Bankruptcy within the first year of business is not an appealing prospect. I assume not. So, how do you avoid such a scenario? We'll be addressing these questions shortly. Hello, everyone, and welcome to Entrefemme, your go-to news site that provides you with life's everyday tips. Today, we'll be delving into accounting. Don't worry; it won't be a lengthy and didactic lecture. Instead, it'll explain elements that will empower you to manage your business finances effectively. As always, feel free to share your experiences and opinions in the comments to grow together. Now, let's get started.

I. The Importance of Accounting

To grasp the significance of accounting, let's consider a simple example. Picture owning a thriving cleaning business where you charge $50 to $100 for house cleaning, inclusive of services like vacuuming, window cleaning, wiping, and more. You decide to handle everything yourself in the early days, which isn't a bad idea. It allows you to save money and gain a deeper understanding, as mastering a task before delegation is often wise. However, as the business grows, let's say, after a year, success strikes. Your schedule is packed, and stress sets in due to the overwhelming tasks, a problem many entrepreneurs dream of having. Crucial decisions arise:

         - Hiring staff

         - Determining salaries.  

         - Ensuring a consistent workflow

         - Most notably, managing expenses

These choices can become potentially harmful obstacles without a thorough understanding of accounting. Here are some things to assist you in making these decisions:

          - Know your profit margin

          - Understand the amount of available cash

          - Recognize your current financial obligations, such as debts and expenses

If this information is absent, you cannot make informed decisions to grow and evolve your business. Making incorrect decisions can be detrimental to your business. For instance, what would happen if you hired someone but had no projects to work on? You'd be wasting money on that person. Whatever decision you make will likely have financial implications; in other words, it will cost money. If you don't understand how money flows in your business, you risk making ill-advised decisions that can lead to your business's bankruptcy. You also risk tax consequences by missing out on business deductions that could save you money on your tax bill. So, let's discuss the accounting you need to implement to achieve this.
 

II- The Pillars of Accounting

Accounting is, by definition, the process of recording, reporting, interpreting, and analyzing financial information. These four words are crucial, and I will break down each component of this definition. To avoid financial headaches, it's essential to establish a reliable accounting system right from the beginning, incorporating these four processes.

1. The Process of Recording Financial Information

The first step is to record every time a transaction occurs; you must document it. Each element must be recorded for a clear understanding of financial flows, whether it's revenue, expenses, assets, liabilities, or equity.

There are five major transaction types that you need to be aware of. These five transactions are:

     - Revenue

     - Expenses

     - Assets

     - Liabilities

     - Equity

Understanding these five transaction types is crucial because it determines how your reports are organized and influences how you interpret your business finances.

Revenue: This is what you earn from selling your products or services. It is the value customers pay in exchange for your products or services. For example, when a customer pays the cleaning company for its services, that payment represents revenue. Revenue is also commonly referred to as sales.

Expenses: On the other hand, fees are the costs incurred to run your business. In the cleaning example, my payments would be hiring a contractor and the cleaning supplies used when those services are provided.

Assets: Assets are resources owned by the company with a measurable future value. For example, if I own an expensive cleaning device, such as a carpet cleaner, this will be an asset to my business.

Liabilities: Liabilities, on the other hand, are what the company owes to creditors. For example, if I took out a loan to pay for my expensive cleaning device, I would also be liable to pay that loan back later.

Equity: Equity is the degree of ownership in your business. It is the difference between your assets and liabilities, or in other words, equity is the difference between what you own versus what you owe.
 

2. Declarations

Let's move on to the second major component of accounting: reporting. Once your accounting is complete, you can prepare financial reports that represent the economic health of your business.

There are three major accounting reports that every business should know:

      1. Income Statement

      2. Balance Sheet

     3. Cash Flow Statement

Let's start by talking about your income statement. Your income statement is where you can find your total revenues, expenses, and, most importantly, your profit. It tells you if your business is growing or slowing down and your operations are profitable. You can review your income statement in two formats: cash basis or accrual basis.

- Cash Basis: Recognizes revenue and expenses based on when money is exchanged. For example, if you paid a hundred dollars to reserve my cleaning service, and I don't deliver the service until next month, under cash-based accounting, the revenue would be recognized when you paid me, not when I delivered the service.

- Accrual Basis: Recognizes revenue and expenses based on when the exchange is complete or, in other words, once the service is delivered. It completely ignores the cash transaction.

Your balance sheet shows which assets the company owns, the liabilities it owes, and the equity belonging to the owners. It helps you understand your company's liquidity and ability to meet its financial obligations. For example, if my cleaning company has twenty thousand dollars in assets, but fifteen thousand dollars of those assets are not liquid (perhaps in equipment), it would mean I only have five thousand dollars in liquid assets, known as cash. This could be problematic if my expenses start to exceed my money in the bank. Moreover, if my cleaning company has a high debt-to-equity ratio, it may indicate that my business is overleveraged and could face difficulties paying obligations during a business downturn. As you can see, your balance sheet can give you a clear indication of the financial health of your business.

The cash flow statement delves deeper into the company's cash position, detailing all cash outflows and inflows consistently. For example, you may have debt and expense payments, but both transaction types show up on different reports. Your debt standing is reflected on your balance sheet, while your expenses are reflected on your income statement.

4-Interpretation and Analysis

Interpreting financial reports involves tools such as profit margin and current liquidity ratio. Unfortunately, financial statements mean nothing if you cannot interpret them, and there are many ways to slice and dice through your financial reports to derive specific information. You can often apply ratios to certain parts of your financial statements to interpret what's happening in your business. For example, on your income statement, you can find your profit margin by dividing your net profit by sales. You can also determine your return on advertising spend by dividing your advertising expenses by your sales revenue.

On the balance sheet, you can assess your company's liquidity using the current liquidity ratio, which divides current assets by current liabilities. You can also find out how quickly your customers are paying you by using accounts receivable turnover, which divides your sales on your income statement by your accounts receivable on your balance sheet, which is the money people owe you.

As you see, there are several ways to interpret, and to be honest, there are hundreds of ways to analyze your financial statements. I know this because of all the years and exams I had to take learning to get the best interpretation of your financial statements; you may need to invest in some financial education courses or consult your CPA.

Accounting emerges as a fundamental pillar for the financial management of a business. Key reports such as the income statement, balance sheet, and cash flow statement provide crucial insights into profitability, liquidity, and overall financial health. A thorough understanding of these elements enables entrepreneurs and managers to make informed decisions to ensure long-term success for their businesses.