Cash vs. Accrual Method: Which is Best for Your Business?

The cash accounting method is a type of accounting that takes into consideration both income and expenses, when payments are made in cash. This payment could consist of either cash received or cash given/paid. In contrast, the accrual accounting method records income as revenue earned while expenses are noted as liabilities. These transactions are noted in the accounting books, without the necessity of cash being paid out or received.

So, which method is best for your business? It depends.

A closer look at the cash method

The cash basis of accounting records the income or expense at the time the cash is exchanged. The cash method is considered an uncomplicated and simpler process. It is also easy to understand and is most often applied to individual or personal finances. Under the cash method, income received is taxable at the time of receipt, while deductions are made at the time of the expense.

This means that a transaction is not recognized until the payments are cleared. If the payment becomes delayed, the process of recording the transaction is also delayed. Thus, the cash method can prove to be an inaccurate measure of the company's accounts.

Although it seems easy to maintain, the cash method could also depict a company's income as being highly inconsistent. For example, if Company A follows the cash method, and it receives a high-value project, the company cannot record any revenue earned until they are paid for the project. This means that if it is a long-term project, the company's income records will not show any revenue as earned until the actual payment is made. This can result in certain periods showing limited income, while others show as high-revenue periods.

Unfortunately, this can lead to an inaccurate depiction of a company's financial status. These discrepancies could have repercussions when preparing tax returns or seeking loans and financing.

A closer look at the accrual method

The accrual method is the opposite of the cash method. Regardless of when the cash exchange occurs, a transaction is recorded in the accounting books. This method accounts for expected revenue, as well as credit payments. As a result, it is a more accurate record of a company's current status.

The accrual method is based on the principle that if a sale or economic transaction has occurred, then cash will exchange hands at some point. Records in the account books thus reflect the point at which the transaction took place. Typically, accrual method entries for income are noted in a column termed as accounts receivable. Regardless of actual cash changing hands, the entry in the account books indicates income received.

The accrual method, in contrast to the cash method, recognizes that long-term financial transactions can reflect upon a company's current financial status. Because of the accuracy required of this method in outlining the financial status of a company, it is more prevalent among larger businesses.

Satish Patel, CPA
President, Analytix Solutions
Satish Patel, Founder-CEO of Analytix Solutions, has more than two decades of experience as a CPA. He has also advised small and mid-sized businesses on diverse matters such as valuation, accounting, and finance. His experience extends to raising capital and arranging for finance from angel investors.

Ratios 101: Key Indicators for any Business

The health of any company depends on several factors. However, a single glance at earnings figures or expenses does not provide enough information to make a firm determination about that company's viability. For example, Company A shows $1 million in sales of computers during Year 1 of operation. In Year 2, this increases to $2 million, twice that of Year 1. So, an increase in sales is always good, right? Not necessarily. In the case of Company A, the business sold fewer units overall, incurred greater expenses, and therefore had overall lower profitability.

A better barometer to gauge the health of any business is the assessment of certain key financial ratios that check various aspects of a company's financial performance.

Debt/Equity:
Dividing a company's total liabilities or debt by the amount of shareholders' equity generates the Debt/Equity ratio of a company. This measures the amount of equity and debt incurred by a company to finance its assets.

A high debt/equity ratio could mean that the company uses a higher percentage of debt to fund operations, as opposed to funding operations through equity. Conversely, if the debt used to fund operations is less than the earnings generated by using it, then it is beneficial to the shareholders.

In addition, if debt financing costs prove to be higher than the cumulative returns, it can lead to an unstable situation for the company and affect future prospects.

Assets/Liabilities:
This is also called the Assets/Debt ratio. The assets/liabilities ratio measures the percentage of assets financed through debt. It is calculated by dividing the total debt or liabilities of a company by its total assets. It is different from the Debt/Equity ratio where debt is divided by the amount of shareholders' equity.

This ratio provides a measure of the company's short-term liquidity. A healthy asset to liability ratio is one where there are twice as many assets as liabilities. A higher proportion of debt indicates poor financial health.

Profit margin (Net Income/Sales):
The profit margin ratio reveals the profitability of a business or the amount of profit earned per dollar of sale. It is calculated by dividing net income by the total revenue, resulting in a percentage. Thus, a profit margin of 16% means that the company made a profit of $0.16 per dollar. In this ratio, net income is defined as the difference between revenue and cost.

This ratio is valuable when conducting comparisons of similar companies. Profit margin shows whether the company's pricing strategy is viable or not. Higher margins indicate better control over pricing. Also, profit margins are a better comparison metric than total earnings, as profit margins take into consideration operating costs and inventory expenses.

Inventory Turnover:
The inventory turnover ratio reveals the speed at which a company moves its inventory. To calculate inventory turnover ratio, divide total sales by figures of average inventory for the period you are evaluating.

A high turnover ratio indicates that the company is moving inventory at a rapid pace, or managing good sales, whereas as a lower ratio could point to inventory not converted to sales, or a poor return on investment. Inventory movement can also be dependent on particular seasons. Hence, average figures are considered when comparing financial health of different companies.

Return on Assets:
The return on assets ratio reveals the profitability of a company's total assets. The ratio proves useful when assessing the viability of using the company's assets in generating revenue. The return on assets is calculated by dividing net income, or revenue earned, by the total amount of assets owned. When evaluating this ratio, it is important to remember that it is dependent upon the industry in which the company operates. Also, if a company incurred a heavy initial investment, it will have a lower return on its assets.

Consistent monitoring of these key ratios should provide you with adequate information to assess whether or not your business is on the right track, financially.

Satish Patel, CPA
President, Analytix Solutions
Satish Patel, Founder-CEO of Analytix Solutions, has more than two decades of experience as a CPA. He has also advised small and mid-sized businesses on diverse matters such as valuation, accounting, and finance. His experience extends to raising capital and arranging for finance from angel investors.

Accurate Bookkeeping System, Reliable Accounting

In a small business, the terms accounting and bookkeeping may be used interchangeably; but each of them has well-defined functions. A well-maintained bookkeeping system is a necessity for the accounting system to function properly, which in turn supports the smooth functioning of the business offerings and its deliverables.

Bookkeeping Functions

The range of functions that falls under bookkeeping is vast. It must be mentioned here that if you're looking for an efficient accounting system, a business must perform certain functions on a daily basis. The foremost among these being recording income and tracking expense. These are entries that the accounting system will build up on, for tracking finances as well as for tax reporting.

An ideal bookkeeping system includes the following tasks:

- Keeping track of all financial transactions of the company such a purchases, sales, payments made, and payments received
- Recording income, cash outflow, and bank transactions of the company
- Reconciling bank accounts, keep track of deposits in the account, writing check, and keeping banking reports updated
- Preparing and maintaining reports such as the income statement and the company's balance sheet

These records, collectively, provide the basis for sound accounting processes in the company. More importantly, the bookkeeper's work allows the accountant to prepare reports for declaring income and filing taxes with the government.

Small business and Bookkeeping

In a small business, resources are limited; it is possible that the business owner or partners themselves function as bookkeepers and accountants as well. A significant disadvantage with this system of accounting and bookkeeping is that because owners and partners are also concerned with managing client deliverables and ensuring sustenance for the business, they may not be able to ensure 100% accuracy in record-keeping at all times.

A viable option for small businesses or companies with limited resources is outsourcing. Locating a trustworthy vendor or accounting and bookkeeping services provider can go a long way in ensuring:

- Accuracy in accounts
- Accurate reports for tax purposes, and
- Less chances of monetary losses as a result of a recording lapse.

Outsourcing saves a huge amount of money that would otherwise go into setting up and maintaining an entire department, complete with infrastructure and manpower. More importantly, depending on your needs, a vendor will ensure high-quality work on time.

Interested in learning more about accounting and bookkeeping outsourcing? Ever outsourced your support functions previously? Share your experience with us, we would love to hear from you.

Satish Patel, CPA
President, Analytix Solutions
Satish Patel, Founder-CEO of Analytix Solutions, has more than two decades of experience as a CPA. He has also advised small and mid-sized businesses on diverse matters such as valuation, accounting, and finance. His experience extends to raising capital and arranging for finance from angel investors.