In my seminars I often ask for a show of hands indicating how many people use cash accounting and how many use accrual. Invariably, everyone gets the answer wrong! That's because EVERY business uses cash AND accrual accounting whether they know it or not.

To be fair, most business owners assume I am talking about which accounting method they use for tax reporting. But as we teach all of our clients, you should never let the tax tail wag the dog. You should be measuring your business results under BOTH accrual and cash accounting and you should be budgeting and forecasting both as well.

Cash accounting is probably the simplest and easiest to understand accounting method available. It basically says that income is recognized when cash is received and expenses are reported when cash is spent. It doesn't get much simpler than that. Cash basis accounting is not only simple to understand, it is very simple to administer.

Another benefit of cash basis accounting is that if it is used for tax purposes the owners are more likely to have the cash on hand to pay taxes. If you think about this it makes sense. Receiving lots of cash means lots of taxable income, which means lots of tax. But if I have lots of cash paying the tax shouldn't be a problem.

Accrual accounting on the other hand uses business events to decide when income should be recognized and when expenses should be incurred. For instance, under accrual basis accounting revenue may be recognized when a product is shipped to the customer. It may be several days before the customer receives the product and many more before the customer actually pays for it. However, if the contract states that the customer is legally obligated to pay for the product upon shipment the income is properly recognized on the ship date.

Technically speaking, accrual accounting attempts to match revenues and expenses to the periods which benefited from them. Many times this type of accounting is at odds with the actual cash receipts and disbursements.

Here's why cash and accrual basis accounting are important to the business owner. Accrual accounting will most accurately measure the operations of your business. Just because you didn't receive payment in a certain month doesn't mean you didn't do any work. Conversely, just because you put off your vendors and didn't pay any bills doesn't mean you didn't incur any expenses. Accrual accounting recognizes these realities and makes sure that your operations are being reflected in the financial statements.

Cash on the other hand is the life blood of any business. And nothing but cash accounting measures the stark reality of slow markets and the danger a business faces when collections are down and expenditures are up.

So here's your homework assignment. Walk into your CPA or Controllers office and make sure you can obtain both cash and accrual financial statements. You should also ask to see projected financial statements using both methods. And finally, you should make sure you are using the best method available for tax purposes given your industry and particular circumstances.

Below are a few links where you can find more information on cash and accrual accounting methods.

Wikipedia page on accounting methods

Cash Flow and Accounting from myownbusiness.org

Understanding Accounting Methods from dummies.com

If you have questions about accounting methods or how they affect your particular business please give me a call or send me an email.

There are two numbers that every business owner should know. They are the gross margin and the net margin of their particular business. Savvy business owners will also know the gross and net margin numbers for their industry, but I'm getting ahead of myself.

Gross margin is the percentage of gross profit compared to total sales. To calculate gross margin you need just two numbers, total sales for the period and cost of goods sold for the period. Using these two you can calculate gross profit, and from there the gross margin number is simply a matter of dividing gross profit by total sales.

Net margin is similar but it uses net income divided by total sales. In other words, net margin is the percentage of gross profit you get to keep after things like overhead, depreciation, amortization, interest and taxes are taken into account.

Why are these numbers important? If you want to compare your business to others in your industry the easiest way to do it is by comparing gross and net margin numbers. Many business owners are unwilling to disclose their actual sales and profit figures but they often don't have the same hesitation when it comes to margins.

Margins are also a great way to measure improvements in your own business. It doesn't matter how much you grow sales, if you can't maintain or improve on the current margin numbers you may not be making any more money (in fact you'll often lose money). Many of the businesses we work with find it is much easier to focus on improving margins rather than increasing sales. Even a little attention to margins can yield big results. A 1% margin improvement on $1 million dollars in sales is $10,000.

But what is the difference between gross and net margins? In my experience gross margins say something about your particular industry. In other words, if I am working with a business and we just cannot seem to match the gross margin numbers for the industry it means there is something fundamentally wrong with the way we're setup to do business. We might be paying way too much for materials, or we might be hiring the wrong labor force, or perhaps our pricing is way off from industry standards. In any case, if gross margins are off we know there's something fundamentally wrong with the business.

Net margins, on the other hand, have more to say about how a particular business owner runs his or her business. An owner who chooses to furnish the corporate offices with antiques and fine art will have thinner net margins than the owner who uses second hand desks and counts paper clips. We may not be able to do much with gross margins unless we're willing to make fundamental changes or introduce new technology to the industry. But net margins can yield many ways to add dollars to the bottom line.

It's also important to make sure that your business is measuring gross margins consistent with your industry. Some industries may allocate labor to cost of goods sold and others may not. Some may calculate sales net of returns and allowances where others report only top-line revenue. You should establish early which items will be considered sales, which will be cost of sales, and which will be considered overhead.

With a little effort margins can become a very efficient tool to gauge progress and make improvements. Our experience is that most business owners know what their margins are, but they have never tried to use margins to place their business in the context of the broader industry or market they serve.

Below are links to more resources on margins.

The Bottom Line on Margins from Investopedia.com

Income Statement Analysis from About.com

Various Industry Ratios from Bizstats.com

If you have found useful applications for margin analysis or have a specific question please give me a call or send an email.

The subject of inventory management is better suited to an entire book than a short newsletter article. However, there is one thing you can do this year, no matter how big or small your inventory, that will improve your business. Deal with obsolete items.

Most businesses have no idea how much their old, unused inventory is costing them. In addition to the cash spent on products they can't sell, businesses must rent space to store the items, pay interest on the funds used to purchase them, maintain personnel and systems to safeguard the inventory, and spend time each accounting period counting it. Here are a few suggestions for identifying and dealing with obsolete inventory.

Run a sales report to identify slow moving items. Inventory that isn't moving is obsolete. Every accounting system, if setup properly, can identify slow moving inventory. Businesses then have the ability to offer discounts or liquidation sales. These sales free up cash that can be reinvested in faster moving inventory (that presumably turns a profit).

Run a "last used" report. In manufacturing businesses will need to identify the last time items were used in a bill of materials. A "last used" report will identify the last production run that required the item. If you haven't used it in production in the last six months chances are it's probably obsolete. You can then return it for cash or credit with your supplier or sell it on the surplus market (eBay anyone?) to free up cash.

Physically aggregate obsolete inventory. There's nothing like the sight of an entire rack of obsolete inventory to motivate everyone to get rid of it. One client told us over and over again that obsolete inventory was immaterial compared to the total amount of inventory in the warehouse. After we finally convinced them to put it all in one place they were shocked to find it took up 90 linear feet of rack space, 20% of their total physical volume.

Trace the problem to its source. Once obsolete inventory is identified find out why it's there in the first place. Here are two examples. A purchasing manager was notorious for not getting along with engineering. Consequently, when a design change was made the purchasing manager was the last to know about it. This resulted in the continued purchase of parts for old designs. Additionally, production ran into constant backlogs because new parts weren't ordered yet. HR was brought in and asked to address the situation once the magnitude of the costs was known and everyone realized that poor communication was costing the company a lot of money.

In another case poor organization in the warehouse led production managers to believe inventory stocks were low when, in reality, there were hundreds of parts scattered throughout the racks. Poor controls over purchase order authorizations allowed the production managers to order more parts rather than forcing them to locate the parts the inventory system said were on site. A bar coding and warehouse mapping system along with tighter accounting controls fixed the problem.

Inventory usually represents the largest carried cost in most businesses. The good news is that due to its size inventory is a good place to look for improvements to the bottom line. Dealing with obsolete inventory is probably one of the easiest improvements any business can make.

Below are a few links to sites dealing with obsolete inventory.

Dispose of Slow Moving and Obsolete Inventory from morebusiness.com

Are You Keeping Obsolete Inventory? from MMS Online.

Excess or Obsolete Inventory Can Lead to Tax Savings by Robin Gilden of Reish Luftman Reicher and Cohen.

If you have stories about obsolete inventory or tips for dealing with it send me an email or give me a call.