Defining Your Financial Framework
the challenge I think that we're gonna discuss in this segment is whether it's accounting generally or whether it's QuickBooks, specifically language. There's a minimum amount of language that we need to know for QuickBooks. So what you see on the slide up there is dividing language really into four sections. OK, one and two. Besides being the bullet points are actually two types of financial statements that you'll use a balance sheet in an income statement. So in addition to defining terms, I'm also going to talk about the statements that those terms turn into, so to speak. Number three is the matching principle that I mentioned at the beginning and a new term called a cruel, which again is accounting jargon that attaches itself to that matching principle. The final is debits and credits, which I mentioned in the first section. And the challenge is how much of this accounting jargon do I need to know? And so I'm hoping that the solution we're gonna provide is you get to the end of the...
segment and you say, OK, I've got a general idea off what these terms mean, how I can use them in my business and how they can be combined into something called a financial statement. Okay, um, for those in the audience here, do you guys see terminology that you're confused by in your business? Maybe that an accountant throws at you or a some other, maybe a vendor or anybody like that? Yes, ma'am. I've never seen that term matching principal before. I don't have any idea what that might mean, and we'll get we'll get to that one, which is the idea of matching the revenue you produced for a period with the expenses to create it. What's unusual about the matching principle is that it's not anything you see in financial statements. Specifically, you don't see that term. However, it's used to figure out profitability. Okay, Um, So what we're gonna try to solve in this section is the problem that I've got this accounting lingo and I need to know some of it to run my business. OK, that's where I'm trying to go in the second. Um, the first term there is called balance sheet. Things have to balance. And in order to understand that formula that I'm gonna comment here in a minute in yellow, you need to know three terms. OK, the first thing and it's not necessarily on the slide is Oh, yeah, it is assets, liabilities and equity at a specific point in time, which means you are taking a snapshot of a point in time. If you, for example, try to run a balance sheet for a period of time, say, the month of February or the year 2000 and 14 QuickBooks and most accounting software won't let you do it because the balance sheet is a snapshot point in time a day. Take a picture of my business on that day. Okay, um, you see, there's a formula with an equal sign in the middle. So what we're gonna find out down the road here is that things have to balance and in fact, in accounting software. Also, if you try to create one of these reports and it's out of balance meeting that the numbers on one side of the equal sign don't equal the other, you'll get an error message. Okay? And again, another purpose of this segment is to slap labels on certain terms so you can start putting financial statements together that you can use. Okay, that's the purpose of this segment. And that's the problem that we're trying to solve. Okay, let me talk about assets. First. I'll ask the audience. You've already talked about a few. What is something you use? Something you used to make money in your business. Now I'm gonna give you a hint. Inventory is something used to make money. You take a piece of inventory, you either put it on the shelf and sell it. Or maybe you do something to it. Change it, improve it and sell it. But what else? What else is something you use in your business website? You use your website to make money. So the point of the term asset is its anything you use to make money in your business. And that's very broad. Okay, Anything you used to make money in your business, so I'll go back to my plumber example. Um, I had a big client did about pretty big. I thought $3 million in sales a year doing residential plumbing, something I didn't know before. I got this client. I see. We've all seen plumbing trucks running around town doing plumbing. Do all of you when you have a plumbing problem. Put it off for weeks. No, of course, it's probably pretty urgent, Right? Um, so I figured, Well, there's a truck driving around town and he probably paid $30,000 for, say, it's a Ford F 1 50 truck. But what I didn't think about WAAS. The amount of equipment that is on that truck, the equipment on a plumbing truck can be is expensive is the truck itself. So if you can imagine, there is a lot of money drive around on the road going to people's houses to fix their plumbing. So the truck itself and the equipment on the truck is an asset the plumber uses in their business to make money. Okay, that's an asset. I'm gonna go down a list of typical assets here in a bit. What we will find out, though, is there are some things you have that are valuable in your business that aren't necessarily quantifiable. And they are not necessarily something that ends up in the financial statements. Okay, later on in the program, I'm gonna use it Turn again. I stole for a friend of mine called secret sauce, which is the thing that you do well Okay. How many of you have figured out kind of an elevator speech of what you do? Maybe even if you haven't written it down formally, what would be yours? For example, can you are you versus eight if you don't want to. That's okay. Uh, no, I could go with it. I say hi. I'm Candice Betty, founder of Organic Radiant Skin Care. I used to work for the pharmaceutical industry, and I decided to make my own natural skincare line. We make, uh, skin care for doctors, officers, uh, that so that they can carry products that air all organic, paraben free on bond. Help fight against aging. Okay, so you and that's great. And so you work that out. You've worked that out. Ironically, people ask me, why are you going to San Francisco? And of course, I have to explain who created live this, right? I'm not the marketing department, but I think the secret sauce of creative live is is that we do very high end useful courses in a live environment. And our differentiation is that's our secret Soft. We're doing it live. Not everybody else is doing it live. Okay. What? I'm getting at is most people who are successful have a process or a method or an expertise that they use Certainly used to make money in their business. But it's not necessarily something that ends up in the financial records, right? So everybody's got that something. And what I'm just trying to make a distinction is that doesn't necessarily end up in your financial records. Okay, so an asset Things you used to make money in your business, And you just, uh, read my mail. That's one thing I was gonna say. OK, good. Will, um, what we will find out in a minute when I start going through examples is goodwill is an area of It's a type of an asset that we call an intangible asset. It's not something you could touch or feel. So a patent, a copyright, any sort of intellectual property. No. Anybody who's an intellectual property lawyer. I know several who spend their days doing two things. They file patents, and they defend patents. When somebody tries to take advantage, use your pad that has value, and that is actually an asset that gets reported in the financial statements. Now you should know something because you guys were in a creative field and that IHS, it's a the technical thing, but it's really big for creative people. If you spend money to create a process of method. Okay, not all of that spending is going to be an asset. In other words, much of it you're gonna just have to end up expensive. For example, research and development. You worked in the drug business. OK, um, I have a friend whose father is one of 12 patent holders for a kind of a pretty big drug, which I can't name, but it's a big one. He lived in a when she was born, and she's my age around 50. Her dad was a PhD candidate in chemistry, and they were living are actually living on campus of the University of Missouri in a mobile home. At the time, he was one of 12 people that worked for years and created a chemical compound that became a drug from the time they discovered the compound and said, Here it is to the time it became a product that was sold by drug represents representatives was 12 years. It took 12 years. Much of that money and expense they incurred over the 12 years is not an asset. The reason is it's not possible for you to know that what you're creating is gonna be sellable down the road. So if you're like me and you drive around and you have lots of ideas on things and you go different directions and you may spend money on those ideas, okay, much, much of that spending, unfortunately, is Justin Expensive does not become an asset formally, so good Will is an asset. So the legal money you spend on a patent is an asset. But other than that, we all in our fields are probably going to be doing a lot of spending on ideas that don't necessarily become asset and then a specific. But it's more into defining exactly so we understand what an asset is, what a liability is, Accounts says. For an e commerce site with the yearly Go Daddy costs being expense for the period and an asset. Great question. So you're spending money. I use register dot com for my site. Go daddy dot com, and this brings us up a great question. The short answer is that is not a NASA set It is probably something you would expense immediately because you can't match the expense with the revenue that it creates. Generally, I'm from ST Louis. So Anheuser Busch has always been a huge employer in ST Louis. Now a B InBev. They show themselves to in bed. Everybody watches the Super Bowl right at my church. They always cancel six oclock Church on Super Bowl Sunday because nobody comes. So they made the Imagine in church. Remember Super Bowl Sunday. Don't come at six o'clock because no one will be here cause everybody's watching the Super Bowl. So Budweiser still is probably Anheuser Busch end up the biggest purchaser of Super Bowl commercial time. However, in their financial statements, all that spending just gets expensed immediately. Why they can't match beer sales revenue exactly with the advertising spending. So it just gets expect. Okay, so let me, let's think about the second part of that formula, and then I'm gonna go do specifics on each. Okay? Very generally, I'm gonna link liability and equity together. So you're you own a pizzeria and you've got ovens and tables and you on your building and you've got, you know, inventory. You've got dough and pizza. You know, stuffed food, raw material, those air, all assets. There are two kinds of people who have a claim on your assets who say, You know, some of that is mine, so to speak, and you'll notice I'm to step over here. That liability and equity is on the right hand side of the equation. That's because the liability of the equity represent the people who have a claim on your assets and their two types of people. Liability is money that you owe someone your accounts payable. Your utility bill is a liability because you owe someone so they have a claim on some of the assets in the pizzeria. Equity, on the other hand, represents ownership. So the pizzerias, owned by malaria and Curly, Moe, Larry and Curly own and have a claim on some of the assets to Okay, So if you're trying to relate well, why is the equal sign formula where it is? Why is it there in the middle? Because the terms on the right represent claims on assets and the assets are on the left. Okay, so why abilities could be bills that you owe a liability can also be long term debt. Obviously, if you have a loan that's called a liability, one that's unusual that I'll cover later is, um, have any of you do any of you right now have a deposit from a client. I have one small one. I have a client that's an MBA student in Nigeria who found me online, and I actually, I use go to meeting dot com to tutor people remotely. And we were having trouble getting the video hooked up. And when the video came up, he had a computer sitting on the dashboard of his car and he had a head, said he was driving. And the first thing I said was, Can you pull over to the side of the road? Because this seems dangerous. Tweet this while you're driving. But anyway, so he sent me, um, more money than it costs to tutoring with the anticipation that I would tutor him and help him later. Okay, that's a deposit. If I don't tutor him later, do I had to pay him back? Yeah. Common sense would say, You gotta pay him back later so that deposit is a liability because I have to do one of two things. I have to either pay him back later or I have to provide the product or service, which in my case, would be teaching himself. So what we'll see later on down the road is that a deposit is also a liability. Okay, if you'll look at the definition of equity, it says if you sell all your assets and pay off all your liabilities, whatever is left over is called equity. So if I use my pizza re example, we're gonna get out of the business and retire. We're gonna sell the the store, the table and shares the ovens. We're gonna sell all that. We've got a pile of money and we're going to use the pile of money to pay off all the bills. So we write the bill for the utility, the utilities, we pay off our bank loan and the amount of money that we have left. We call equity. We call equity down, depending on what type of business you form. Different people are gonna have a claim on that equity. If you're a sole proprietor and you sell the pizzeria and you get the soul, the assets and get the cash and then you pay back all the assets and this much is left your sole proprietor. That's all yours. If you're a partnership, you might have to divide that up. And finally, if you're a corporation, which is a little more complicated, we'll see later. You might have numerous shareholders that have a claim on the pile of money that's left that we call equity. Okay, those are the three basic areas. So just to reinforce, there's two types of claim on assets. There are creditors and there are owners, which reinforces the formula. Assets equals liabilities plus equity. Okay, let's talk specifically about some assets, liabilities and equity specific examples. Now, I use the example of the plumbing truck for the asset liabilities. I used the example of the utility building alone. Now let's talk about why we call it a balance sheet in the first place. We call it a balance sheet in the first place, because those numbers have to always be in balance. When we start doing transactions here later on, you will see that if I have a debit and a credit that they have to balance on both sides of that equation, debit credit, just like they have to balance on both sides of here When they teach it an accounting class, the way they do it is whenever you do any type of transaction, you're gonna When you first learned accounting, you post it under one of these three headings and you keep the equal sign in the middle, and I'm gonna do some transactions later. But you'll see that all the numbers have to stay in balance with the equal sign. So when they first teach accounting, you'll get three columns and you'll start posting numbers, and those numbers in total have to balance. And that's how the most people teach accounting at the very beginning. And that's how they teach that relationship. Okay, we talked about inventory being an asset. You use money, you use inventory to make money in your business because you sell it for a game. What other assets do you think about in your businesses? And I'm gonna use some examples of my own. Do you think equipment? Yeah, that was the next one. I was thinking of equipment. So particularly for those of you who are photographers, we had this discussion with the the producers that technology is always changing. So not only for photographers, but for people in the film industry. You've gotta upgrade all the time. Okay? That means that you're buying equipment. Those air certainly assets that you use in your business. But you're in, in, in, in your In an industry where there's always the next thing that I've gotta upgrade to because I could do a better job in my profession, my competitors air probably buying it. And I could just generally do a better job. Maybe I could do it faster than I was before by getting better equipment. So equipment is an asset. Now here's cash is obviously an asset, and we're gonna do a whole segment on the vital importance of cash. And I will say it several times in the course. Most people businesses that I see fail or don't succeed, not because they're not profitable. They don't succeed because they can't collect cash fast enough. If you can't click cash fast enough and your compass constantly having to go out and find more cash, we'll talk about how you do that. At some point, you just can't raise any more cash. You can't get any more investors reasonably. And you can't take out any more bank loans and you fall further and further behind from collecting cash. So we see a balance shooting QuickBooks later. The first asset is probably cash. Inventory is going to be up there. And then there's one that very few people think about, which is accounts receivable. People that owe you money. That is an asset for you. Accounts receivable. People that owe you money. That is an asset for you. Okay, here's another way to think about it. Cash is cash. What's gonna happen? You hope within 30 days with your accounts receivable, do you think hopefully what's gonna happen to somebody who is your money? Hopefully, they're gonna pay you, and that will become cash. And if you own inventory, what do you hope is gonna happen? You hope that eventually you'll sell it right and that will end. You will collect cash so we see something in common. Don't way. That cash by itself accounts receivable will eventually become cash. An inventory will become cash. Okay. Besides your example, how many of you know people that have businesses were you carry inventory, right? What kind of business with inventory. Hmm. Good question. Retail retailers like a shop. Okay, And how about you re tell us well, but also skin care. This is Let's think about that for a minute. And, um, this is kind of a preview or touching on something to get you thinking about a segment later on down the road. If you start off in your business with, let's say, $10,000 and you start on February 1st and you get to May 1st. So you've been in business for a while and you've been profitable, but you're cash level has gone down from, Let's say, $10,000 to $2000. Edgy and you've been profitable. Where do you think it's tied up? Where did it go? I'm profit wars on my cash. It's tied up in probably one of two places. It's tied up in inventory. If you're a retailer or any commerce, or it's tied up in accounts receivable. Okay, so you see that even though you were in business from February to May and you were profitable, the fact that your cat that your collecting cash more slowly is a big stress. Okay, the example and I will repeat it because it bears repeating the plumbing company I mentioned. And we mentioned that most of us are not putting off plumbing problems. Right Way had an exciting weekend about 10 days ago in ST Louis, where we got 10.5 inches of snow in 12 hours and when the temperature was below was 10 degrees below zero for two days in a row. Fabulous. It's what love coming out here. I said that I was on the plane. I said, I don't care how long it takes to get here. It's above 50 degrees it could take. I don't care if I gotta climb the Himalayas. I just just please get me out here. So what happens when it gets cold? Well, we had opera pipe freeze, and Mrs Boyd said, Go downstairs and check out the pipe. So, like all of us, that is in business, the plumbing business where there is, Ah, high sense of urgency, right? Plumbing electrician's H V A C. So you would think these guys are rolling in the dough. You think you're gonna put off point paying your plumber? No, right garage door guys riffing. You'll put off gutters you'll put off. Generally, I know a lot of guys who were in the trades but plumbing and Electrician's and H V A. C. I'd like just to consider occupations where Hey, it's urgent. Okay, now let's think about that. In terms of cash, if it's urgent and people are paying right away, you would think these guys are never short cash. Okay, so now let me related to my plumbing example. This is a company doing $3 million a year in sales. This is a big operation. He was constantly short cash. And you think to yourself, How can that be? He was so short cash that he would have to go to the bank practically every day just to figure out what checks we're gonna clear enough. It was It was insane. It was It was making him physically ill. And this is a person who is good at what he does. Great reputation in a cash business. Well, here's what happened. So he is a residential plumber meeting that he is going doing home plumbing. He took some of his cash and he invested in a business doing commercial plumbing. It was an apartment complex and because probably he doesn't know his. That businesses well is his residential business. He lost money, and because he had a loss, he lost some of that cash. And because he lost the cash in his residential business, he was constantly behind the aapl. See what I mean? Unfortunately, this is an example of somebody going into a business that was not their expertise. Bummer Number one is you lose money. Bummer. Number two is now your original business. A short money to really a shame. Eventually there's a happy ending because he was able to find an investor who said, This guy's profitable. I'm willing to put up more cash and take some ownership because I know he's profitable and I can share in the profit. So he was able to get the cash he needed to get through that crisis. Okay, so that is balance sheet. Now, go ahead. What about like a sports team that has Ah, an athlete that is very valuable to them? How do you place a monetary value on that asset? That's a good question, to the best of my knowledge, and I could expand the example. Athlete entertainer. Let me explain the example, you've explained, expand the example even further. How about your number one super salesman? In your business, that guy has a lot of value. Generally, we don't put on accounting. We don't record in accounting entry for the value of people, with one exception kind of in most of those situations. Athletes, entertainers, the valuable employees. You're going to get insurance on those people so that if the Ashley gets injured, you recover some of the value that contract that you're paying them. Or if the entertainer can't show up into his contract, you're willing to reimburse the vendor. Or, if you're my wife, works for a company where there was a founder of a company who was very critical. You get that person insured. OK, but does that make it to into here? It does not. It does not like the insurance would just be expensed every year, But it happened to them. Would you have an account receivable that would? So let's say that your valuable person, whatever field there in for some reason can no longer do their job, and the insurance company says yes, we owe you the money. Um, I think how that would be treated would be beyond the scope of this class, but it would not be an asset. It would not be an asset, because you've got to consider that you were paying all those premiums all those years. Expense, expense, expense. So in a way, you're kind of recovering that, and that's beyond the scope of this class. But it's a really good question, and it brings up the point that not everything of value makes it in the in the financials. But if you're in business situations were you guys I know provide unique skill sets value. Where this does come into play is when you're thinking about Should I bring in a partner? Should I collaborate with somebody? Another reason I did the Myers Briggs test is I'm starting a new venture with a good friend of mine. We both did the Myers Briggs and in fact, more complicated testing to really figure out well, what can he do and what can I do that's about value of people? And that's about forming a working relationship, but not necessarily getting into the financials. Okay, so that is balance sheet and what I meant, I meant to say, also before I left. This is most businesses don't have. Most small business owners have no interest in this other than the collecting cash aspect. Most of us Ercan most concerned about the next thing. Which is the income statement, Yes, but I still have a question about, um, and I think a lot of it goes back to goodwill. A swell. So how do you get a complete picture of your business? Because there's one that you can look at this balance sheet and you could look at the income statement and I can tell you a lot, as in one of my liabilities, what are my assets? Equity is in on paper. How much is my business work? But then those intangibles that on paper, my business maybe barf, Let's say a $1,000,000. But there may be somebody out there who will pay $ million for because of all the goodwill associated with. And how do you almost like evaluate that for various things in your life? Because when you start a business, usually you do want to have a exit playing. Do you want to sell? Eventually, you may need toe be able to know the value of your business for pre nup, a divorce, whatever. And how do you How do you get to that? To that number, that's great. Let's talk about that because that brings up several really important issues. Let me talk about exit plan First I mentioned in the first segment most business people I know, including my dad, Dural Dad. He was 81 years old, still working, is in the investment business, and he has a radio show on local radio, where he talks about investments outside of ST Louis. This is a person who decided I'm just working cause I enjoy what I do. There is no exit strategy when I can no longer do this. It ends, and that's fine. That is the opinion, the attitude I should say for many people that I see, however, and this is the most painful part of not only being in business but particularly starting a business which is talking about the end. How does it end? How do you get an exit strategy? What do you ultimately want to do? Most people never talk about it. Okay, so I wanted to just address exit strategy. First it becomes particularly important again in a partnership and a corporation to say What if a partner dies, would have a partners disabled? What if a partner just withdrawals and leave? And this is a discussion? We need to have it the front end and nobody wants to talk about dying or be disabled. That's depressing. Who in the world wants to talk about that? But it's an important conversation to have. So that's number one. Um, another thing I used to do. And you're gonna start thinking, I don't think Ken can keep a job. What? How many jobs is this guy had? I mean, come on. My first teaching experience was I would teach a test prep course for people who were getting licensed to be investment brokers, and this was my first experience because I had been in the investment business, and now I was teaching it, and I had a guy in class, was a former NFL football player and way we were laughing because he made the point that what something is worth based on his experience as a professional athlete is what somebody is willing to pay for, which is similar to what this discussion that he and I just have. So you make the point that what you're willing, what you can sell your business for, maybe completely unhinged and unrelated to the financial stuff I'm talking about because somebody sees value beyond what's on the balance sheet. That could be they have a secret sauce. Yeah, they have this person. Has anybody read the Steve Jobs book? Walter Isaacson. Yeah, I think that's on my list, is it? And what you find out is that I walked away from that book, and I'm halfway through it that when you try to quantify everything that Apple came up with and how it changed everything, it's practically unquantifiable. It really is. So there's value to a business that can't be put on the financial statements because of intangible assets like secret sauce or people, or a process that can't be quantified. Now let me comment on. So there's two questions. How do I figure out what that is and what, if anything, gets put in the financial state? So the 1st 1 is how do I figure out what that is? There are accounting friends of mine who are certified as valuation experts. Again, this gets us away from the traditional accounting. But it's important for this class because some of you may eventually sell a business and you need to know about valuation, typically, how we value a company that has both revenue and sales. I use those terms interchangeably, and earnings is. You look at the business that they're in and you see historically what have people paid as a multiple of their earnings, and I'll explain what that means in a minute or their sales. So, for example, um, you haven't you have a business that has a 10% profit margin in every year, and they've grown sales every year, and now they do $5 million in sales a year, and they have a 10% profit margin, which I will define later. And there in the grocery there. Ah, grocery store evaluation. People can look at other grocery stores that have been sold and say, Well, yeah, they paid a $1,000,000 in sales. Let's say they paid five times the sales or $5 million if they made $200,000. Historically, people have paid 10 times the profit 200,000 times 10 or $2 million The point is, that's how somebody is calculating what the company is sold for, and that assumes that you have earnings and that you have sales. Now, as we've seen all over San Francisco in particular, just loved being out here with all the creativity. You have businesses that are not yet profitable, that are sold for big amounts, right? That is based on speculation. Not in that same speculations bad. But I'm saying it's based on speculation that this thing, this thing, this business has value that's way above the sales that it's doing now. And you know, the company may be operating at a loss. The example I use with Twitter, I think I read that Twitter won't even be profitable into which, by the way, was co founded by a guy named Jack Dorsey was from ST Louis is a co founder. Twitter is not going to be profitable, at least until 2015. They had to disclose that when they issued stock, yet people paid a lot of money, not even for a majority of Twitter for a small fraction of Twitter. Okay, so to a certain extent, what what something sells for is what somebody is willing to pay for it, which is what this football player and I were kidding about because I said what led to this whole me bringing this up was I said, That's a really nice car and he goes, You want to buy it? So why would you? Why would you want to sell it? He goes, Anything's for sale, you know, it's whatever somebody was willing to pay for it. I'm going to sell. For now, let's talk about how it gets into the financials just a little bit. If the grocery store sells for a value that's way above. If I take the fair market value of everything in the business, call it a pizzeria. I take a fair market value of the ovens and the furniture in the building, and let's say it's a $1,000,000 the business sells for two million. Okay, the company paid a 1,000,000 mawr than the value of the assets, and the question is, do we do anything with that from an accounting standpoint? And the answer is, we do and we call a goodwill. But that goodwill is only created if somebody outside buys the business. In other words, for the most part, you can't create goodwill yourself. No, most of the creative people out there in the audience are saying, Well, what do you talking about? I've got all kinds of value I've created. How can it be that it doesn't get recorder in the financial statement because it's too hard to quantify. But when somebody raises their hand and says, I'll pay you acts, then it does get created. So if you're in a situation where you're considering selling your business, what you may want to do is find somebody who's, uh I can remember the distinction exactly, but it's basically evaluation person. There's a friend of mine in ST Louis, Kevin, and all he does all day is work on valuations. So find evaluation person and also fine. You know, venture capitalists and angel investors. They have their sense of what they're willing to pay for based on history, ALS okay, but that's an important point for this creative audience. Is that what we just talked about