In the U.S., there are accounting standards known as Generally Accepted Accounting Principles (GAAP). They are the accounting standards used for all businesses in this country and provide principles for the two types of accounting used; cash and accrual accounting. The difference between the two relates to when revenue and expenses are recognized in the books.
Most people are familiar with cash basis accounting even if they don’t know the name. The majority of individuals use this method when balancing their checkbooks and paying bills. Cash basis accounting recognizes money as it comes in or goes out. This is the approach most used by small businesses, particularly ones that have tight cash flow or sell good or inventory. This method keeps the books up to date and gives the owner a real-time view of his or her business finances. One of the major limitations, however, is that accounts receivable are not accounted for and therefore don’t always show the big picture of a company’s finances.
Accrual accounting, on the other hand, books the earned revenue or expenses when they are incurred and not when they are received. This method is by far the most common in the business world and in fact is legally required for companies that have inventory or goods, C corporations, or those with $5 million or more in annual revenue. Accrual accounting gives a holistic perspective of the business and a good view of the overall health of the company.
Here’s an example, if a farmer sells a bushel of wheat to a customer for $500 and doesn’t add it to his books until he is handed the cash, he is using cash basis accounting. However, if he accepts the order and accounts for the sale as revenue in his books before actually receiving the payment, he is using the accrual method. The accrual method records the revenue immediately, even if payment is not for days or weeks, whereas cash basis accounting only recognizes revenue when it is actually received.
Expenses work the same way. If the farmer has a fuel bill for his equipment of $100, under a cash basis, he wouldn’t mark down the expense in his books until he actually remits payment. For accrual accounting, the expense would be booked immediately, even if his payment won’t be made for a while.
And what, you ask, does this have to do with applying for a small business loan? Well, it is important to know how the lenders view loan applications and how cash and expenses are recognized.
Traditional banks and mid-prime alternative lenders that offer bank style loans, will want to see accrual based books from the businesses applying for financing. This methodology properly matches revenue with expenses. It allows lenders to have a good view of the overall health of the company. It allows a lender to determine if the finances are healthy and the income is sufficient to service the debt the company already has and for which it’s applying. (See my recent article on Debt Service Coverage Ratio for more on this topic.)
Those businesses that rely on cash-based accounting are at a disadvantage during the application process if they are looking for term loans or lines of credit. Since the accounts receivable aren’t recognized until they are paid, those credits to the books often can’t be properly included in the profitability analysis during the underwriting process.
That doesn’t mean there is no hope. Some lenders may be willing to take the extra effort required to take all the factors into consideration. There would likely be a requirement for additional information like the accurate aging of your accounts receivable and accounts payable, and a schedule of additional obligations.
In addition, there is another type of lender for which accounting practices aren’t considered. Merchant cash advances (MCAs) are short-term, high interest-rate loans that are processed very quickly with funding in as little at 24-48 hours. These lenders are advancing money based solely on bank statements that will indicate if there is enough cash flow through the business to support daily repayments made directly from the business’s bank accounts or by taking a percentage of daily credit card processing fees.
So what does all this mean for a small business owner? The bottom line is when your business is young or small, using cash based accounting is an easy way to keep a handle on the finances. But as your company grows, it will be a good idea to start to consider how to transition into the more complicated, but more globally accurate, accrual accounting method. This will set your business up for growth and for more success when looking for financing.
And no matter what, it is always a good idea to consult with an accounting professional when considering any changes.
Ethan Senturia is co-founder and CEO of Dealstruck an online direct lender that creates customized loans for business. Dealstruck is the first online lender to offer multiple products — including flexible term loans and multiple line of credit solutions — to small- and medium-sized business (SMB) owners. With a mission to provide growing SMBs with access to capital that is unique, appropriate and affordable with honesty and transparency, Dealstruck is committed to placing SMBs on a credible path to bankability. As CEO, Ethan leads all institutional and marketplace lending relationships and drives the company’s product strategy. Before founding Dealstruck, Ethan ran Internet marketing for lead generation startup Ampush Media, growing annual spend to $15M in less than two years. Prior to Ampush, he worked as a distressed credit analyst at Lehman Brothers, where he started his career. Ethan graduated Summa Cum Laude from The Wharton School.