Note: all statements below are INCORRECT and you should answer with No, because .....
If after reading this introduction you think: "But what is wrong with that?" read the rest of this article or get my free book Financial Management Unravelled!
1. Costs are the same as payments, just like revenue and receipt.
Costs are not equal to payments: Costs arise as a result of consumption, cash outflows are the result of payments.
"Cost" means something completely different for the financial person within your company than for you. The accountant and controller make a big difference between "using / consuming" and "paying for". You have costs in your P&L when you deliver a product or service and use or consume items or time to create it. Both the delivery of products or services and the associated costs are included in the Profit and Loss statement. The difference between the value of the delivered and the consumed is called the Profit. Read my article about the Profit and Loss account for more information.
What an accountant calls cash out is also known as "to pay". The actual debit from the bank account or the handing over of money to someone else. In order to be able to pay, you need sufficient (money / cash) resources. So if you are talking about payments, a financial person will immediately think about his bank account and if there is enough on it. All payments and receipts are shown in the cash flow statement. The Balance Sheet shows both at the beginning of the period and the end of the period the amount of Cash and Cash equivalents available at the firm. The Cash Flow Statement of that period shows where the cash came from and went to.
Conclusion: If you buy a pizza from the grocery store and pay it at the cash register, you have an cash out; the moment you eat it (or throw it away because it is no longer fresh) you have a cost!
Revenue is not equal to receipt: Revenue is generated by the delivery of the product or service. The receipt has to do with the payment by the customer.
Just as with costs and payment, a financial person also makes a big difference between "delivering" and "getting paid for". The moment the goods are delivered to the customer there is a revenue. This performance is also called turnover and is shown on the first line of the Profit and Loss Statement. We refer to the revenue as the total of the value of all delivered products and services in the period. Read more about the Profit and Loss Statement here.
Conclusion: At the moment that you are working for your boss, you provide a service and you realize a revenue (every minute, every day); the receipt takes place once a month when your salary is paid into your bank account.
2. The Balance Sheet is in balance through an accounting trick.
The Balance Sheet is in balance because it shows you twice the same but from a different perspective.
The Balance Sheet is constructed, in short, as follow. On the left side it is shown "what does the company have" and on the right side it depicts "to whom does it belong". Because all the items a company works with belong to somebody it is equal. The reverse is also true: If a property loses value, someone is unhappy, in most cases the owners of the firm.
Conclusion: What I have and to whom does it belong are two values of the same magnitude but a different perspective. Read my complete article on the Balance Sheet for more insights.
3. If I make a purchase I incur costs in the P&L and that is detrimental to the profit.
If I purchase something, I do not incur any costs in the P&L.
As discussed in point 1, non-financial people make little difference between "promising to buy", "receiving things" and "consuming them". However, there is a big difference for the controller. After all, when I order items, nothing happens in the three major accounts. I am going to receive goods at a certain point in time that I will have to pay later, but as long as I have not received them they are no part of the Profit and Loss, Balance Sheet or Cash flow Statement. I might log my orders to others so that I know what to expect. For the result (Profit or Loss) or my assets (Balance) it has no impact.
The moment I receive items I can still use them and they represent a value. This value is processed by the bookkeeper in the Balance Sheet. The Balance is the overview of all assets and liabilities.
If I have consumed or used the item the value is gone and I have to account for that. The accountability of what I have consumed is represented in the Profit and Loss Account. Costs arise due to consumption. The costs are deducted from the value of the item on the Balance Sheet so that if I have used it the profit will be lower and the item is no longer represented on the Balance Sheet.
Conclusion: If I order something, nothing happens (first the other party has to prove that he can deliver), on receipt I have something of value that I show on the Balance Sheet and with consumption I have a cost.
4. The interest percentage that I can borrow at from the bank or the WACC should be used when assessing a possible investment.
I can NOT use the percentage against which I can borrow from the bank for the assessment of investments nor should I use the WACC!
Think about it: If you invest money into a project you want to receive it back as soon as possible and with as little as possible risk. Financials therefore assess investments on the time value and the risk profile. If a project has a high risk and I get my cash back in many years, I will only consider the project if the potential profit is very high. I am also prepared to settle for a lower yield if an alternative project will pay out earlier or with a higher probability.
The interest rate that I can borrow from the bank, on the other hand, is based on two principles: How much risk does the company have as a whole and how much collateral the company can offer as a guarantee. After all, if I own a property on a top location of which I can grant mortgage rights, the interest rate will be lower. The bank also creates a time and risk profile from me.
The Weighted Average Cost of Capital is based on the average risk of the company. So only if the project has an equal risk profile as the company in a whole should the WACC be used. Most companies however have a mix of risky and safe projects. Make sure to evaluate each on their own merits.
Conclusion: The individual project of the company must be assessed on its own "time" and "risk profile" and not on the average profile of the company, nor the possibility of the company to provide collateral.
5. If equity is on the right side of the balance sheet, it has the same meaning as when it is represented on the left.
Is the equity on the right side of the balance sheet it represents a property of the owners is it on the left side it represents a deficit.
The Balance Sheet of a company is made up of two sides. All the company's posessions are on the left. We call this the asset, or in other words the things that the company "works" with. These are, for example, the land, buildings, machines, but also the raw materials, patents and the money in the bank account. The asset side of the balance sheet therefore provides a description of everything the company owns.
On the right-hand side of the balance sheet you will find an overview of equity and liabilities or otherwise defined who has which claim on the company.
Beware of the situation in which the Equity is represented with the Assets. In this case it is not a worth from the owners of the firm but it’s a "deficit" from the owners.
What happens when the equity is on the left? In this situation, the debts of the company are higer than the assets and the owners are, as it were, "guarantor" for the difference.
Is this possible in practice? Yes: if the company is owned by a person who has faith in the future of the company, he can choose to keep the company afloat for the future.
Conclusion: Is the Equity on the right: it’s a possession, a valuable thing, is it on the left (with the assets) a bad thing because it is a debt.
6. I can best stop delivering to customers that create losses for me.
Customers that I lose money on still can be very valuable to me.
When evaluating a customer relationship, a number of aspects are important:
- If you make losses on the customer, this means that if all costs are assigned to the revenue the customer generates a negative result. But it is quite possible that the customer contributes for a small part to the fixed costs of the company. If you stop delivering the customer, you lose this contribution and thus the total loss of the company increases.
- Does the customer have a perspective to become profitable in the (near) future?
- Does the customer influence other customers or suppliers?
Conclusion: Clients that generate losses and which do not contribute to the fixed costs and have no prospects are best disposed of.
7. Companies go bankrupt because they make heavy losses.
Companies do not go bankrupt because they make losses.
Making losses refers to the Profit and Loss Statement. In the P&L we describe the value of the activity carried out and what we have consumed to deliver the activity. Read my article about the Profit and Loss account for more information. However, there are companies that have never made a profit in their entire existence. Consider, for example, Tesla (date 2018). Yet these companies continue to exist because they find investors who believe in the future of the company and are willing and able to provide capital.
Conversely: We have a business in fax machines or film rolls. We have never made a loss in the company's entire existence. Now a large loan expires that needs to be renewed. I cannot find any lenders who will provide it to me due to lack of future profitability.
Conclusion: Cash is King! Companies go bankrupt because they have no cash and cannot find anyone who wants to step in as owner or as a loan provider.
8. All financial statements within my company must comply with the law.
Internal financial overviews do not have to comply with the law.
Obviously, all documents that go to external parties must comply with the law. For example, the declaration to the tax authorities or the overviews in the annual report.
However ... If I am the boss of a company and have to make a decision, I decide how long I will use the item. An example: Officially, I have to write off my lap-top in three years for the tax authorities, which I also do nicely. However, now I have to buy a new laptop and I have a choice of different models. But at the same time I also know that I am traveling a lot and quite clumsy. As a result, my new laptop is probably broken after 1.5 years. In my calculations and decisions I therefore assume 1.5 years of use.
Conclusion: For all decisions that I take as an entrepreneur, I am responsible and I make the best choice based om my specific situation and conscience. These estimates are seldom the same as the overall average used by the tax authorities. I am responsible for my decisions, so I make them according to my estimates which I apply on the financial calculations and overviews I make.
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