It's the end of the month, quarter or year and time to meet with your accountant. As you enter your accountant's office, you notice a big smile on his or her face. Your emotions are a bit confused since you seldom see a smile on his face. As you sit back in the chair, your accountant says something like "Congratulations you had a wonderful year. Your company made thousands of dollars in profit last year!" Your reaction to the news is quite different from your accountant's. You are thinking, "If we made all that money, where is it because it sure isn't in our checkbook!"

Sound familiar? It does to lots of contractors. Your accountant said you made all this money last year (which you must pay taxes on) but there is nothing in your checkbook. Guess what? You just experienced the difference in cash flow and accounting. Cash flow deals with the "real" dollars that flow in and out of your company on a daily basis. Accounting, on the other hand, tends to work with paper dollars. Does that mean accounting is bad or useless? No. Accounting is needed and necessary. The process can tell you a lot of things about your business and it's what the government requires to determine what you owe at the end of the year. Accounting dollars cannot, however, be used when you want to know what profit you "really" made or when it comes time to determine your hourly rate. Accounting isn't much help either when it comes to projecting your monthly cash flow needs. Cash flow projections and hourly rates must be set based on cash flow dollars, not accounting numbers.

Several years ago I was doing some consulting work with a contractor in Texas. The first thing we did was to review his accounting income statement to see how things were going. His statement showed $3,000 in interest expense and a net profit of about $15,000 for the year. Not bad for a company his size. All seemed to be in order except for one overriding problem. The contractor was broke and didn't understand why. According to his accountant all was well-he was making money. Then we began to model his company using our software program. Now, before we solve his problem we need to discuss one of the major differences in cash flow and accounting. The biggest difference, although not the only difference, is how loan payments are handled. If you have a $500 loan payment where $400 is principle and $100 is interest, guess what shows up on your accounting income statement. Right, only the interest portion of the payment, the $100 dollars. The other $400 simply goes off to never-never land. It shows up in your assets and liabilities but, not in your income statement. In case you have forgotten, you pay taxes based on what shows up on your income statement not what is left in our checkbook.

Now back to our friend in Texas. As we began to model his company on the computer, we came to the overhead portion of the program. When we got to loan payments the lights began to come on. This contractor didn't have one or two loans. As a matter of fact he didn't have six, eight or 10 loans. He had fourteen loans. The good news was that he was doing an excellent job of paying them off, most of what he was paying was the principal with very little going to interest. If you will remember back a bit, you will recall that his income statement showed a $15,000 profit for the year with $3,000 listed as interest expense. Would you like to guess what our contractors' total loan payments were for the year-principle and interest? His total loan payments came to $62,000. That meant there was a $59,000 difference in cash flow and accounting. From an accounting standpoint he was paying $3,000 interest a year and therefore showed a $15,000 profit. From a cash flow standpoint (actual dollars in and actual dollars out), however, when you consider the additional $59,000 paid in principle that did not show up on his income statement, he was loosing $44,000 a year. The accounting income statement showed a $15,000 profit for the year but the real story (from a cash flow standpoint) showed a $44,000 loss. That was why he was broke!

Another significant difference in cash flow and accounting deals with depreciation. In case you are not familiar with depreciation it takes the value of your equipment and then allows you to "write off" a certain percentage a year. For example, let's say you bought a new truck three years ago. The truck cost $18,000 and the tax table from Uncle Sam says you can write the truck off over a 5-year period. Bottom line that means you can show a line item on your accounting statement called Depreciation Expense of $3,600 a year ($18,000 divided by 5 years). If you are real smart, you write yourself a check each year for the $3,600 and you put it in a savings account. In five years you will have your $18,000 saved up to buy a new truck. One minor problem-now it's time to replace your $18,000 truck, but the current cost is $22,000. You find yourself $4,000 short of what you need.

Cash flow looks at replacing your equipment a bit differently. From a cash flow perspective, we replace depreciation with a term called Equipment Replacement Cost. Equipment replacement cost determines what you have to build into your budget each year in order to have the money you need when it is time to replace the equipment. For example, let's go back to our previous example. When we originally purchased our new truck for $18,000 we "should have" projected that in five years it would cost of $22,000 to replace it. If we had done that we would have built $ 4,400 per year ($22,000 divided by 5 years) into your budget and therefore into our labor pricing. If we had, when it came time to replace our equipment we would have had the funds available to purchase the new truck. You will notice there was a difference of $800 a dollars a year ($4,400 minus $3,600) between what was built into our budget from an accounting standpoint verses what should have been built in from a cash flow perspective.

The $800 a year may not seem like a lot of money, but let's stop and think for a minute. At this point we probably have not put any money back for equipment replacement. Our original truck now needs to be replaced in two years. In order to pay cash for it, we now have to divide the needed $22,000 by the two remaining years. That means we have to build $11,000 into our budget. If that were not bad enough think again. How many trucks do you own-three, four, five or more? Guess what just happened to your Equipment Replacement Dollars-they grew- a lot. Now will your original depreciation dollars cover the cost? Absolutely not.

If you put the full amount of the loan payment (principle and interest) into your budget AND the real equipment replacement dollars into the same budget you will see a decidedly different bottom line projected profit. Those of you that have been through our full-day seminar on labor pricing know the basic principles of determining your hourly rate. Simply stated, you calculate your "real" cost of doing business, subtract your net profit from material sales and divide the remainder by your billable hours. As you can plainly see you would come up with a significantly different hourly rate using accounting numbers than you would using cash flow numbers. Cash flow numbers must be used when determining your hourly rates.

Next time you look at your accounting income statement, think about the above major differences. Just for fun, take out the interest expense and depreciation expense and add in the entire amount of our loan payments and put in equipment replacement dollars instead of depreciation and then look at the bottom line. I think you will see a real difference.