While finance and accounting can seem daunting to those without a financial background, you don’t … [+]
Learning some basic accounting principles will not only help startup founders to manage their projects effectively but also make informed decisions that will benefit the company’s growth and success in the long run.
While finance and accounting can seem daunting for those without a financial background, you don’t need to dive too deep into finance as an early-stage startup founder. Initially, your project would be relatively simple, which means you’ll be able to make informed financial decisions and communicate effectively just by knowing certain fundamental accounting concepts and by consulting experts on the topics you need help with.
Later on, as your company grows and the level of financial complexity grows with it, you should be able to hire a specialist (a CFO) to take care of that part of your business.
Until you reach this stage, here are three crucial accounting concepts to make you more confident when you spend time in front of the spreadsheet in which you organize the finances of your project.
1. Accrual Accounting
Accrual accounting is the method of recognizing revenue and expenses when they are earned or incurred, rather than when cash is received or paid.
For example, if you deliver a service to a customer in January but you get paid two months later in March and you need to cover the expenses related to the service in April, under the accrual accounting method you’d put down all the revenues and expenses in January when the actual value was generated.
This is important because the payment date can distort the picture you see of your company’s financial health and performance. Continuing with the example from above, if you account for all transactions in the months they happened then it would seem as if in March you generated a higher revenue, while in April – higher costs. When your business has multiple projects, this could add up to a lot of confusion and the finances of your business could seem more volatile than they are in reality.
Accrual accounting helps you distinguish when and with what activities you were able to generate the most value for your company without letting payment dates distort your understanding of the financial health of your business.
2. Cash Flow
Cash flow is simply said the opposite concept. It is the movement of cash in and out of the company, and it can be positive or negative. Consequently, it cares about transaction dates, rather than the period when a service was provided.
Positive cash flow means that the company has more cash coming in than going out, while negative cash flow means the opposite. Knowing the cash flow status of the company is crucial because it determines the company’s ability to meet its financial obligations.
In other words, while accruals accounting makes sure you understand if your company is profitable and how it generates value, cash flow accounting helps you plan successfully to have enough cash to cover your expenses. It lets you see in advance if you would need financing (from banks or investors) in order to cover periods of negative cash flow and let your business run without hiccups or strained relationships with partners and suppliers.
3. Financial Statements
The three commonly used financial statements include the balance sheet, income statement, and cash flow statement, and provide a snapshot of the company’s financial health at a specific point in time. Depending on where your business is registered, your company would be required by law to produce these statements. Generally speaking, this would be done by professional tax accountants.
It’s important to keep in mind that the main concern of your tax accountants would be to make your business compliant with tax laws and regulations and to minimize the company’s tax liability – in other words to optimize things so that you owe as little taxes as possible.
Because of this, it is fairly likely that the professionally created financial statements would look a bit differently than the documents you use to manage the finances of your business – this shouldn’t worry you, as the two types of documents serve two different purposes.