Finance and accounting: The language of business
Mar 24, 2008
After 28 years of working with architects and engineers who are either sole or part owners in their firms, I can honestly say that these folks are deficient in their knowledge of rudimentary finance and accounting. I am trying to be nice— sometimes, it is really frustrating (and bizarre) that people who have fairly sizable investments in their businesses riding on their ability to preserve and grow this capital don’t know what I call “the language of business.” How can you be in business if you don’t speak the language? That’s why I decided to use my allotted space this week explaining a few things in terms that anyone can understand: Cash vs. accrual accounting. Cash-basis accounting is very simply cash in vs. cash out. Just think about your check register and you will understand cash-basis accounting. You have a starting balance; you make deposits, and pay bills. The difference between cash in and cash out is your cash basis profit or loss. Accountants don’t put much stock in cash-basis accounting because it does not accurately reflect what is going on in the business now. Just think about it. If you were going great guns four months ago, then cut a bunch of people and other costs, you will look wildly profitable when the cash comes in from a cash-basis point of view. But your real earning power has been greatly reduced by your reduced size. Accrual accounting is what you earned vs. what your expenses were. You earn the money when you DO the work. You may or may not have billed or even collected that money yet, or may or may not have paid those bills, but either way, the money was earned and is owed to you, and you incurred some obligations that you have either paid or will have to pay in the future. If you still don’t understand this, send me an e-mail! Financial statements. The basic financial statements everyone needs to know are the income statement, the balance sheet, and the cash-flow projection. I need to see these three reports, at a minimum, to be able to tell how any A/E/P or environmental firm is doing. Income statements represent the firm’s profit-and-loss performance over a period of time, such as from Jan. 1, 2007, to Dec. 31, 2007. The income statement tells you whether or not your firm is profitable. It does not tell you whether or not you will have any cash. That’s what a cash flow projection does. It is a way for you to look ahead and see whether or not you will have the cash you need to meet your obligations. The way you do a cash flow forecast is to take your starting cash and then look, week by week, at what you expect to collect and what you expect to pay out. The difference, if positive, will add to your projected cash position at the end of the week. If negative, it will reduce your cash accordingly. The balance sheet is very simply a summary listing of what you have and what you owe at one point in time. It contains all of your assets (stuff you own) and all of your liabilities (debts). The assets minus liabilities is the owner’s equity. Theoretically, if you liquidated all of your assets and paid all your debts, this should equal the owner’s equity. Ratio analysis. If you want to see how any company stacks up, you should be able to look at your financial statements and run a few ratios on the data they contain. These ratios can then be compared to industry data provided by ZweigWhite or other sources that will instantly tell you how your firm is doing compared to what’s typical in the industry. Utilization ratios are very popular in this business because they very simply tell you what percentage of your labor is going to things that pay the bills (projects) and what percentage of it is creating no income (overhead). Labor multiplier is another key piece of information. For each dollar of labor that you charge to a project, how much are you charging your clients (on average)? Debt-to-equity is one I like to look at. It is the total amount of money you owe compared to your book value or owner’s equity. This will help tell you whether or not you have too much debt. Banks commonly look at this one as well. Average collection period is another— how many days of receivables are owed to you? This tells you how effectively you are collecting your money. It is essential that EVERY firm give EACH of its owners and managers the training he or she needs to understand basic finance and accounting for our “industry.” I am not just talking about finance and accounting related to projects. FIRM-WIDE finance and accounting knowledge is critical. Without it, your managers are lost and will be unable to do their jobs. And as the economy worsens, this will be even more important to you. Originally published 3/24/2008
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