With the current issue of the Northwest Arkansas Business Journal focused on accounting and finance — two subjects near and dear to my heart as someone who teaches in a college of business — I thought I would write about numbers and how they are the language of business.
I don’t think many of our readers would disagree with me that numbers are the language of business. Unfortunately, it might as well be a foreign language to many of those same small- and mid-size business owners. What I mean by that is that even the most fundamental concepts, such as what an income statement and balance sheet are—and what the difference is in cash and accrual accounting—are not understood. And that hurts the ability of these owners to manage their businesses.
When I teach my students about income statements, I try to get them to think about their situations. How much money do they bring in each month from their jobs or parents? And what are all their monthly expenses regarding rent, utilities, food, and so on? The difference is either a positive or negative number.
In a business, that is a profit or loss. You could do that for a week, a month, a quarter, or a year — for any time period. Income statements cover a period of time. Most can quickly understand what an income statement is.
Balance sheets are another matter. To teach this concept, I find someone who owns a vehicle they are making timely payments on. I ask them what the car is worth and how much they owe on it. The difference is their equity. That is precisely what a balance sheet for a business is. Add up the value of all of the assets, then subtract the value of all debts or obligations. That is owners’ equity or net worth. That is at a specific point in time. It is a snapshot view of the firm’s financial condition. If it is positive, they are solvent. If it is negative, they are bankrupt. If I asked the same question a month from now, they would likely have a different answer.
Accrual accounting versus cash basis accounting is another one people struggle with. Accrual accounting looks at income and expenses when they are incurred versus when the money comes in or those expenses are paid. It is a generally accepted accounting principle that accrual accounting gives a better view of how a business performs during any given period.
For example, if a service business does something and then sends a bill to their client or customer, and it takes them 90 days to get paid, the income would have been earned when they did the work versus 90 days later when they actually got paid for it. Same with the expense of the labor to do it. It would be accounted for when the labor was performed versus when the labor got paid to do the work — which could be, for example, a week later. I have dealt with veteran business owners who didn’t understand this.
Financial accounting seems really complex the way it is usually taught. Debits, credits, T-accounts — people struggle with this stuff. But if you explain the big picture first — how this information is used to put gauges on the business by creating income statements, balance sheets, and charting cash flow — and why cash and accrual accounting are two different things — the details of where that information comes from make a lot more sense.
Mark Zweig is the founder of two Fayetteville-based Inc. 500/5000 companies. He is also entrepreneur-in-residence teaching entrepreneurship in the Sam M. Walton College of Business at the University of Arkansas and group chair for the Northwest Arkansas chapter of Vistage International. The opinions expressed are those of the author.