One of my favorite TV game shows when I was growing up was a show called The Match Game, hosted by Gene Rayburn. Two pairs of contestants would try to match celebrity’s answers to questions. In business, it is crucial that business owners also play a “match game” in order to manage their companies properly. Let me explain.
In my work over the years with CEOs, Presidents, and other key people of growing companies, I have found that often the number one priority is to ensure that they understand exactly what the true profit margins are each month. Many times small and medium size business owners are reviewing their financial statements on a cash basis. This means their financial statements are simply reflecting actual cash coming in and cash going out. Whatever is left is shown as profit. This may be okay when a company is very small but not so as the business begins to grow. Reviewing company profits or loss on a cash basis is very misleading. Do not get me wrong, measuring cash is of the utmost importance and ultimately is the true measure of value and whether the company will prosper or fail. It must be measured and forecasted continually. However, a good cash position is only possible if the company is making an adequate profit margin on the sale of its products or services, and the only way to know if the profit margins are solid is to measure the financial statements each month on the accrual basis of accounting. Please note the following definition of accrual accounting.
“An accounting method that measures the performance and position of a company by recognizing economic events regardless of when cash transactions occur. The general idea is that economic events are recognized by matching revenues to expenses (the matching principle) at the time in which the transaction occurs rather than when payment is made (or received). This method allows the current cash inflows/outflows to be combined with future expected cash inflows/outflows to give a more accurate picture of a company’s current financial condition(investopedia).”
The key phrase from the above definition is matching principle. Only the matching principle accurately reflected will show the true profit margin as reflected in the following simple example.
Sales $ 100 ( amount billed for period, no cash received but accounts receivable)
Cost $ 50 ( costs incurred for period, no cash paid but accounts payable)
Profit $ 50 (true profit margin although no cash has exchanged hands)
In the above example note the actual sales for the period is matched with the actual cost for the period to reflect the true profit margin. Cash efficiency comes into play with effective collection procedures and proper payable controls, but ultimately profit margins drive everything.
Make sure you are playing the match game in your business.