In this issue of our accounting blog, we would like to explore a very important realization in terms of a sale and the associated timing of cash flow into your business.
The Double Entry
In order to achieve this insight, we will return to the topic of double entries with reference to your bank account as the central hub for entries.
When a cash sale is made, you will remember that the double entry system will require a debit into your General Ledger account for Bank and a credit into your GL account for sales. (We will look at the impact of Vat on the type of entry at a later stage.) In the event of a cash sale, the money is immediately available to you to pay expenses.
The double entry becomes a little more complicated in the event of a sale to a customer with an account or delayed terms e.g. 30 days after invoice. In this case, when a sale is made the GL account for Sales is still credited. Due to the fact that no money has changed hands yet, the second leg of the transaction cannot go to bank. I would like to remind you that if we had debited Bank, it confirms that asset accounts will have debit balances. A positive bank balance is an asset.
Cash Flow Management
The second leg in this case will be the account in the GL known as Debtors. A debtor is someone who owes you money and the name debtor is linked with debit, which you know is an asset. Having somebody owe you money is an asset as, in the event of deciding to close your business, this money can be collected and banked.
The two entries then are a credit to Sales and a debit to Debtors. Your income statement shows that you have sold goods or services but your balance sheet shows that you don’t yet have the cash as it is sitting in Debtors and not Bank. Only when the money comes in will your cash flow be enhanced. When the money comes in, the double entry system is once again driven by the activity in your bank account. Bank receives a debit and the corresponding entry is driven by where the money came from. As it came from a debtor, the credit will go there.
In Debtors, you now have an entry on both the debit side (at the time of the sale) and the credit side (at the time of payment). These two entries will cancel the debt if the amount of the sale was paid in full. The money has moved to a different asset – Bank.
This is one of the tricky parts of cash flow management. You generated a sale and were only paid at a later date. The longer the terms the greater the gap between the sale and the availability of the money in your account.
Simply looking at sales levels in a month is not a true indicator of what money will be available to you to use to pay suppliers, staff and yourself.
Through the understanding of the entries for both cash sale and sales on terms, you begin to be able to manage your business better. Cash flow management is a critical element in business management.
Exercise:
Analyse your business activity to establish the following:
- Levels of sales.
- Split in sales between cash and credit.
- The length of time each debtor is taking to pay you.
- Your monthly expenses.
- The difference between monthly costs and monthly cash sales.
- The degree to which you can predict the date when your Debtors will pay you.
For further insight (and in case you missed them) read through our previous Accounting Building Blocks posts:
Volume 2 : The Chart of Accounts
By Louis Gerke
Development Facilitator – The Ripple Effect
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