Being an entrepreneur is complicated enough without throwing finances into the mix. I myself enjoy avoiding money matters at all costs.
But if you’re a small business owner or the founder of a startup, there are some things you just have to be aware of.
Here’s Tim Berry’s list of 7 must-know financial facts:
1. Every single dollar in Accounts Receivable is a dollar less in cash.
Accounts Receivable (AR)—in a nutshell—is amount of money owed to your business by clients who have already used your service or bought your product. It’s the total of all the unpaid invoices that you’ve given to customers.
“That money shows up as sales in the Profit & Loss (P&L), but it’s not in the bank; it’s in AR. This brings up AR aging, collection days, and a flock of related concepts that are all important because a business can die over failing to collect on AR – even profitable businesses choke on AR.”
Tim notes that if you sell to consumers in cash, checks or credit cards, then this concept is not as important. It also helps if your business asks for a deposit in advance.
2. Every dollar in inventory is a dollar less in cash.
Note: Most service businesses don’t have to worry about inventory.
“…money spent on inventory doesn’t show up in the P&L until you sell the stuff and it becomes cost of goods sold. So whatever is in inventory isn’t in your bank account… companies that are profitable in the P&L can run out of cash in the bank because they got their inventory constipated. In some extreme cases, expenses get misdirected to inventory, and the system clogs up with inventory that pretends to be assets and creates a fiction that ends up with the reality of no cash in the bank.”
3. Every dollar in Accounts Payable is a dollar more in cash.
Accounts Payable (AP) is the total of your unpaid bills; a business’s short-term debt.
“Most businesses buy stuff on credit, meaning they get the stuff along with an invoice they have to pay in a few weeks. Almost nobody pays bills in cash immediately. Ideally, you finance inventory and AR with the money you owe to your vendors. You have to manage the pull between paying on time, paying late, and stretching AP without getting a reputation for late payments or a bad credit rating.”
4. Debt repayment doesn’t show up in P&L.
“It costs you money, but you won’t see it if you don’t track cash flow. The interest portion of payments is an expense, so that shows, but principal – debt repayment – doesn’t show up. You have to watch and plan for it.”
5. Buying assets doesn’t show up in P&L.
“It takes money to buy your assets (equipment, plant, land, furniture, etc.) but those don’t count as expenses, so you don’t see them in P&L.”
6. Fixed vs. variable costs matter.
“That’s because the trade-offs come up often and matter a lot, and this area is full of choices you can make. Do you hire the person as an employee or contract out for skills? Fixed costs are generally lower than variable costs, but they also increase the risk.”
Examples of fixed costs: office rent, marketing expenses
Variable costs: hourly wages, inventory
7. Sunk costs don’t matter.
“We so often think we have to continue down some path because we’ve already spent so much money on it. It’s hard to let that go. But the money already spent is a sunk cost. You don’t get it back by spending more. So decide based on whatever decision criteria make sense, in a specific situation; money already spent is never a good reason, by itself, to spend more.”
Sunk costs cannot be recovered; remember that before you spend any more money on an “investment” or business project.