: You, as a director and officer of the company, have a fiduciary obligation to all of your minority stockholders, irrespective of the number of shares they own. So be very careful.

Example #1: If the company redeems or buys back part of a shareholder’s stock, the full amount paid (not just the profit) to the stockholder may be taxed as a dividend at ordinary income tax rates up to 38.6 percent, rather than at the capital gain rate of 20 percent.

Example #2: If you sell all of your stock back to the company – for example, if you wish to retire – you also must completely sever your relationship with the company for the next 10 years. Otherwise, the full proceeds may be taxed to you at ordinary income rates. That means you can’t be an officer, director, consultant or employee. It’s okay, though, to be a supplier or rent property to the company on an arm’s-length basis. You may also be able to be a creditor, under certain circumstances.

Again, be sure to consult your tax advisor before you make plans to buy back the stock of any shareholder. The rules are complex and the IRS filing requirements are detailed. More information can also be found in the Internal Revenue Code, Sections 302 and 303.

The IRS will allow businesses with annual revenue as high as $10 million per year to use the cash method of accounting. Owners of businesses with revenues below this level that are not currently using the cash method should consider doing so as it generally allows for greater control of when revenue and expenses are recognized. The primary benefit of having such control is ability to delay recognition of income and thus delay when income taxes are due and payable.

To review, two primary accounting methods exist – cash method and accrual method. The cash method is very simple. Revenue is recognized on the income statement when money is actually received (not when the product is shipped), and expenses are recorded when bills are actually paid (not when the purchase order is issued or the bill is received).

The accrual method is a little more complex, but accounting software has eased the burden significantly. Revenue is recognized when it is earned (i.e., when the sale is made) and expense is recognized when the liability is incurred (i.e., when the purchase order is issued). This method was developed to more accurately report the financial performance of a business. Generally, it does so, rendering more useful and informative statements.

But for many businesses, the accrual method causes income to be recognized earlier than it would under the cash method. This can be particularly true in businesses that purchase large quantities of products in advance of customer purchases or payments, such as retailers and contractors. This can cause income tax to become due before cash is actually received from sales, causing a cash flow burden.

The IRS has a long-standing bias toward accrual accounting, and until 2002, required all businesses with revenues in excess of $5,000,000 to use it. The threshold has now increased to $10,000,000, allowing some 500,000 additional U.S. businesses the freedom to choose which is best for them. For more information, contact your accountant or tax advisor. See also section 448 of the Internal Revenue Code; Notice 2001-76 in Internal Revenue Bulletin 2001-52; and IRS Publication 538, Accounting Periods and Methods.

Take the analogy of the golfer. Why hold the golf club a certain way? Well, you can hold it any way you want, but over hundreds of years golfers have tried virtually every technique conceivable, and the best results are generally garnered from one particular grip.

The same concept holds true for the financial management of a business. You can organize the financial data any way you wish, but you might want to express your creativity elsewhere.

The accepted “best practice” for the organization of a business’ financial data has evolved and been refined over thousands of years. The concepts are embodied in what we call Generally Accepted Accounting Principles (GAAP).

Maintaining a Healthy Gross Margin Is Mission-Critical

Business owners and managers would also be wise to know which part of the income statement is the most important. That is: “Get this one thing right and you’ll be well on your way. Get this one thing wrong and you’ll have a very hard time ever finding success.”

This one thing is — the gross profit margin.

Keeping with the golf analogy, the universally accepted #1 swing tip is: Keep your head still. The “keep your head still” of business financial management is: Watch your gross profit margin. That is, make sure you earn a healthy margin. Don’t let it erode, and make sure you at least match what is earned by your most successful peers. Peer gross profit data can be obtained through your industry association.

Your Gross Margin Provides the Cash Your Business Needs

But to explain why the gross profit margin is so important, let’s use some more analogies.

You run on food and water. Your car runs on gasoline.

Run out of food and water, you die. If your car runs of gasoline, it becomes worthless.

Your business runs on cash. It needs cash to buy raw materials, pay the rent and employ the employees who create the products and services, market and sell them, collect the cash and deposit it in the bank. A healthy business will generate more cash than it consumes. If it does not, it will die.

So the stream of cash that flows into your business is the gross profit. The higher the gross profit MARGIN, the larger the stream. The lower the gross profit margin, the smaller the stream of cash available to fund your operations and investment in future growth.

Revenue Is Important, Gross Profit Is More Relevant

One could argue that revenue is the most important number, but this is simply foolish. Every product or service you sell has expenses directly associated with it. Let’s say you publish books. For every dollar you take in from the sale of a book, you have direct costs in the printing, payment of author royalties, salesmen or broker commissions, shipping fees, etc. So the only relevant number is the profit (cash) that remains after the direct expenses are paid. Right?

The gross profit is all you get to keep to pay the rest of your bills (i.e., operating expense, also referred to as sales, general and administrative expenses). You don’t get to keep revenue; just what’s left over after you’ve paid the direct expenses you incur in the production, sale and delivery of the product or service.

The gross margin is the ratio of gross profit to revenue. For example, if you make $50K gross profit on $200K in revenue, your gross margin is 25% ($50 divided by $200). Of course, this would mean your direct expenses (i.e., cost of goods) were $150K.

Gross Profit Margin Drives Bottom Line

To further drive home the critical nature of the gross profit margin, let’s take a look at how changes in the gross margin impact the bottom line. Take a company that has a 40% gross profit margin (i.e., cost of sales takes 60% of revenue) and a 10% operating profit margin (also referred to as pretax profit) — a healthy income statement by most standards.

Now let’s say that the owner fails to closely manage his gross profit margin and, either through a rise in cost of goods or a lowering of the price they get for their products or services, gross margin dips from 40% to 34%. This 10% increase in the cost of goods reduces operating profit by 60%. Here’s the math with percentages:

The lessons?

1. Without a healthy gross profit margin, bottom line profit is almost impossible.
2. A small erosion in gross profit margin can wipe out bottom-line profit.

Sell Quality, Not Price; Wring Direct Costs Out

How does one manage gross profit effectively? Unfortunately, there’s no magic potion. It’s just a matter of:

a.      resisting the temptation to win sales by lowering prices.
b.      wringing direct cost out at every turn.

It’s very hard to run a profitable company by competing on price. Only the firm with the lowest cost structure can win with such a strategy. The low-cost strategy is typically viable only for the firm with the highest volume, and virtually every industry has a firm that competes on price. To succeed, they must go for volume, “no frills” service and merely “acceptable” quality. The only logical and viable competitive strategy for the firms with lower volumes (most everyone) is to offer higher levels of quality and service at higher prices — prices that will more than offset the added expense incurred in the delivery of the higher levels of product and service quality.

Just a Few Low Margin Sales Can Devastate Overall Profitability

Business owners should also keep in mind how sensitive the overall profitability of the business is to the profit margins earned on individual sales. That is, the impact a few money-losing products and services can have on a company’s overall profitability. To illustrate, let’s look at a consulting firm that has 20 types of consulting projects. Peerless Consulting tracks the labor hours and direct costs required to deliver each of its project types. Peerless also knows the income that each job brings. Here’s the simplified 2008 data:

• Total annual revenue was $1,000,000.
• Each of the 20 project types generated $50,000 in revenue.
• Fixed overhead costs were, and will continue to be, $205,000 per year.
• Operating profit was a negative $5,000.

A look at the data revealed that two of the 20 project types lost money. In fact, the money-losing two together cost $50,000 more than the $50,000 in income they generated (i.e., together the two products brought in $100,000, cost $150,000 and therefore lost $50,000). If Peerless were to eliminate these offerings altogether and the labor associated with the delivery of such projects, revenues would decline to $900,000, but operating profit would increase from negative $5,000 to $45,000 in the black. Here is the comparison.

Income Statement — Peerless Consulting

By simply eliminating 10% (two of the 20) of the project types and 10% of overall revenue, Peerless becomes a profitable company at a respectable operating profit margin of 5%. If fixed expenses could also be reduced, then the bottom line would rise dollar-for-dollar and the operating profit margin would increase sharply.

Now, another alternative would be for Peerless to find a way to keep the two money-losing offerings but make them profitable. The average gross profit of the 18 profitable offerings is 28%. If we assume that the two losers could also earn 28% or $14,000 gross profit each, then Peerless’ Pro Forma Income Statement would look like this:

By turning around the two money-losers, Peerless’ operating profit has increased to a respectable 7.5% margin. And that, compared to a net loss, makes all the difference in the world.

A small number of money-losing products or services can have a devastating impact on the overall profitability of a company. Peerless lost money in 2008 though 90% of its products were profitable!

The lesson: Analyze your per-product profitability. Use the information to create profitability across your entire product line. The impact of losers is too great to ignore.

In conclusion, the business world is complex, but business management, at its heart, is pretty simple. To manage and grow a profitable business, your most important task is to find ways to sell more and more at healthy profit margins. The most critical number is the gross profit margin. Deliver a consistently healthy gross profit margin and the rest of your job will be a heck of a lot easier.

In cases where such is required by a governmental agency, lender or bonding company, the answer is pretty simple – you have to pay to play. But for the vast majority of business owners, it’s a choice. The correct answer to “should I” is not readily apparent. It’s a judgment call.

First, by way of review, the issue is one of “quality of financial statements.” Of course, by “financial statements” we mean your income statement, balance sheet and statement of cash flows. Generally, compiled statements are deemed to be of higher “quality” than company-prepared statements. Reviewed statements are viewed as higher quality than compiled, and audited statements are viewed to be of higher quality still. Here’s a description of each:

Company-Prepared Financial Statements: Also referred to as internally prepared and/or management statements, these have not been organized, reviewed or validated in any way by a certified public accountant (CPA). Of course, your accounting firm could have helped you set up your accounting system and the methods you use to keep your books and generate your statements. Or you could be an accountant yourself and your company-prepared statements are well-organized, prepared according to GAAP, and represent fairly in all respects the performance and financial condition of the business. But unless an accountant or accounting firm compiles, reviews or audits the statements, they are simply company-prepared and – given that no independent person of authority (i.e., certified public accountant) attests to their “quality” – investors and creditors have little way of knowing what methods were used to prepare them or how fair or accurate they are.

Compiled Financial Statements: These are financial statements that have been created by an accountant or accounting firm from the company-prepared statements. The firm simply took the information provided by the subject company and created financial statements that conform to how statements are supposed to be organized. “Supposed to look like” is dictated by GAAP. Compiled statements don’t carry any warranty or pledge of any kind by the accountant or accounting firm as to accuracy or whether or not the books were maintained or developed in conformity with GAAP. In essence, one could say compiled statements are just made to look pretty and professional. And, as we know, this is worth something since people judge a book by its cover.

Obtaining a compilation for a small or midsize private company might cost between $1,000 and $7,500, depending on the audit firm, geographic location and complexity of the subject business.

Reviewed Financial Statements: As the name implies, reviewed statements have been reviewed by an accountant or accounting firm. The extent of the review is limited, not nearly as thorough as a full audit. Reviewed statements should and will include a letter from whomever did the review. This letter will explain the extent of the review, notes about how or where the statements may deviate from GAAP, and any opinion or representation that the reviewer can provide about the statements. When reviewing reviewed statements, one should keep in mind that a review is limited and does not guarantee accuracy.

Obtaining a review for a small or midsize private company might cost between $4,000 and $20,000, depending on the audit firm, geographic location and complexity of the subject business.

Audited Financial Statements: Audited statements have undergone in-depth review and testing by a qualified third party. Similar to reviewed statements, they should be accompanied by a letter from the auditor. Among the important things revealed in the letter is the extent to which the auditor is able to render an opinion of the accuracy and fairness of the statements. An unqualified opinion means that the accountant has no reservations or concerns. As far as third-party assurances go, an unqualified audit opinion is the highest level of assurance about the quality of a firm’s financials. A qualified opinion means otherwise, so take caution.

The audit firm also issues a letter to management, which can be helpful to the owners and managers, and contain suggestions for improving accounting methods and processes.

Obtaining an audit for a small or midsize private company might cost between $7,000 and $50,000, depending on the audit firm, geographic location and complexity of the subject business.

Even GAAP Leaves a Wide Gap
Business owners, investors and creditors should keep in mind that two identical businesses could generate financial statements that look very different. Furthermore, both could receive unqualified audit opinions. How could this occur? Well, quite easily, really. GAAP allows considerable room for management to interpret and apply GAAP rules, primarily because many of the rules require management to assess situations and apply the rules accordingly. To be sure, different people see situations differently. One executive could deem a receivable highly collectable while another feels strongly that the account is at risk. The accounting would likely reflect the divergent views. Similarly, one firm could be aggressive in how it applies the rules – in an attempt to show maximum current income, for example – while another set of managers could be conservative and less motivated to maximize today’s book profit and/or equity.

Quality and Credibility of the Auditor
As we all learned in the 1990s, the credibility and quality of the audit firm is an all-important factor. Arthur Andersen audited the books of Enron (among others) and year after year issued unqualified opinions. We later learned that its accounting was an abomination. Those who relied on the statements, and trusted the opinion of the auditor, lost billions.

As another case in point, in a recent M&A transaction (i.e., business purchase/sale) that I was involved in, the selling company had an audit. All things being equal, the existence of an audit is a good thing to the extent it adds to one’s ability to rely on the statements to present a fair picture of the financial health and performance of the business. This was true in this case, but the buyer also noted that the audit firm was not one we recognized or could easily find much information about. Not even a Web site.

Then, early in due diligence, the buyer found that the cost of the audit was well below standard rates – another red flag. So the buyer conducted his own audit and found material deviations from GAAP. The auditor was a solo artist and old friend of the controlling shareholder of the selling company. In the end, there really was no audit conducted. Still, the books and records of the business were fairly well organized and buyer was able to assess the business, develop his own view of its performance and health, and eventually complete the purchase.

For the Business Sale?
I commonly hear business sellers say, “I got an audit because I was told buyers require it.” Well, I’ve worked on a lot of business purchase and sale transactions, and my experience is that selling firms do not need an audit. First, few small and midsize private companies have reviewed or audited statements. As such, buyers of small and midsize companies (along with their debt and equity sources) are used to dealing with company-prepared financials. Second, whether or not the selling firm has compiled, reviewed or audited statements, the buyer will have to investigate how the selling firm prepares its books. No buyer will just rely on the audit stamp as proof that the financials are “fair.”

And so, I would say that – for the business owner who wants to sell his or her business in the near future – reviewed and/or audited statements are a “nice to have,” not a “need to have.” The bigger issue is the overall health of your business and whether your books are kept according to GAAP and in a fair and reasonable manner. Buyers just want to know how much money the business is making. So long as you can help them get a pretty good feel for this, your accounting and financial statements will serve their purpose.

For General Principles?
For many businesses, there are no clear and convincing reasons to pay for improved financial statements such as a compilation, review or audit. And so, I think it comes down to personal preference. Some business owners like to do everything “first class.”

“We do things like the big boys,” I think I heard one business owner say as he proudly presented his audited financials.

To be sure, it’s not going to hurt. The question is what is the highest and best use of those dollars? In some cases, maybe it’s an audit? Or in some cases, one might be able to consider it more of a personal expenditure of the owner. Let’s say the audit has no real business purpose and the business owner would not pay for it unless there were excess profits to be had. So, in this way, the business owner could take the $50,000 out of the business as a return on investment or pay for the audit. The business owner can do whatever he or she wishes with his money – save it, buy a boat, give it to charity or buy an audit.

Do you have an opinion on these matters? If so, send them to editor@thebusinessowner.com. We’ll share them in the next issue of The Business Owner.

Brent Johnson, assurance partner with HoganTaylor, contributed his expertise to this article.

A. To keep track of your income and expenses, which improves your chances of making a profit.

B. To collect the financial information necessary for filing your various tax returns.

Sounds pretty simple, doesn’t it? It can be, especially if you remind yourself of these two goals whenever you feel overwhelmed by the details of keeping your financial records.

There is no requirement that your records be kept in any particular way. As long as your records accurately reflect your business’s income and expenses, the IRS will find them acceptable. (There is a requirement, however, that some businesses use a certain method of crediting their accounts: the cash method or accrual method. If you don’t know whether your business is required to use one or the other, check with your accountant.)

Three Steps to Keeping Your Books
The actual process of keeping your books is easy to understand when broken down into three steps.

1. Keep receipts or other documentation of every payment made and every expenditure by your business.

2. Summarize your income and expenditure records on some periodic basis (daily, weekly, or monthly).

3. Use your summaries to create financial reports that will tell you specific information about your business, such as how much monthly profit you’re making or how much your business is worth at a specific point in time.

Whether you do your accounting by hand on ledger sheets or use accounting software, these principles are exactly the same.

Step One: Keeping Your Receipts
Each of your business’s sales and purchases must be backed by some type of record containing the amount, the date, and other relevant information about that sale. You’ll use these to create summaries of your transactions.

From a legal point of view, your method of keeping receipts can range from slips kept in a cigar box to a sophisticated cash register hooked into a computer system. Practically, you’ll want to choose a system that fits your business needs. For example, a small service business that handles only relatively few jobs may get by with a bare-bones approach. But the more sales and expenditures your business makes, the better your receipt filing system needs to be.

Step Two: Setting Up and Posting to Ledgers
A completed ledger is really nothing more than a summary of revenues, expenditures, and whatever else you’re keeping track of (entered from your receipts according to category and date). Later, you’ll use these summaries to answer specific financial questions about your business, such as whether you’re making a profit and, if so, how much.

On some regular basis – like every day, once a week, or at least once a month – you should transfer the amounts from your receipts for sales and purchases into your ledger. This is called “posting;” how often you do this depends on how many sales and expenditures your business makes, and how detailed you want your books to be.

Generally speaking, the more sales you do, the more often you should post to your ledger. A retail store, for instance, that does hundreds of sales amounting to thousands or tens of thousands of dollars every day should post daily. With that volume of sales, it’s important to see what’s happening every day and not to fall behind with the paperwork. To do this, the busy retailer should use a cash register that totals and posts the day’s sales to a computerized bookkeeping system at the push of a button. A slower business, however, or one with just a few large transactions per month, such as a small website design shop, dog-sitting service, or swimming-pool repair company, would probably be fine if it posted weekly or even monthly.

You can purchase an accounting software program that will generate its own ledgers as you enter your information (and then automatically generate the necessary financial reports from the same information). All but the tiniest new businesses are well advised to use an accounting software package to help keep their books (and micro-businesses can get by with personal finance software such as Quicken).

Step Three: Creating Basic Financial Reports

Financial reports are important because they bring together several key pieces of financial information about your business in one place. Think of it this way: while your income ledger may tell you that your business brought in a lot of money during the year, you may have no way of knowing whether you turned a profit without measuring your income against your total expenses. And even comparing your monthly totals of income and expenses won’t tell you whether your credit customers are paying fast enough to keep adequate cash flowing through your business to pay your bills on time.

That’s why you need financial reports: to combine data from your ledgers and sculpt it into a shape that shows you the big picture of your business. The key reports you need to create regularly are a cash flow analysis, a profit and loss forecast, and a balance sheet. (Both QuickBooks and Quicken Home and Business, as well as other accounting software, can provide these regular reports.)

Reprinted with permission from the publisher, Nolo, Copyright 2006, www.nolo.com.