Episode 42: Understanding your Books

February 21, 2022

In this episode Sarah and Trudi talk about the importance of understanding your businesses financial books. They talk through some of the terminology and explain what the reports are for, but most importantly explain why each report is important and how it can help you in your business. If you want to learn more about your business finances this is the episode for you. We also highly recommend the Helix Planning course.

Podcast Transcript Available Here

Duration: 28:16

Trudi Cowan: Welcome to season three of the Financial FOFU podcast where we talk all things finance, money and mindset. To find out more about us or to listen to some old episodes, you can visit us on our Instagram or Facebook pages or check out our website. So let's get into it today. Trudi Cowan: Hi everyone, today's episode is about understanding your books and I'm Trudi Cowan. Sarah Eifermann: And I'm Sarah Eifermann . And when we say books, we mean Trudi Cowan: Your accounting and financial records for your business. Sarah Eifermann: Yay. Thank you for clarifying that for everybody. It's kind of a topic that can be a little bit confusing if you don't have a really good understanding of it. So books are kind of like a colloquial term for everything. Trudi Cowan: It is Sarah Eifermann: Kind of not. Trudi Cowan: And it's kind of reminding me of the episode we did last year about all the jargon that we use. Sarah Eifermann: Yes. Trudi Cowan: I'm looking at some of my notes. I think we have a little bit of jargon today, so just make sure I do some explaining. Sarah Eifermann: You have jargon never, so I think this is something that I come across with every single client that I have, a business strategy and advisory and accountability coaching. And it's usually the first place we start when we do business on it because it is so important to everything else. It's like literally that foundational piece, that keystone for everything else that happens in business, but a lot of people have little understanding, to no understanding. Sarah Eifermann: Or they just don't focus on it at all. Trudi Cowan: Yes and that's probably, the common one is that people don't focus on it, they outsource it to their bookkeepers and accountants and just assume that it's all in hand and think that they don't need to focus on it, as well. Sarah Eifermann: Yes, so why do you think that's important, that they focus on it? So no, I think that's important Trudi Cowan: Because your bookkeeper and your accountant are very focused on making sure that everything is done correctly, and that you're meeting your obligations. At the end of the day, it's your business and your focus should be on, Am I making money? Am I increasing my profit? Am I increasing my revenues in my margins? And am I making the kind of money from this business that I want to be making, from it? So it's a different focus those professionals would be having on it. Sarah Eifermann: And for me, it's like, how do you know that your pricing strategy is sound? How do you know what your operating expenses are? How do you know if you're paying if you can pay yourself a living wage if you don't have any understanding of your turnover? Your profit? What your expenses are? And how do you even quote like, one of the common questions is the first thing I ask is, what's your profit margin? Especially from the trade-based industry, I'll get oh, it's like 22%. And I'll say net of expenses or gross of expenses, and I get a blank face stare back at me. Trudi Cowan: Because they're looking at their job costs, their profit over their materials, maybe over some of their contractor costs, is what they're thinking about, but they're forgetting about their rent, and they're forgetting about their stationery bill, their insurance and Sarah Eifermann: All the other things that they need to pay for to run a business, right, that are not necessarily Well, there are the fixed costs in some way. Like there's an average cost that you pay, because your phone bill is usually the same cost per month, and your petrol bill is about the same cost per month. So why don't we maybe start explaining some of these things, Trudi Cowan: Some of these things? Yes. Of course. Sarah Eifermann: What is a chart of accounts, Trudi? Trudi Cowan: So the chart of accounts is the list of all the different accounts that make up your books. So when I was Sarah Eifermann: So what's an account then? Trudi Cowan: The account is your different types of asset accounts and different types of accounts, your categories, so motor vehicle expenses could be one account, your bank account could be another account, your materials costs would be another account, your revenue is another account. So each one of those different labels or categories that you break everything up into is your chart of accounts. Okay. Sarah Eifermann: The chart of accounts is broken into categories as well though, isn't it? Trudi Cowan: It is, so you can then break that, summarize those smaller amounts up into your assets, your liabilities, your expenses, your revenue, your owner's equity. Okay and those accounts are what then generate your reports, your profit and loss, your balance sheet, they can sometimes also flow into your cash flow reporting, as well. So it's the foundation of your books. It's important to know how your chart of accounts is set up because we often find that clients will just use the standard accounts that their accounting system has set up. But that doesn't always provide them with useful information and a common one is that a lot of businesses will just book all their revenue to one line saying revenue. Sarah Eifermann: Yes, this is a common one that we immediately change. Trudi Cowan: Because it's more helpful for you to split that revenue up into the different types of revenue that you earn. So it might be that you sell five different products, so you might have a separate line for each of those different packs. Sarah Eifermann: How do you know which product is making, not necessarily more money because it comes down to profit, but you're selling more financially from an income category we're talking about? So yes, you can go into your sales software and look at, do a report and see which product is selling the most. But we're talking about breaking down your income so that we can work out where you're spending the most of your time, and then is that profitable? If it's not a product and it's a service. If you're a trade, and you're an air conditioning, and gas fitting plumbing business, you may be doing inspections for rentals at the moment, or you may be doing air conditioning installs, because it's summer, or you may be doing just your standard gas replacement works or whatever. Sarah Eifermann: Or you might even have a separate category of solar products. Yes, you might be on selling products to your clients and charging them a markup. So how much of that is going through your books? And what is that doing in terms of your income and your revenue position? Trudi Cowan: Yes and the category that all accountants and bookkeepers hate is the other income and the other expenses. Soda banks, because it doesn't provide any useful information to your business and look, I don't say don't have it at all. But I do say that it should never have more than two or three, maybe four transactions in it. Yes, because it's those things that are legitimate what stuff, I'm never going to spend this money. Sarah Eifermann: You've got grant income, job keeper, or job savor whatever the new buzzword is. Make sure it's split out and listed because if you are applying for finance, that will be the first got account code that they scan their eyes over to see what's sitting in there. And they'll come back to you, which means they'll have to go back to the accountant and it will hold up your application. If that hasn't been split out properly and labeled. Trudi Cowan: Yes, but it's also relevant for your purposes, just to recognize that this is not revenue that you've generated from the operations of your business. This is something that you've received from the government or wherever else. Sarah Eifermann: And to be fair, before COVID it wasn't very common unless you were a business that regularly applied for research and development grants or tourism and hospitality grants, the entertainment industry. I mean, there weren't that many available small business grants, so it's become a thing now because we're seeing a lot of it. Trudi Cowan: The chart of accounts would then feed into your general ledger. The general ledger is your chart of accounts, but then listing each transaction that is sitting within that account. For example, in your chart of accounts, we have our revenue of air conditioning installations. So within the general ledger, it would then show the 10 transactions of the different sales. Sarah Eifermann: If this was an Excel spreadsheet, because we know how much you love Excel spreadsheets back in the day before accounting software when computers were still around, could you say that then the general ledger would be multiple sheets inside an Excel spreadsheet with each sheet listing the transactions of that individual code? Trudi Cowan: You could say that? Yes Sarah Eifermann: Just trying to give people a bit of a visual explanation in a way they may understand it because I know it's such a foreign concept. Yes, so Trudi Cowan: They do tend to download in one very long sheet. But yes, it's exactly that it's if each account within your Chart of Accounts was a different tab in Excel, the general ledger would then be the detail on each of those sheets of transactions sitting in that account. Sarah Eifermann: Back in the day, a long time ago when people use pencils and books to do their accounting. The General Ledger was literally the whole book. Yes, so that's where the name comes from. But it's just sort of morphed a little bit with technology into how you view the information. Trudi Cowan: Yes, exactly. Right, so these transactions all then again, as I mentioned earlier, they get summarized up into your profit and loss, and your balance sheet reports. Your profit and loss being the statement of how much profit your business is making, and would include all of your revenue and expenses. And the balance sheet is a point-in-time statement of what your business is worth. So it will show your assets and your liabilities. Sarah Eifermann: Yes, so it's good to note that the profit and loss may, in fact, be negative. Therefore, it would be a loss, as demonstrated. So if you ever see red or a negative, or in brackets, sign on that report, it's saying that you're not making money, you're losing money, or you're below zero. You did not have an even point for what you earned versus what you spent. Trudi Cowan: Yes and the profit and loss become really important in how you've laid out that profit and loss. Because it's helpful in understanding how your profit, what it's made up of. This is where, when it's generated properly, you would be splitting between what we would call your direct costs and your variable costs. Sarah Eifermann: Yes Trudi Cowan: So if we stick with the air conditioning example, your direct costs might be the purchase of that air conditioner that you need to go and install into a customer's site. It would also be maybe some labor costs, to send the guy out there to do the work for you. There might be some other material costs around having wires and yes, bits and pieces that you need to create that install job. Sarah Eifermann: And if you're not a qualified electrician, you may need to contract in an electrician to connect office splits if the split system break for you, for example. Trudi Cowan: And we call them variable costs because they tend to vary based on how many jobs you have. Yes, for example, you may not need to buy in that air conditioning unit. If you don't then have someone to sell it to correct, right. So the more that you install, the more that you have to buy. Whereas the costs we would other costs, we would have our fixed costs, you find the bill is going to be your phone bill, whether you do one job or 10. Yes, and your rent is going to be your rent the same price, again, whether you have one job or 10. So they're fixed in the sense that they don't change Sarah Eifermann: Based on the number of jobs you do. Trudi Cowan: Yes, that's right. Trudi Cowan: And so the reason that we would split them into two different categories is that we'd normally take your revenue less to variable costs, to get to your gross profit. So that's kind of just your job profit. If all we did was just take into account those specific direct costs. That's how much money you're making on each of those jobs. Yes, then we would take off all the fixed costs to get to your ultimate profit. Sarah Eifermann: This is the conversation like I said earlier that I have right from the get-go with new business advisory clients because it's often very common that literally, this conversation is a very large Aha Oh, crap moment when they realize that they're not making any money and working their butts off because they haven't priced or become efficient enough to be profitable across their total expenses, not just their variable costs. Trudi Cowan: If this is you, our next episode we're going to do is talking about an analysis of how to work out your break-even point. Yes and then how you need to look at those direct and fixed costs to pricing. Sarah Eifermann: Yes, so Trudi, where does GST come into, like understanding your books? , because that can be confusing as well. Trudi Cowan: It can be confusing, and one of the biggest bugbears I hear from clients is that why am I paying all this tax to the government when they're referring to their GST? And the thing that you need to understand about GST is that GST was never yours. The way the GST system works is you are collecting the tax on behalf of the government. So you're merely receiving the GST to pass it through to the government. It was never your money in the first place. Okay, so if you sell $100 profit $100 product, that's why we say you then charge 110 to add in that 10% GST so when it comes to doing your books, you don't record $110 as revenue you only record 100 as revenue because that's all that your revenue is, that $10 you're just passing through to the government and the same goes for your expenses. If you pay GST on any of your expenses, you don't include that GST component in your profit and loss. Again, it's just gets passed through in the calculation of what you need to pay to the government. Sarah Eifermann: So I find that often, people understand quite well, but they get confused between cash and accrual accounting methods. Yes and then cash accrual versus tax accounting. So without spending the next 45 minutes trying to explain the differences there. Can we quickly talk about that? Trudi Cowan: Yes, so cash and accrual are two methods for reporting in your financial books, as well as in reporting to the ATO for GST purposes. Literally, cash is on the basis that you have spent or received that cash. So somebody has physically paid your invoice and you have physically paid your expense. That's the cash basis where an accrual basis ignores whether or not you've paid any money and goes off, have received the invoice or done the work.. So your income is on the basis that I've done the work and I've given my client. The invoice don't care whether they've paid me or not, I still record that as income. The same goes for the expense. I've received my phone bill had not paid it yet, but I have received it. Therefore it is an expense. Okay, so it's very much on have I paid money, versus have I received the paperwork? Sarah Eifermann: Yes, then how does that impact the business? Because obviously, a sole trader versus a company may have different accounting methods. Trudi Cowan: So you'll find most businesses, regardless of their type will work on an accrual basis for reporting their income and their expenses. For GST, or just in general Sarah Eifermann: Yes, Trudi Cowan: You may find that smaller businesses do what we kind of call quasi accrual basis, in that they may not necessarily into their phone bill into their books as soon as they receive the paperwork. But it tends to go in pretty close in terms of, timing. So it's sort of they're working on the theory of accruals, but sometimes it doesn't quite get there. But for a smaller business, that's not necessarily an issue. Sorry, I've confused you. Sarah Eifermann: No, you haven't confused me. My question would be, then, if that's the case, why are there so many that are still thinking or that they have their businesses set up as cash accounting? Trudi Cowan: For accounting bases? No, there's not most would not be on a cash basis. The only businesses that should be working on a cash basis are those that are genuinely the businesses' cash trade. Sarah Eifermann: Like what? Trudi Cowan: Butcher, no because he would still be purchasing his goods. Probably on an invoice basis. That's why I'm saying it's very few businesses that would generally be cash and I'm actually really struggling to think of one that we get these days, generally work on a pure cash-only basis, maybe a market stall type situation. Sarah Eifermann: But if they've purchased goods, but then again [cross talk 18:34] Sarah Eifermann: So this is what I was getting at, so I know that from your point of view, no one should be set up on cash. But I often see clients that are all set up on cash. Cash accounting and that's where it then becomes complicated for them. Are their books, correct? Is there GST, correct? Because their GST bill may be going out as a crew, but their books are set up on cash, and then there's a variance. Trudi Cowan: Yes Trudi Cowan: And it's the difference for GST you can actually if you're a smaller business can elect whether you do it on a cash or accrual basis. And for a small business, we would always recommend the cash basis because it means you're not paying the ATO GST that you haven't yet received. Sarah Eifermann: Correct, so this is where I was going with that. Yes. I'm glad you went with that. You may have a flipYes, you may have an accrual accounting method and a cash payment on your GST, not the other way around. Trudi Cowan: Yes and that's what a lot of small businesses would have cash for GST but accrued in terms of their books. Sarah Eifermann: All right, if you want to know more about that, give Trudi a call. Trudi Cowan: Yes, happy to talk. Sarah Eifermann: But there's one more that I want to throw into this mix of cash versus accrual, which is versus tax accounting or your tax return? Trudi Cowan: Again, tax returns should reflect is the most appropriate method of reporting your income. So again, for most businesses, that is going to be a cause. Sarah Eifermann: Yes, so what I suppose I'm getting at, is where there's the variance between their financial statements and then, their tax return. Trudi Cowan: Okay, so the tax rules are legislatively based and they are a different set of rules to what we would follow for accounting in terms of doing your financial reporting so Sarah Eifermann: I was confused much. Trudi Cowan: So what we report in your books for accounting is not always the way that the tax rules work. So a really easy example would be that the tax rules specifically say that you can't claim a deduction for superannuation unless you have paid it. So even though you've to expense it in your books, if you haven't paid it in that relevant financial year, you can't claim the deduction in that financial year, and you won't be able to claim it till the next year when you have paid it. Sarah Eifermann: Do you put it in your books, because it's relevant to that financial year, though, right? Trudi Cowan: Yes, it's just that the tax rules then say you didn't pay it? Sarah Eifermann: Your books can have it, you don't get the deduction in your tax return. And then say that the superannuation payment drew was $10,000 your tax return would be different from your financial statements by $10,000. Trudi Cowan: That's right. Sarah Eifermann: Yes, so this is another highlighting moment of why you need to have quality advisors around you to help you pick up on these things because that knowledge alone may be the difference between you paying your superbill before June 30, or paying your superbill after June 30, depending on what it does to your taxable income and tax that may be payable to the ATO. Trudi Cowan: Yes and it probably also demonstrates another reason why it's important to understand your books. Because if you don't understand your books, do you understand that you need to pay your superannuation, when you need to pay your superannuation and what's included in your bags? Yes and how is that made up? Because that's all a component of your books. Sarah Eifermann: Yes and also knowing as well that sometimes, especially come the end of the fourth quarter financial year, so your April to June quarter that payment, may have a grace period from the end of the financial year, and you may not pay it till the end of July, early August. But then how does that impact your financial year when you close off the year? Because the payment is actually in the new financial year? Not in the financial year that it's due for? Trudi Cowan: Yes. Again, coming back to your cash flow, which is again, a comparison of your books. All these things interact with each other and so if you're relying on others to manage your books, or not understanding them, then it's going to have implications for how you run your business, how you manage your cash, how you Sarah Eifermann: Has implications for everything Sarah Eifermann: Which is why we're doing this episode, Trudi Cowan: Which is why we're doing this episode and which is why it's leading into some of our following ones where we are gonna talk about the break-even analysis, we are going to talk about how to look at your pricing, we are going to look at one of our favorite topics around budgeting. Sarah Eifermann: Yes, again, sorry. I am a broken record when it comes to budgeting. Trudi Cowan: But you must understand your books so that you can price properly so that you can make a profit or a wage that you deserve for the effort that you're putting into your business. Sarah Eifermann: Yes, completely and so speaking about profit, let's quickly touch on profit margin as our last topic, I suppose. Trudi Cowan: Yes, aspect. Sarah Eifermann: That's the right word. Trudi Cowan: So for profit margin is really what's the margin between your income and your expenses.And it could just end. People represent it in different ways. Some would say it as a percentage, some would show it as the number of differences between their profit and expenses. But I think as a percentage, it's more helpful, especially when you're comparing year on year or six months to each other. You can see where that is that profit margin going up? Is it going down? And if you understand your books, you can then have a bit of a look to further understand why is it moving? Sarah Eifermann: When we talk profit margin, it's also really important to clarify, as we talked about earlier as to whether that profit margin is net of all expenses or only net of your direct costs. Trudi Cowan: We'll see then that comes back to terminology. Sarah Eifermann: Because if you were just saying just if your direct costs, it would be your gross profit margin. Sarah Eifermann: Correct, not your net profit margin. And so profit margin gets thrown around. Margin in itself means percentage. But some people as you said, don't represent it as a percentage, but it's important to understand that. What's your understanding of what profit margin means could be different from what profit margin means and that will have an impact on the true profit of your business, depending on how you're calculating it. So if you wanted to learn more about this stuff Trudi, where would you recommend our listeners go? Trudi Cowan: Okay, check out the helix planning, money course. Sarah Eifermann: Thanks for the oversold subtle plug. Yes for a start, I mean, remember that our course is about basic financial literacy that was discussed in the last episode. I think it's very valuable, though to lead into, then having a better understanding of this. You would talk with your bookkeeper. Trudi Cowan: Yes, sit down and have a session with your bookkeeper or your accountant. Sarah Eifermann: You can even book a session with me I talk about this in a slightly different way, than what Trudi would talk about it because I don't view it from the accounting point of view, I view it from more of a business decision point of view. Trudi Cowan: Sit down with someone that you're willing to share your books with so that they can explain it in a real-life way, relevant to you and your business. And they can take you through exactly what's going on in your books, and what are the aspects of your books that you should be understanding, have some knowledge around? Sarah Eifermann: Yes, completely. So if you want to learn more about this, our next episode coming out next week is break-even analysis and it will. Trudi explain to them again, how the break-even analysis will benefit this discussion. Trudi Cowan: So break-even analysis is looking at the point of how many units of a product do I need to sell to cover all my costs? In doing that analysis, One, you need to understand your books to be able to do it in the first place, but understanding your break-even point is going to help you understand how you make your business profitable. Sarah Eifermann: Yes, absolutely and we will have a downloadable as well, on our website for that example that we go through next week so that you can get an understanding and you can apply on a template, so you can apply this to your own business. So between now and the next episode, I highly recommend you get stuck into your books and understand them, and make sure that they're all sorted. And if you need help, reach out, ask for some assistance, and we can point you in the right direction. Trudi Cowan: Definitely, yes. Drop us any questions, because given that we're talking about similar topics for the next few weeks, we might be able to bring your question into the next episode. Sarah Eifermann: Absolutely, okay. Until then guys, catch you next time. Trudi Cowan: Bye. Announcer: Thanks for listening to this week's episode of Financial FOFU. We appreciate you tuning in and hope that you have subscribed to our channel. I just wanted to let you all know that the information and material in our podcast and any supplementary and associated information available is for general purposes only. It should not be taken as constituting professional advice from us, the podcast owners, and our special guests. And we recommend that you seek independent suitable advice that is specific to your unique circumstances. Thanks for tuning in. Hope to see you next week. Please use our link and send us any requests or any feedback. We'd really appreciate it. Cheers

———————-

Just two industry experts (and guests) having a friendly chat and sharing our knowledge. We aim to raise your knowledge base and dis-spell any myths surrounding finance. tax and a range of other financial topics.

This is a safe space to ask questions and hear useful info on financial matters. 

Read more about FOFU here 

And, as always if you'd like to leave us a message, or suggest a topic, you can do so here 

———————-

DISCLAIMER- The information and material in this podcast, and supplementary and associated information available, is for general information only. It should not be taken as constituting professional advice from the podcast owners, and we recommend you seek independent suitable advice that is specific to your unique circumstances.