PAYMENT AND ACCRUAL BASIS FOR CALCULATING THE METRICS FOR A NEW COMPANY

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When calculating the metrics of a new business, it is important to take into account the difference between the payment and accrual basis. The payment criterion is based on the company's actual cash flow, i.e. the revenues and expenses that have actually been collected or paid in a given period. This criterion is mainly used in the early stages of a company, where the important thing is to ensure liquidity and avoid cash flow problems. On the other hand, The accrual basis is based on income and expenses that have been generated during a given period, regardless of whether they have actually been collected or paid in that period. The accrual basis is mainly used for keeping company accounts and for paying taxes. It is important to note that even if a company is profitable on an accrual basis, i.e. has accounting profits, it may have liquidity problems if it does not manage its cash flow correctly on a pay-as-you-go basis. For this reason, Both criteria need to be used in a complementary way to calculate a company's metrics and make appropriate financial decisions.

Entrepreneurs use the criterion of payment rather than accrual to make their numbers and make decisions.

The accrual basis is the one that accountants use to keep profit and loss accounts and pay taxes, entrepreneurs use the payment criterion because in the early stages of a company the important thing is to ensure liquidity. Entrepreneurs use the payment criterion to estimate cash flows because in the early stages of a business the important thing is to ensure liquidity and have enough cash to meet payment obligations. On the other hand, the accrual principle is used by accountants to keep profit and loss accounts and pay taxes. This approach recognises income and expenses when they are earned, regardless of when they are received or paid. In other words, income is recognised when earned and expenses are recognised when accrued, even if payment is made at a later point in time.

It is important to bear in mind that a company may be profitable from an accounting point of view using the accrual basis of accounting, but may have liquidity problems if it does not have sufficient cash to meet its short-term payment obligations. Therefore, It is essential for entrepreneurs to estimate cash flows using the payment approach to ensure that their business has sufficient cash to meet its expenses and payment obligations in the short term.

To estimate the cash flows (+) entrepreneurs use the criterion of payment

The payment approach is a way of estimating a project's cash flows based on the timing of actual payments and receipts. Under this approach, revenues or expenses are considered to be those that are actually paid or collected in a given period, regardless of when the payment obligation or collection right arose. In other words, the payment criterion isThe focus is on when the movement of money takes place, rather than when the obligations or rights are generated. Therefore, actual cash flows, rather than potential or theoretical cash flows, are considered.

This approach is particularly useful for cash management and investment or financing decisions, as it is based on the actual liquidity of the company. For example, if a company has a long-term payment commitment, but does not have sufficient liquidity at the time of payment, it may have difficulty meeting its obligations and face financial problems. In a nutshell, the payment approach focuses on actual cash flows, allowing for effective cash management and more accurate financial decision-making.

The danger of keeping your numbers on an accruals basis

A profitable company, i.e. with accounting profits on an accrual basis, may close down due to lack of liquidity. It is true that a profitable company can close due to a lack of liquidity, although this may seem contradictory at first sight. A company's profitability is measured by its accounting profit, which is calculated on an accrual basis, i.e. when sales or expenses are generated, regardless of whether they have been collected or paid. On the other hand, a company's liquidity refers to its ability to meet short-term payments, i.e. to have the cash needed to pay invoices, salaries, taxes, etc. Lack of liquidity can be temporary or structural, and can be due to a variety of factors, such as poor financial management, a decline in sales, a reduction in bank credit, among others.

Therefore, it is possible for a company to be profitable in accounting terms, but not have sufficient cash to meet its short-term payments and have to close due to a lack of liquidity. This is why, in addition to profitability, it is essential for the survival of a company to have proper cash flow management and to ensure adequate liquidity.

Practical example of a profitable company, i.e. with accounting profits on an accrual basis, which may close due to lack of liquidity.

Imagine a company that manufactures and sells personalised products. In January, the company receives product orders totalling $50,000 and manufactures and ships them to customers in February. On an accrual basis, the revenue for these orders is recognised in January, even though the money is not received until February. In addition, the company has some expenses in January, such as the payment of rent for the premises, employees' salaries and the purchase of materials, which are also accounted for in that month. At the end of January, the company has a positive accounting profitability, as revenues are higher than expenses, and therefore the accounting profit is $10,000. However, if the company does not have sufficient liquidity to pay for February expenses, such as employee salaries, factory rent and materials needed to manufacture the products, it will not be able to continue its business and may be forced to close down. In this example, although the company was profitable on an accrual basis, the lack of liquidity prevented it from continuing to operate and it had to close down. This demonstrates the importance of taking into account both accounting profitability and liquidity in the management of a company.