The number of young entrepreneurs I meet who are afraid of their numbers is really striking. Financial statements are unknown territory to them, and they are scared by what they might find there. Business owners become especially fearful when things start happening that they don't understand--such as running out of money while sales are increasing.
A young woman I'll call Molly came to me with just such a problem a few months ago. She has a shop in Brooklyn, where she sells clothing, handbags, and dream catchers that she makes, as well as jewelry and other items crafted by independent, local designers. The shop has attracted a following, and her sales have grown substantially in the past year, but she was finding it harder and harder to pay her bills. She was worried that she might not be able to stay in business. How could that be?
In our initial discussion, I learned that she was idealistic and that her goal was to be financially independent. She also had no understanding of her numbers. She thought she was in trouble because she didn't have enough sales, but insufficient sales weren't the problem. Her difficulties were instead due to the effect that inventory has on cash flow. When I asked about her inventory, she admitted there was a significant amount that she'd had for a long time and hadn't been able to sell.
That's where her missing money is. She spent cash making or buying those items, and until she sells them, she won't get it back. Her mentality was that, if she made something for $10, she would sell it for $20, so she must be profitable. But if you make three things for $10 each and sell only one of them, you're short $10.
Ultimately, Molly will find the solution to her problem in changing how she tracks sales and expenses. Like the vast majority of small-business owners, she's been operating on a cash basis, rather than an accrual basis. That is, she's been recording sales when the cash came in and expenses when the cash went out. But cash-basis accounting is good for only one thing: figuring out how much you owe in taxes. It doesn't tell you what's actually going on in your business. If you collect cash for your sales but don't pay all of your bills, you could think you've earned a profit when, in reality, you may be losing money.
To have an accurate picture of your business, you need to track sales and expenses on an accrual basis. That means recognizing sales when the sales are made, not when the cash is collected, and recognizing expenses when they are incurred, not when the bill for them is paid.
So I have given Molly a homework assignment, as I do with almost everyone who comes to me for advice. Her task is to calculate how much old inventory she has--that is, how much she has spent on products that she hasn't been able to sell for a year or more. Once we figure that out, we can figure out what to do with those products--such as holding a big sale. Even if she sells everything at a 70 percent discount, she will at least get back some of the cash she spent on it.
I'll also show her how she can use her QuickBooks program to track sales and expenses on an accrual basis. (She'll still be paying her taxes on a cash basis.) That way, she will know what inventory she has and can deal with it in a timely fashion, thereby maximizing her cash flow--and making her less afraid of her numbers in the future.