Understanding Business Accounting For Dummies, 2nd Edition (79 page)

The IRR is a number you can use to compare one project with another to assess quickly which is superior from a financial point of view. For example, Project 2 has an IRR of 17 per cent, which is clearly better than that of Project 1, a fact not revealed by using the payback method.

The Solutions Matrix Web site (
www.solutionmatrix.com
) has a very neat tool for working out payback, discounted cash flow, Internal Rate of Return, and a whole lot more calculations relating to capital budgeting. You have to register on the site first before downloading their free capital budgeting spreadsheet suite and tutorial. Just go to the home page and click on ‘Download Center' and ‘Download Financial Metrics Lite for Microsoft Excel'.

Staying Flexible with Budgets

One thing never to lose sight of is that budgeting is a
means to an end
. It's a tool for doing something better than you could without the tool. Preparing budgeted financial statements is not the ultimate objective; a budget is not an end in itself. The budgeting process should provide definite benefits, and businesses should use their budgeted financial statements to measure progress toward their financial objectives - and not just file them away someplace.

Budgets are not the only tool for management control. Control means accomplishing your financial objectives. Many businesses do not use budgeting and do not prepare budgeted financial statements. But they do lay down goals and objectives for each period and compare actual performance against these targets. Doing at least this much is essential for all businesses.

Keep in mind that budgets are not the only means for controlling expenses. Actually, we shy away from the term
controlling
because we've found that, in the minds of most people,
controlling
expenses means minimising them. The
cost/benefits
idea captures the better view of expenses. Spending more on advertising, for example, may have a good payoff in the additional sales volume it produces. In other words, it's easy to cut advertising to zero if you really want to minimise this expense - but the impact on sales volume may be disastrous.

Business managers should eliminate any
excessive
amount of an expense - the amount that really doesn't yield a benefit or add value to the business. For example, it's possible for a business to spend too much on quality inspection by doing unnecessary or duplicate steps, or by spending too much time testing products that have a long history of good quality. But this doesn't mean that the business should eliminate the expense entirely. Expense control means trimming the cost down to the right size. In this sense, expense control is one of the hardest jobs that business managers do, second only to managing people, in our opinion.

Chapter 11
:
Choosing the Right Ownership Structure

In This Chapter

Seeing profit as a small piece of the sales revenue pie

Taking stock of the company as an important ownership structure

Watching out for negative factors affecting share value

Discerning profit allocation and liability issues

Looking out for Number One in a sole proprietorship

Deciding on the best ownership structure for tax purposes

T
he obvious reason for investing in a business as an owner rather than a safer kind of investment is the potential for greater rewards. As one of the partners or shareholders of a business, you're entitled to part of the business's profit - and you're also subject to the risk that the business will go down the tubes, taking your money down with it. This chapter shows you how ownership structure affects your share of the profit - especially how changes beyond your control can make your share less valuable. It also explains how the ownership structure has a dramatic impact on the taxes paid by the business and its owners.

From the Top Line to the Bottom Line

Chapter 5 explains the business profit-making process and the accounting profit report for a period, which is called the
profit and loss account.
The chapter focuses on the financial effects on the various operating assets and operating liabilities of a business of its sales revenue and expense activities. To make sense of a company's
balance sheet
(its statement of financial condition at the end of the profit period), which is explained in Chapter 6, you need to understand how its sales revenue and expenses propel the company's operating assets and operating liabilities. And to round out the financial picture of a business, you need to look at its sources and uses of cash flows for the period, which are presented in its
cash flow statement
- see Chapter 7.

Whew! These three business financial statements present a lot of information. But, if you're a manager or owner of a business you should have a good grip on these three
accounting reports
(as they're sometimes called). Accounting often is called the language of business, and learning the basic vocabulary of accounting is extraordinarily helpful, if not downright essential, for business managers and owners.

There is one aspect of the business profit-making process that it is easy to lose sight of when reading a profit and loss account. How does a business get from the top line in its profit and loss account (sales revenue) down to its bottom line (net income)?

In our free enterprise, largely unregulated and non-government-controlled economy, business managers have the responsibility of negotiating the prices paid for labour, subject only to minimum wages legislation, and most of the other services, supplies, and other factors used in the profit-making process. This book isn't the place to delve into the fields of labour economics and political economy. But we would point out that business profit and loss accounts are one key source of information for scholars who do research in these areas. In particular, the financial statements prepared by accountants report how sales revenue is divided among the different parties in a business's profit-making process.

A business collects money from its customers and then redistributes that sales revenue to the many parties clamouring for their fair share. You may think that the second part of this process would be the easy part, but business managers sometimes have a tough time deciding what constitutes a fair share for each claimant. For example, in deciding how much to pay employees in regular wages and fringe benefits, business managers have to ask what value each employee adds to the business, whether to raise sales prices in order to pay higher wages, and so on.

The distribution of total sales revenue among the various claimants on the revenue is a
zero-sum game
. This means that if one party gets a bigger piece of the revenue pie then some other party gets a smaller piece, keeping the size of the pie (total sales revenue) the same. (The alternative is for the business to increase the size of its sales revenue pie - by raising its sales prices or selling more units.) If a business increases compensation to its employees, for instance, without changing the prices paid for all other services and supplies, then the shares of total sales revenue going to the Chancellor in tax and to the owners as after-tax net income decrease. (Note that a business may increase wages expecting that labour productivity gains will offset the wage gains.) Business managers must constantly calculate how changes in the prices they charge customers and changes in the prices they pay for labour, materials, products, utilities, and many other expenses affect bottom-line profit.