Some 158 years before Van Riebeeck arrived at the Cape, Luca Pacioli, an Italian monk with an inventive mind, worked out how to keep score in business. In 1494 he published his De Scripturis, a treatise on accounting – and to this day the key principles have remained unchanged.
But over the past 500 years, accountants have turned a simple task into a black art. Pacioli’s great “discovery” was to appreciate that every transaction has two sides. One, you buy a book for R100 and, two, you incur a debt. One, you pay the shop and, two, you’re now R100 poorer. This is the basis of the double entry bookkeeping system.
All transactions need two entries (and sometimes more, but that’s another story) and all should balance out. If it doesn’t, there’s a mistake somewhere. But all of this goes on in the accounting engine room. What really matters is that we, as business managers, understand the “products” generated – that is, the balance sheet, profit and loss statement and cash flow – and can “read” these “scorecards”.
There are a number of other quite simple concepts which, if understood, throw further light on the accounts. Perhaps the most important is the difference between cash and accrual.
“Accrue” is a specific accounting term. Assume you bought that book in January on a 60-day account. Payment is due in March, therefore. But you can’t pretend that because you don’t have to pay until March, you don’t have the book.
So, in January, you “recognise” it’s in your possession (stock goes up) and that you owe R100 (creditors go up). When March comes you settle the debt (creditors go down) and you have R100 less in the bank (cash goes down).
That’s accrual. It’s a transaction with no matching cash changing hands – a non-cash transaction, in other words. And this must be reflected in the accounts of all transactions in the accounting period covered – and not only when the paperwork catches up.
Another source of confusion is the convention of recording everything at historic cost. It works fine for
things that don’t have a long life, but can seem bizarre when it comes to fixed assets. Take the land dad bought 35 years ago for R150/ha. Today it’s worth 50 times this figure, but still R150 in the books. But what should the new figure be? Who will estimate it?
As soon as estimated or assumed figures are used, things tend to go awry. Always remember this when reading accounts and recorded values.
It’s not only concepts such as these that you must understand to gain the financial literacy needed to read a set of business accounts. For example, “net profit” (NP) is often cited, but not looking behind this number can lead to problems.
“Net profit before tax” (NPBT) tells you a little more about the business, but once again the word “profit” means the need to look behind the number. Then there’s EBITDA – “earnings before interest, depreciation and amortisation.” Here is a number which strips out some non-cash costs such as depreciation and amortisation and is probably closer to the truth.
Best of all is “cash flow”, which is difficult to misunderstand, but even here there’s sometimes something called “near cash” added. Huh? We’re back to the black art! To become a balanced business manager, take time to develop your financial skills. Leave accounting to the accountants, but at least be able to ask the right questions to understand whether the business is doing well or not.
Contact Peter Hughes at [email protected]. Please state “Managing for profit” in the subject line of your email.