Many business owners are completely unaware that their profitability is a load of nonsense. This is because accounting records are completed on a cash basis without an understanding of the effect of timing on their business. These business owners often look at their accounts; dismiss them as being incorrect and provided there is enough money in the bank, go back to running the operations. It’s a bit like insanity… doing the same thing and expecting different results.
Let me illustrate how the detail of this can affect your business:
Imagine you buy product for sale in the month of January and keep it in stock and sell it in February. The buy price is $100 and the sell price is $200. (For simplicity lets forget GST, as this does not affect profitability).
How will your bookkeeper post the entries for these transactions?
In January they will likely make this entry:
DR Cost of Sales $100
CR Accounts payable or Cash $100
DR Accounts Receivable or Cash $200
CR Sales $200
You don’t have to be Einstein to see that this will mean in January you make a loss of $100 and in February you make a profit of $200; both of which are incorrect!
While from an operational point of view it is clear that the product is in inventory during January and part of February, the books of the company don’t show this and therefore the profitability is completely wrong.
Most times, the owner does some averaging in their head or completely dismisses the accounts as ‘a load of hogwash’. Provided there is money in the bank they continue on with running the business, unaware of their true profitability.
So what’s wrong with that?
Profit is one of the strongest measures of performance in a business, but unless the book keeping is done correctly, owners will not be in a position to determine if they have succeeded in developing a most profitable business.
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