If you are like most entrepreneurs, you have a big idea you want to develop as quickly as possible. While you may wonder how you will raise funding for your startup, chances are that you haven’t had much exposure to accounting or finance and have no idea how you will keep track of the money flowing through your business. Your degree of financial literacy can make a huge difference in how much success you achieve.
Here are three reasons why every entrepreneur needs to acquire at least some of the knowledge taught in an Accounting 101 course.
Reason 1: To Know How Much Money You Make
Several years ago, when I was working with an innovative energy-efficient lighting company that wanted to raise a half-million dollars, I asked the CEO why he needed to raise funding. His answer was typical: so he could grow his business. He and his partner had used home equity loans to finance their launch, and now they wanted to expand. But when I asked him how much money his company was making, he had no idea.
“I have to ask my accountant,” he said.
I was stunned. How could someone who had put his home on the line, and now said he needed to raise capital, not keep track of the money his business was making—or worse, maybe losing? This man was an intelligent and effective salesperson, highly capable of attracting new business. But he and his partner, who provided the technical brains, had completely outsourced the financial side of the business to their accountant. Once we had the financial statements in hand, it was obvious that the company had plenty of income and plenty of cash flow to fund a good, steady rate of organic growth. They just needed to keep plowing their earnings back into the business.
Reason 2: To Enable You to Raise Financing
Blindly trusting an accountant or using QuickBooks to do your books yourself—when you don’t have a basic understanding of accounting or of general financial management—can hurt you as you try to get financing from a bank or an equity investor.
In another case, I was developing a business plan for a fashion designer. Even though she kept meticulous spreadsheets detailing the amounts and the costs of every item that went into the clothes she produced—everything from imported fabric to buttons—she left her bookkeeping to her accountant. The statements he provided convinced her that she was losing money, and she desperately wanted to get a line of credit from a bank to enable her to create samples and inventory. She had to spend money on raw materials, labor, warehousing and shipping months before she was paid by the boutiques that sold her line.
When I saw the statements, I was incredulous. Using QuickBooks, her accountant had allocated 100 percent of her raw materials to her cost of goods sold as they were purchased. A key principle of accounting is to match revenues and expenses. Some of those raw material costs should have been capitalized on the balance sheet. Then, as she sold her merchandise, she could match the revenues and the cost associated with producing those revenues. When we took her records from her own spreadsheets and developed fresh financial statements using Excel, it was clear that the designer had excellent gross margins and even made a net profit in some quarters. Her biggest problem was timing of receivables and payables through the different fashion seasons. She needed working capital to tide her over from season to season.
Armed with the revised statements, the designer went to her bank and received an unsecured line of credit, enabling her to produce new samples to sell at New York’s Fashion Week and to expand distribution to more boutiques.
Reason 3: To Build Financial Resources for Expansion
Contrast these first two scenarios with the following. Ed McLaughlin, with whom I am co-writing a book on entrepreneurship titled The Purpose Is Profit: The Truth about Starting and Building Your Own Business, did not have a degree in business, so he asked his accountant for instructions on how to keep track of his cash and his accounts. His company did all the bookkeeping in-house, and he took home a printout of the financial statements at the end of each day. Ed wanted to know where his company stood because he had bootstrapped his real estate services outsourcing business, USI Companies Inc., with personal savings, and he had a young family that relied on his income.
As USI grew, Ed hired a CFO who used more sophisticated accounting software. After achieving breakeven, Ed stopped taking statements home every day, but he continued to read his financial reports each week throughout the life of the business. Armed with this knowledge, the company built a war chest of retained earnings, which they used to invest in regional and product-line expansion. Ultimately, when Ed and his partners sold USI to Johnson Controls, they realized the value of their financial discipline.
Ed quickly learned to understand and track his revenue, expenses, payables and receivables. He found people who showed and explained the concepts to him, so he could grasp how much cash was flowing through his company. It is cash flow, after all, that determines whether a company can stay alive or not.
The accounting systems we use today were first developed in the Renaissance by Venetian merchants to keep track of the trade flowing through their ventures. If you are starting a business or own a business, it will pay to invest some time in understanding the power of these systems and in developing financial literacy. If you are starting or building your own business, take the time to learn about basic accounting principles.
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Editor’s note: The original version of this article appeared on the Wharton Entrepreneurship Blog on Feb. 27, 2015.