“How can that be my net income?”
“I didn’t make that much, check my bank account?”
“This income statement makes no sense to me”
I have sat with many business owners and heard these lines seem time and again. Their income statements make no sense. It’s no wonder many owners look at what accountants do as some sort of voodoo. The sad fact is that most of us accountants do a bad job of explaining the financial statements. As a result, the common perception is that the income statement shows how much cash a business made or lost.
The truth about income statements are just one of a few different financial reports that a business owner should use to gauge the health of their business. While the net income or loss of a business is important, for most small businesses the most important number is actually what is in the bank account. To many small business owners’ surprise, that can actually vary greatly from what is on the income statement.
By this time, if you are a small business owner, you are probably frustrated enough with accountants and finance people. And I get….why did some numbers guy call it the income statement if it doesn’t even show how much cash you made? I have seen so much frustration in business owners’ eyes when it comes to their accountants. My profession does a crappy job of making it easy for a business owner to understand where their business really is.
Let’s not digress too far from the point of this article though… why doesn’t your income statement for the year equal the change in your bank account? At the most fundamental level an income statement shows the revenue and expenses of a business over a certain period of time. Below is a list of items that will have cause a difference between the net income on the income statement and the actual cash flow to your bank account.
Not All Cash Payments are Expenses
A lot of small business owners have debt. They might have borrowed it to purchase the business, buy inventory or equipment, or do many other things. When a business owner receives money from a lender, that is not considered income. Likewise, when a business owner pays down the principal portion of that debt, it is not considered an expense. As a result, you can have a major cash outflow (paying down the debt) that has no impact on your income statement.
Certain cash outflows are also not considered to be an expense initially. The first example is when a business purchases a capital asset (or fixed asset). For instance, if a manufacturing business purchases a new piece of equipment to package their inventory, that piece of equipment is not expensed initially. As a result, it will not show up as an expense in the period it is purchased on the income statement (I am going to skip the concept of deprecation for the moment).
A second cash outflow that isn’t initially expensed is inventory. When a business owner purchases inventory, it is accounted for on the balance sheet. Only when that inventory is sold is it accounted for as an expense on the income statement. This concept leads us to our next key point of why we see a difference in the income statement and cash flow of a business….
Timing Differences
Revenue is not receipts. If you are a business that sells your services or products on credit and you follow the accrual method of accounting, you are recording the revenue when you ship your inventory and bill for those goods. As a result, you are recording revenue before you actually receive the cash for that sale.
Likewise, once a business receives an invoice for an item received or service performed from a vendor, that invoice is recorded as an expense on the income statement. It is accounted for as an expense at this time regardless whether it was paid for right away. Some business owners will stretch out their accounts payable up to 30-60 days (yep, this does happen). As a result, they may have 30-60 days of expenses recorded prior to actually paying for them.
Not All Expenses Involve Cash
OK, now you think I am just screwing around with you…but it’s true….companies can have expenses that don’t require a cash outflow. I won’t get into some of the non-cash expenses that SEC companies deal with. However, one very common one most businesses deal with is deprecation (I told you we’d circle back to this).
When you purchase an automobile for your business, your accountant most likely capitalized or accounted for the purchase by recording an asset on your balance sheet. As a result, there was never an expense on your income statement for this cash outflow. The expense on the income statement is therefore recorded over the “useful life” of the asset. In other words, if you will use the car for 5 years, each year 1/5 of the cost of the asset is recorded as an expense on the income statement.
Why Growing Businesses Feel the Pinch
If you are a growing business, congratulations! However, you are especially feeling the pinch. This is even truer if you are lucky enough to be a business that carries a significant portion of inventory. Let me paint a picture of why this is happening….
As a business owner, you purchase inventory on January 1st. When you purchase this inventory, you get a bill from your vendor that requires payment by January 15th. You pay for your inventory on the 15th and sell it just two short weeks after, on the 30th. You are a flexible business owner and you extend terms to your customers that say they must pay in 30 days. On March 2nd, a check comes in.
In this scenario, you paid for your inventory on January 15th however you didn’t get paid for your sale until March 2nd. This almost 45-days where you had to pay for rent, overhead, labor, and oh yes…for the inventory you sold until you got paid. However, you also sold your inventory on January 30th so you had to buy more. That second order had to be paid for on February 15th. So, prior to getting paid for your first group of sales, you have purchased 2 orders of inventory, on top of all the other expenses.
Your business begins to sell more and more so you order even more and more. This cycle I described above starts going faster and faster. The numbers get to be bigger and bigger.
Finally, you are at your wit’s end and you sit down with your numbers person and ask “I didn’t make this much money you’re showing me on the income statement. Where is it all at?”
The answer is most likely a combination of the items above….not all cash payments are expenses, timing differences, and non-cash expenses. However, a good numbers person would have helped you forecast this. A good numbers person would have headed off these questions before they began. You would have had control of the situation had your numbers person been on the ball.
I can see the pain in some business owners’ eyes when they ask why their income statement says they owe money yet they don’t know where it is. The accountant goes and does something behind the curtain and then…Sim Sala Bin! Here are the numbers!
Hopefully, this piece gives you a little idea of why those differences might be there. However, this is just the tip of the iceberg. Best practice business owners are getting better reporting, projections, strategy, and advice from their numbers people.
About Krieger Analytics
My name is Matt Krieger, and I am the founder of Krieger Analytics, an accounting and advisory partner for small businesses and franchisors. Our goal is to completely outsource your accounting department from bookkeeping and taxes to CFO advisory services. I am also the owner and franchisor of a concept called Monkey Bizness, in Denver, Colorado.
As a small business owner with a background in finance and strategy, I realized the benefits that a CFO could bring to smaller organizations. Most franchisors and small business owners don’t have a need (or budget) for a full-time CFO or bookkeeper. To better fit my clients, Krieger Analytics is a part-time resource. While most think of CFO’s being involved in finance and accounting (we are), we are also involved in much more. We partner with clients by coaching, giving them clarity into their business, and creating growth strategies. Conversations are free, so don’t hesitate to reach out to me at [email protected]