Courtesy of thedailygreen.comWe were watching the movie Colony last weekend (highly recommended) and I was inspired to follow-up on a topic that I think confuses the heck out of most people. Cash vs. Accrual Accounting. Don’t be alarmed by the word “accrual”, you don’t even need to know what it means to understand the concept. Press on!
Colony is about beekeepers. Not just any beekeepers, these are hardcore beekeepers. They perform a task that I never knew existed. These individuals literally manage and care for thousands of bee hives and transport them all over the country on giant flat-bed trucks to pollinate various crops (almonds, blueberries, etc.). I could write a whole post about how cool that is and how that’s just one more critical component of the food supply chain that most people will never know about, but I’ll save it for another day.
Today Cash vs. Accrual accounting rules the roost (or hive?). In the movie the Seppi family is highlighted as a young, start-up beekeeping family/company that is attempting to survive in the intensely competitive beekeeping business. The “children” (really young adults) run the business with the eldest son acting as the day-to-day operator while Dad funds the business through a non-farm job as a teacher. All businesses need some start-up capital and it’s fantastic to see a father investing in his kids’ futures. The Seppi’s business is portrayed as growing at a rapid clip, expanding from only a couple hundred hives to almost two thousand hives a few years later. Now that’s fast growth!
However, as the mother in the film says, the business is consuming $20,000 in cash per year just to keep it running. Well, that may sound like a lot, but there’s no discussion about whether the business is actually unprofitable (e.g. Sales cannot cover the Business' Operating Expenses) or whether the business is just growing so fast that it needs the $20,000 to finance the growth. I think it’s an important topic because I frequently hear comments about “making money” and “being in the black”, but there’s no clarification about whether its on a cash or accrual basis and it’s an important distinction! Here’s where cash vs. accrual accounting comes into play.
Cash accounting is the simplest way to view a business, but can often lead to some confusion about the actual profitability of a business. I suspect this is how the Seppi’s were viewing the family’s beekeeping business (although I really have no idea and am just using this example for illustrative purposes).
However, as the mother in the film says, the business is consuming $20,000 in cash per year just to keep it running. Well, that may sound like a lot, but there’s no discussion about whether the business is actually unprofitable (e.g. Sales cannot cover the Business' Operating Expenses) or whether the business is just growing so fast that it needs the $20,000 to finance the growth. I think it’s an important topic because I frequently hear comments about “making money” and “being in the black”, but there’s no clarification about whether its on a cash or accrual basis and it’s an important distinction! Here’s where cash vs. accrual accounting comes into play.
Cash accounting is the simplest way to view a business, but can often lead to some confusion about the actual profitability of a business. I suspect this is how the Seppi’s were viewing the family’s beekeeping business (although I really have no idea and am just using this example for illustrative purposes).
An Example
Before we get into the details I thought a simple example would help. In this example a business (Sam's Sausages) sells 100 sausages per year for $1 each. Each year Sam's generates $100 in sales. After paying for the meat, spices, labor, insurance, rent, etc Sam's makes $20 in profits before depreciation or capital expenditures are taken into account. The company's only capital expense is $50 meat grinder that was purchsed in the first year. Lets say the meat grinder has an expected useful life of 5 years, so it is depreciated over 5 years. On a cash basis the sausage company would make $20 in profits the first year because you would subtract the $50 meat grinder expense from the $20 in profit for a loss of $30. In years two through five, however, Sam's would make $20 in profits every year and have no capital expenditures. The total cash profit over five years equates to $50 ($30 loss in year one plus $20 profit each year in years 2-5). From an accrual perspective the $50 meat grinder purchase is depreciated over 5 years, for a charge of $10 per year. Under the accrual method the business still earns $20 profit, but now it subtracts $10 each year instead of one lump sum at the beginning. That means Sam's is making $10 per year over the five year period, or $50 in total. Same end result after five years, but in year one the business is losing $30 from a cash perspective and making $10 from an accrual perspective. That's why young and growing businesses need to clarify if they're making/losing money from a cash or accrual perspective. Here's a quick chart:
Cash Accounting
“Cash accounting” judges a business on how much cash is going out vs. coming in the door, simple as that. For sake of argument I’ll assume that the Seppi’s were “losing” $20,000 per year on a cash basis. What that means is that despite renting out their bees all year and earning plenty of Sales dollars, the operating expenses combined with the reinvestment in the business to fund growth created a $20,000 cash outflow. In cash accounting you’re literally tracking every dollar in vs. every dollar out, so you could be making $100,000 in profit, but if you’re spending $120,000 to fund the growth of the business (e.g. buying more bees, hives and a new tractor) then you’re technically losing $20,000 on a cash basis. So what are some of the cash drains (besides operating expenses) that you need to monitor very closely, especially during times of growth?
The first major bucket of cash expenses that can make a farm appear unprofitable during a rapid growth period is called Capital Expenditures (CapEx). CapEx is a USE of cash that is associated with buying property, plant or equipment (PP&E). When you buy that new tractor for $30,000 you would be subtracting that from your annual earnings on a cash basis and that could make your farm look far less profitable! The same idea goes for any long-lived assets that you are buying. In the first few years of starting up CapEx can have a huge impact on your cash profitability.
The second major bucket is called “Working Capital”. The components of Working Capital are Current Assets and Current Liabilities. The big three to keep an eye on are Accounts Receivable (Asset), Inventory (Asset) and Accounts Payable (Liability). The concept is pretty simple, an increase in an Asset account is a USE of cash. An increase in a Liability account is a SOURCE of cash. Accounts Receivable are when someone owes you money for product you’ve sold them. The faster you grow the bigger your Accounts Receivable balance will be and as the Asset side of the equation increases it is a USE of cash. You want to keep your Accounts Receivable terms as low as possible! Same goes for Inventory. As your business grows so does the Inventory you are holding. Inventory is a USE of cash. Accounts Payable, on the other hand, may actually be a SOURCE of cash if you can extend your terms with the people that you owe money. The longer your Accounts Payable terms are the better it is from a cash flow perspective. Ideally your Payables will be longer dated than your Receivables and you can operate with a minimal amount of Inventory. That’s why a CSA works so beautifully from a cash/reinvestment perspective. The farm gets the cash upfront (no receivables) and can fund growth each year with that capital.
When you invest in new bee hives and new farm equipment, for instance, that may be cash out the door and you might not see a penny of benefit from those uses of cash for a number of months. But is that a business that’s losing money? Not really. On a cash basis yes, but on an accrual basis it is probably doing just fine. So what’s all this accrual accounting business about?
The first major bucket of cash expenses that can make a farm appear unprofitable during a rapid growth period is called Capital Expenditures (CapEx). CapEx is a USE of cash that is associated with buying property, plant or equipment (PP&E). When you buy that new tractor for $30,000 you would be subtracting that from your annual earnings on a cash basis and that could make your farm look far less profitable! The same idea goes for any long-lived assets that you are buying. In the first few years of starting up CapEx can have a huge impact on your cash profitability.
The second major bucket is called “Working Capital”. The components of Working Capital are Current Assets and Current Liabilities. The big three to keep an eye on are Accounts Receivable (Asset), Inventory (Asset) and Accounts Payable (Liability). The concept is pretty simple, an increase in an Asset account is a USE of cash. An increase in a Liability account is a SOURCE of cash. Accounts Receivable are when someone owes you money for product you’ve sold them. The faster you grow the bigger your Accounts Receivable balance will be and as the Asset side of the equation increases it is a USE of cash. You want to keep your Accounts Receivable terms as low as possible! Same goes for Inventory. As your business grows so does the Inventory you are holding. Inventory is a USE of cash. Accounts Payable, on the other hand, may actually be a SOURCE of cash if you can extend your terms with the people that you owe money. The longer your Accounts Payable terms are the better it is from a cash flow perspective. Ideally your Payables will be longer dated than your Receivables and you can operate with a minimal amount of Inventory. That’s why a CSA works so beautifully from a cash/reinvestment perspective. The farm gets the cash upfront (no receivables) and can fund growth each year with that capital.
When you invest in new bee hives and new farm equipment, for instance, that may be cash out the door and you might not see a penny of benefit from those uses of cash for a number of months. But is that a business that’s losing money? Not really. On a cash basis yes, but on an accrual basis it is probably doing just fine. So what’s all this accrual accounting business about?
Accrual Accounting
Accrual accounting is different from cash accounting in that it matches sales with expenses regardless of when the cash transaction actually takes place. Growth in Accounts Receivable, for instance, is reflected as an increase in Sales. As your Sales increase, growth in Inventory and Accounts Payable are reflected as increases in your Costs of Goods Sold. You are effectively taking each Sales dollar and subtracting just the costs associated with it. Capital Expenditures are depreciated over a period of time ($30,000 tractor over 10 years, or $3,000 per year, for instance) and that depreciation is subtracted as a cost, not the entire $30,000, just the $3,000. In this method the business isn’t immediately penalized for investing in growth. It is more reflective of the profitability of the business if you just looked at it on a transaction by transaction basis. My guess is that if the Seppis looked at their beekeeping business on an accrual basis (i.e. without taking into account their investments in future growth) they’d be pleasantly surprised to be making money, but I could be wrong!
That’s the problem with growth: where do you find the money to finance the growth and when do you stop reinvesting in the business and harvest the cash flow? That’s a personal decision for many farms and hopefully many farms are lucky enough to have that dilemma! One thing is for certain, you better know what’s happening to your cash and how much you’re reinvesting in the business because when it comes time to pay the bills the bank won’t care if you have a ton of customers with huge Accounts Receivables balances, they want their cash! Plan accordingly and always keep a cash cushion.
If you run a business, how do you think about cash flow and profitability? Can you think of instances where a business may be losing money from a cash perspective but profitable from an accrual perspective?
That’s the problem with growth: where do you find the money to finance the growth and when do you stop reinvesting in the business and harvest the cash flow? That’s a personal decision for many farms and hopefully many farms are lucky enough to have that dilemma! One thing is for certain, you better know what’s happening to your cash and how much you’re reinvesting in the business because when it comes time to pay the bills the bank won’t care if you have a ton of customers with huge Accounts Receivables balances, they want their cash! Plan accordingly and always keep a cash cushion.
If you run a business, how do you think about cash flow and profitability? Can you think of instances where a business may be losing money from a cash perspective but profitable from an accrual perspective?
Here’s how the accounting works:
Accrual Income Determination
Sales
Less: Direct Costs
= Gross Profit
Less: Operating Costs
=Earnings Before Interest, Tax and Depreciation
Less: Interest, Tax and Depreciation
=Net Income (This is your income on an accrual basis)
Cash Income Determination
Net Income (from above)
Less: Change in Accounts Receivable
Less: Change in Inventory
Plus: Change in Accounts Payable
Less: Capital Expenditures
= Free Cash Flow (This is your income on a cash basis)
Accrual Income Determination
Sales
Less: Direct Costs
= Gross Profit
Less: Operating Costs
=Earnings Before Interest, Tax and Depreciation
Less: Interest, Tax and Depreciation
=Net Income (This is your income on an accrual basis)
Cash Income Determination
Net Income (from above)
Less: Change in Accounts Receivable
Less: Change in Inventory
Plus: Change in Accounts Payable
Less: Capital Expenditures
= Free Cash Flow (This is your income on a cash basis)
As a disclaimer: I don’t personally know the Seppi family and they seem like honest, hard-working people. I’d consider myself lucky to know them. I’m also sure that they have a great grasp on their business and also know the difference between cash and accrual accounting. It just so happens that the movie brings up a very pertinent topic to farming and a critical topic for farmers to understand and I thought it would make a good example. Who knows, maybe they’ll see this post and give some more insight! If you’re out there Seppi family beekeepers we’d love to hear from you!