Proper small business financial management requires several essential skills, including expense tracking.
First, you must ensure the business is an ongoing opportunity, generating revenue and maintaining cash flow.
Second, you must manage expenses within revenue created and cash retained. But how does one best track and manage business expenses?
Expense Tracking Guide: Start with Your Books
A proper set of books will always allow you to track expenses.
Maintaining books is essential to:
- Proper direct cost management.
- Proper general expense management.
- Budgeting (including planning, direction, and control).
- Legally minimizing income taxes.
- Audit preparation and support.
- Providing required financial information to outside interests.
- And preparing accurate tax returns.
A Proper Set of Books
A proper set of books is crucial to the success of any small business. Any business, large or small, must get its numbers right on a timely basis and then put those numbers into a format understandable to the owner and anyone outside the business so they can make sound business decisions.
A professional, such as a Certified Public Accountant (CPA) specializing in small business financial management, can help businesses accomplish this. Solid books include:
- Chart of Accounts – a listing of all the relevant categories of the business’s financial transactions. The chart is the basis for effective expense tracking.
- Source Documents – for expenses, including bills and paid invoices, among other records. These should be saved and organized.
- Journals – once transactions are identified and properly categorized, they need to be recorded on a timely basis (daily or weekly) in an orderly, consistent manner in journal entries.
What Are “Journals”?
For expense tracking, there are three main categories of journals. There can be more, but the following are the most common and useful.
- Cash Disbursements Journal – Money a business uses to pay its bills.
- Purchases Journal – The bills the business receives for the goods and services it needs to operate.
- General Journal – Used to record unusual items or adjustments recommended by an outside accountant (to ensure you record all of the business’s financial transactions).
By utilizing these items, the small business owner can generate financial reports that will help track their expenses and allow for informed financial decision-making. You can keep these records in any spreadsheet program, such as Excel, but a more practical option is using a software booking system.
QuickBooks Online is a basic booking system and is the most popular of these software programs. One strength of this system is the ability to collaborate with a CPA in real time.
Another alternative is QuickBooks Desktop, a more robust accounting program that does not allow real-time collaboration. Finding one that suits your business needs is the key to “the best” system.
Why Is Expense Tracking Important?
Proper Direct Cost Management
Direct costs contribute to and directly fluctuate with sales. There are several examples of direct costs, depending on the type of business, such as labor and materials in a manufacturing company or goods purchased for resale in a retail business.
Service businesses may or may not have direct costs, so it is up to the business owner or management to determine what is relevant.
The key is to identify and track these specific costs so you can compare them with revenue to determine a gross profit margin.
- Gross Revenue (a), less Direct Costs, equals Gross Profit (b)
- Gross Profit Margin = (b) divided by (a)
Your Gross Profit should be a positive number (i.e., Gross Revenue exceeds Direct Costs). If this is not the case, the business will be in trouble because the sale costs more to make than it does to sell.
To remedy this, the business must increase sales dollars, reduce costs, or both. Simply increasing sales volume with a negative Gross Profit will lead to further problems because every transaction loses money.
Proper General Expense Management
Another reason for wanting to know the Gross Profit is to make sure it is enough to cover general expenses. General expenses do not fluctuate with sales. Some may be fixed, such as rent or administrative salaries, but others may fluctuate, though not directly related to sales. These kinds of expenses include insurance, utilities, or office expenses.
While knowing and controlling these figures is important, they won’t significantly affect a business’s bottom line (Net Profit). The Gross Profit level still needs to be at least as much and preferably more than these expenses. An analogy is saving on paper clips won’t make or break the business.
Budgeting (Planning, Direction, and Control)
The challenge for small businesses when it comes to budgeting is determining who will establish the budget. Large companies have departments with staff dedicated to this process. In a small business, the owner or manager is usually responsible, but it can be challenging to find the time.
A good CPA specializing in small business financial management, while not actually doing the budget, can provide templates, processes to follow, and advice on the process that can save businesses valuable time.
Having a proper set of books will also provide much of the necessary information for building a budget because the business is already tracking costs and can reasonably project into the future.
The budgeting process facilitates Planning, Direction, and Control:
- Planning – every business should have a plan. A good plan begins with projecting future monthly expenses from records, starting with a two-year timeline, then planning annually for three to eight years.
While this may seem daunting or unrealistic, this planning forces the owner or manager to consider where their business is going and what opportunities are worth pursuing. A good practice is to reduce hypothetical sales in the budget to a break-even point and see if the result is still sustainable.
Doing so may reveal the business will require an infusion of capital by the owner or outside financing.
- Direction – Formulating plans also requires thinking about how to achieve the plan. This provides insight into the processes and staff necessary to accomplish it. The resulting operating procedures will help drive the business.
- Control – No plan is entirely accurate, but the planning process provides benchmarks to compare with actual tracked expenses. This comparison can reveal variances for a business owner or manager to analyze and address. You can control some variances, but those you cannot control may need adaptation.
Legally Minimizing Income Taxes
A business can deduct all ordinary and necessary expenses to conduct that business. Tracking these expenses is a crucial part of paying the smallest amount of taxes.
Should the IRS audit your business, having a proper set of books with a record of ordinary and necessary expenses and documentation supporting those transactions will greatly simplify the process.
You can save supporting documentation in paper or digital format by filing or scanning receipts and invoices. QuickBooks Online allows you to scan and attach documents directly to the recorded transaction.
The IRS requires that taxpayers keep receipts and other transaction documentation for three years.
Providing Required Financial Information to Outside Interests
Outside financial interests – such as banks, potential investors, the IRS, or state taxing agencies – may want to know the business’s expenses and revenue. Tracking these in a proper set of books will simplify sharing financial information.
Tracking expenses is also necessary to prepare an accurate tax return.
Effective Expense Tracking Supports Effective Businesses
Tracking expenses in a small business provides valuable information about business operations that owners and managers can use to make sound business decisions. It is one part of small business financial management that contributes to the business’s success. A CPA specializing in small business financial management can provide help in this and other essential bookkeeping areas.