Cash flow vs Profitability

Whilst on a “course” a few weeks ago I commented to my golf partner (and accountant) after I had just hit another ball out of bounds that I would have to do a provisional return.  At first, this gem of genius yet subtle wit went unnoticed and without the response it deserved. However, when I explained that I had just made an accounting joke – the chuckles continued right to the end of my next follow through. Now for those who are accountants and play golf this is probably the funniest thing since … well ever. But for the rest of you … tumble weed and crickets may come to mind.

In light of this and also following on from the article last year on the Mini MBA I thought I would use this month’s article to take a closer look at the exciting world of accounting.

In coming up with a phrase to encapsulate this article I realised that I could not use “The idiots guide to accounting” or “Accounting for dummies” due to possible copyright infringements so I thought I would call it “Accounting for the financially challenged”.

To be or not to be … an accountant

Accounting is usually best left to your accountant, or is it? The answer is yes and no. On the one hand you need a qualified accountant with all their years of experience to make sure that all your books are in order and on the other hand you need to take responsibility for your own affairs, after all it will be your signature on your year-end returns.

The more you know about the accounting process the better prepared you will be to manage the smaller things in your business like simple sales all the way through to making bigger financial decisions which affect cash flow, accounting fees and tax liabilities.

I will now attempt to explain some very simple accounting principles using as much humour as possible to dispel the view that accounting is boring. Join me as we take a roller coaster ride filled with thrills and spills, debits, credits, assets, liabilities, balance sheets and income statements.

O.E = A – L

“O.E = A-L” is the Accounting Equation and stands for Owners Equity = Assets – Liabilities. The Accounting Equation is to accounting what Einstein’s theory of relativity (E=MC2) is to Physics. Well not quite, but close enough to make my point that it is very important. Everything in accounting terms really hinges off this equation.

What it means to the financially challenged in simple terms is: “What you are worth (O.E) = What you own (Assets) – What you owe (Liabilities). For example if you buy a house for R500 000 and have a bond for R500 000 then you have a net worth of zero because what you own (assets) is equal to what you owe (liabilities). However, if after a year your property is valued at R1 000000 (in your dreams) and your bond has been reduced to R400 000 (well done) then your net worth would be R600 000 because you own more than what you owe. This is an oversimplified example but you should get the point.

And this is pretty much all there is to it … you are now just as qualified as your accountant! Well there are a few other details we could perhaps examine a little more closely.

I’m rich! Hang on a moment …

If you had Two Million Rand in your bank account you may be forgiven for thinking that you are quite wealthy. One would completely understand your need to make a few acquisitions of essential items like a new sports car, samples from Christian Dior’s winter collection or that weird fleece sleeping-bag night gown thingy you see in the infomercials so that the whole family can dress up like OB1-Wan Kenobi on a cold winter’s night.

The only problem is that money in your bank does not equal money to spend. Apply the accounting equation: Money you can spend (O.E) = Money you have (Assets) – Money you Owe (Liabilities). Therefore if you have not paid your rent, your stock suppliers, your electricity bill and your staff wages for the past 6 months then you are not quite as wealthy as you think and the new Ferrari may have to wait, at least until next month.

Conversely if you made a profit of two million rand for the year but none of your clients have actually paid you yet then Cash Flow will be a problem, i.e. on paper you are actually wealthy but in reality you can’t put two cents together.


At this point I would like to introduce a very scary term called Double Entry Accounting. Take a deep breath; we’ll get through this together.

Double entry accounting is in fact a very simple principle, although it has been rumoured that this was in fact the real reason for Van Gogh’s insanity.

Just like Isaac Newtons observation of gravity that what goes up must come down so too it is with double entry accounting, for every debit there must be a corresponding credit. For example, when I purchase the Ferrari for R1 000000 my assets (Motor Vehicles) will increase by that value, however my bank account (incidentally also an asset) will decrease by that same value. Get it? What goes up must come down. There must always be a corresponding entry (Contra). The only consideration is to think more in terms of left and right rather than up and down, i.e. Debit = Left and Credit = Right.

What to spend your money on?

If you are fortunate enough to get towards the end of your financial year and are sure that you will reflect a healthy profit and wish to reduce your taxable income be sure to understand what you are spending your money on. For example are you spending it on an Expense or an Asset?

A very simple definition of the two is that with an expense you usually do not have anything tangible to show for your money, whereas with an asset you do. Rent, electricity, advertising and salaries are examples of expenses; whereas computers, motor vehicles and property are examples of assets.

Expenses (incurred in the production of income) appear on your Income Statement and these are tax deductible, whereas Assets appear on your balance sheet and need to get depreciated over a period of time in order to enjoy a tax deductible benefit.

For example, if you buy a motor car for R100 000 it will appear on your balance sheet as an asset. However, as you “write it off” or depreciate it over time you will enter this depreciation as an expense on your Income Statement, which over 3-5 years will reduce your taxable income.

Are you still with me? Excellent!

Tax on Toilet Paper

After attempting to study a little bit of tax at university I was blown away by the fact that you could hardly turn left at an intersection without somehow having to pay tax. What was really going through my mind was more the idea that you could hardly go to the toilet without paying tax.

For example, did you know that if you drive a company car then you need to pay a Fringe Benefit Tax on it? Well now you know. Or if you receive an interest free loan from your company greater than a certain amount then you pay tax on the difference between the market related interest rate and what you are being charged by your company.

If you declare a dividend as an owner then you pay what is called STC, which stands for Secondary Income Tax on Companies, which means that after you have paid Income Tax on the profit that you have made then you pay a secondary tax of 10% of the dividend you declare.


In one sense Accounting is very complicated and must be handled by qualified professionals but every business owner should know the basics. The abovementioned points are just the tip of the iceberg in the world of accounting so keep your accountant close by and try to learn as much as possible from them instead of blindly just handing over everything to them each month.

The information contained above is not intended to be definitive instruction on conducting your financial affairs but rather an overview of some of the basic principles of accounting. Please consult your accountant wherever possible.

Our company uses the accounting firm RSM Betty & Dickson in Cape Town and if you would like to contact them to discuss any of your accounting needs please let me know and I will forward you their contact details or the closest RSM firm to you.

Chris Parker
Tel: 0861106203