To create financial projections, it helps to understand the difference between cash and accrual accounting. For most businesses, “cash” is different than “revenue”. This is a bit tricky, and gets into questions you need to ask your accountant about. Here’s an introduction for a non-accountant (from a non-accountant!) There are two common ways to do accounting: cash based and accrual based.
Cash based accounting just looks at cash. What comes in each month is counted as revenue. What goes out of the checking account each month is expense. But with cash based accounting, the revenue you get doesn’t always line up with the timing of when you “earned” that revenue. In a way, you “earned” the revenue when you ship the product to the customer – but you may get paid months later. Similarly you may purchase something on terms and not have to pay for it for 30, 60, 90 days or more – but you get the use of the thing you bought right away.
The advantage of cash accounting: it makes sense compared to what’s actually in your checking account! The drawback: revenue and expenses don’t always line up well with reality.
Accrual accounting tries to be more sophisticated by putting “Revenue” into the month it was earned, and “Expenses” into the month where they were incurred. Example: suppose your business model is “subscription service” and your customer pays in advance for one year. With cash accounting, your accountant will record the full customer payment as revenue when you receive the payment. With accrual accounting, your accountant might end up recording 1/12 of the check received as revenue each month, starting in the month the subscription begins.
So if I receive a $120 check in December for a one year annual subscription that starts in January, then with accrual accounting, it may be that my accountant records no revenue in December (when I received the check and it got deposited) but instead recognizes 1/12th of the check each month starting in January. That way, the revenue matches the timing of the delivery of the service – the service being delivered over a 12 month period.
So bottom line: an income statement and your cash position can be two very different things! With the subscription example, the full $120 in cash is available to pay expenses in December, but the revenue is “recognized” over the next 12 months.
If your business uses accrual accounting (and many businesses should – talk to your accountant) then it’s clearly important for you to understand why your Income statement (revenue and expenses) can be a lot different from you cash flow! For a startup, “cash is king“. You can be profitable, and still run out of cash! So keeping a close eye on your cash projection is very, very important!