Lesson 4
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Lesson 4 - Profit & Cash
Now, we see that our profit is $8,500. $10,000 less after we recognize the cost of the inventory. Well, it’s time our customer paid us for the sale. How do we account for that? We get $20,000 cash and we put it in the bank. We debit cash for $20,000 and we credit accounts receivable for $20,000. Notice cash went up by $20,000 and receivables went to zero. This transaction did not affect our profitability.

Now it’s time to talk about something important. Profitability is not cash flow. Profitability is what we get after we account for a sale that we have not been paid for, after expenses we may not have paid yet, either. Cash flow is money coming into and out of the business. They are connected, but having a profit may not mean cash flow. All of your profit may be in accounts receivable, not collected yet.

Now, let’s pay off some bills. First, let’s pay off the note on the truck. We debit short-term loans $4,000 and then we credit cash. This transaction is cash flow. It does not affect our profitability. Cash went down by $4,000, and the $4,000 short-term loan went to zero. Let’s pay some more bills. Let’s pay off the inventory that we bought earlier. First, we debit accounts payable by $20,000, then we credit cash by $20,000. Again, this is cash flow – of course all of it outward, not profitability. Our cash drops to $14,500 and our accounts payable are zero.

If we’re going to stay in business we need more inventory to sell, so we buy $15,000 more in inventory. To account for it we first debit inventory for $15,000, and then we credit accounts payable for $15,000. Now, our inventory is up to $25,000 and our accounts payable is $15,000. We are still in balance. Again, this transaction was part of a cash flow – not profitability. If we only were to purchase everything for cash, and make all of our sales for cash, our cash flow would be closer to our profitability, but still not exactly. The problem is that inventory purchases and purchases of assets are exchanging one asset for another. This does not affect profitability, but it does affect cash flow.

Now, we’re going to learn something new called accruals. We need to accrue $2,000 for payroll. First, we debit payroll expense for $2,000, then we credit accrued payroll for $2,000. An accrual might be an expense that you owe, but haven’t paid yet. Sometimes, we won’t even have a bill for it. For instance, it’s the end of the month and we are getting ready to do the payroll. Payday might actually be the first day of the month, but the payroll is for the last half of last month. Why do an accrual? Well, accountants love when the income for the month is accounted for in the month that it occurred – even if it isn’t paid. The way to do this is by doing an accrual. The goal is to match the income with the expense associated with generating the income. This all occurs in the same accounting period.

What is an accounting period? Usually, it’s a month. It can be a quarter, or a half of a year. Of course, it could even be a year. Because months are natural cycles, however, they are usually the best fiscal periods.

Now, back to our $2,000 payroll accrual. First, we debited payroll expense for $2,000, and then we credited accrued payroll for $2,000. We should note that high quality accounting software will do payroll accruals automatically. When we post our end of month payroll, it accrues in one month to be paid in the next. Make sure to choose software that does a thorough software accrual including FICA, FUTA, state unemployment, workers compensation, withholdings, and the like.