How To Understand Basic Accounting

By Jennifer Fletcher, 21 Jan 21:57

Basic Accounting to Impress Financial Lenders Accounting ... more than just adding and subtracting numbers, accounting can be a difficult subject to master.

Just ask the tax student cramming at 4AM for a 9AM exam, or the CPA working 90 hours a week during the busy tax season. As a business owner, manager or entrepreneur, you don't have to master accounting, but you do need to understand the fundamentals in order to manage your business's finances successfully, especially in the funding stages.

Whether you're forecasting revenue for a business plan or breaking out financials for a loan, Ed Ketz, associate professor of accounting at Penn State University, says there are three basic concepts you need to communicate effectively with a banker or lender.

1. Earnings-profit or net income

2. Debt to equity ratio-debt divided by equity

3. Potential cash flow

To increase your chances of speaking the lender's language, Ketz would like owners and managers to look at all earnings in terms of cash, rather than accountant numbers. "Bankers and investors like to see cash," he says. "They are more interested in hard dollars versus number movement on paper."

Earnings:
Earnings is the easiest of the three basics to understand. Subtract all sales revenues from expenses and that will give you earnings. Sales are easy to understand, but expenses are harder to pin down.

Ketz likens expenses to the cost of product, materials, supplies, labor, utilities, rent, etc. "Bankers want to see everything," he says. "They don’t like to be surprised with hidden expenses."

Debt to Equity Ratio:
Debt to equity ratio is tougher to understand, but simple when you know the vernacular. Ketz gives an example: The owner of a business puts $100,000 to start the business and that company makes $400,000 in profit for a total of $500,000.

According to Ketz, most lenders or investors will not go higher than 50 percent of a debt to equity ratio, especially for smaller companies. So in the scenario above, a banker or investor would not lend more than $500,000 typically, unless it is a large corporation.

Potential Cash Flow:
Potential cash flow is a projection of sales for the coming year. "Most people can handle cash in hand," Ketz says. "Projecting what sales are going to be over the next year is tricky, but bankers and investors insist on it."

Potential cash flow goes back to marketing. Find out which customers are interested in your product or service. You can do this with a formal survey by a professional company, or you can take an informal survey. But the company has to have names and potential sales.

"Bankers and investors are capitalists, after all," Ketz says. "They want to know they will get their money back with interest once they lend money to you."

Recommended Resources:
Ketz suggests three books for further reading and study.

Introduction to Financial Accounting by Jones, Werner, Terrell & Terrell, 2000, Prentiss Hall. This book assumes you know nothing about accounting with examples and traditional accounting concepts.

Financial Statement Analysis by Martin Fridson, 1995, John Wiley. This book is a level above introductory accounting, but still basic for neophytes.

Financial Statement Analysis by Leo Bernstein & John Wild, 1998, Irwin McGraw Hill. Not to be confused with the book above. This is a medium level accounting book.

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Tags: accounting