Run a mock round

Cash accounting records transactions only when money changes hands. Accrual accounting records revenue when it is earned and expenses when they are incurred, regardless of payment timing.

Accrual gives a truer picture of performance because it matches revenue to the costs of earning it in the same period. That is why accounting standards such as IFRS and US GAAP require accrual accounting for most businesses, and why public companies report on that basis. Cash accounting is simpler and is often allowed for very small businesses, but it can distort results. A big sale in December with payment in January looks like a January event, and a large annual insurance premium hits one month hard.

Under accrual we use adjusting entries such as accrued expenses, prepayments and deferred revenue. The trade off is complexity and more judgement, but the benefit is comparability and a more faithful view.

I look at profitability, liquidity, leverage and cash generation together, because any single ratio can mislead.

Profitability: gross and net margin, and the trend over several periods. Liquidity: the current and quick ratios, and whether working capital is positive. Leverage: debt to equity and interest cover, to see how much shock the business can absorb. Cash: operating cash flow and free cash flow, and whether profit converts into cash.

I compare these against the company's own history and against industry peers, since benchmarks vary widely. I also read the quality of earnings. Are profits driven by one off items or aggressive revenue recognition?

Beyond the numbers I consider customer concentration, contract length and competitive position. A company can look fine for a year and still be fragile if it depends on one client or one product. Trend and context matter more than any single figure.

Deferred revenue is money a customer has paid before the company has earned it. It sits on the balance sheet as a liability because the company still owes the customer a product or service.

Under accrual accounting and standards such as IFRS 15 and ASC 606, revenue is recognised when the performance obligation is satisfied, not when cash is received. If a customer pays 12,000 for an annual subscription in January, the company records 12,000 of cash and a 12,000 liability. Each month it recognises 1,000 of revenue and reduces the liability by the same amount.

It is a liability because failing to deliver would require a refund or a substitute. Deferred revenue is also a useful signal: growing deferred revenue often indicates a healthy subscription business, which is why analysts watch billings alongside recognised revenue.

I build the forecast from drivers, not from a flat growth assumption.

First I establish the opening cash balance, then project inflows and outflows month by month for the next twelve months on a rolling basis. For collections I use actual invoice terms and customer payment behaviour, so a sale in March on sixty day terms lands in May. I separate committed revenue from pipeline and weight the pipeline by probability.

Outflows include payroll, rent, supplier payments, tax, loan repayments and capital expenditure. I add known one offs such as quarterly VAT or annual insurance.

Then I produce three scenarios, base, downside and upside, and identify the minimum cash balance and the month it occurs. That tells us whether we need a credit facility or can invest. I refresh it monthly by replacing forecasts with actuals and extending the horizon, and I review variances to improve my assumptions.

Profit is an accounting measure of performance over a period, while cash flow is the movement of actual money.

Profit follows accrual accounting: revenue is recognised when it is earned, not when cash arrives, and expenses are matched to the period they relate to. So a company can be profitable on paper while running out of cash if customers pay slowly or if it has spent heavily on inventory or equipment.

Cash flow comes from the cash flow statement and splits into operating, investing and financing activities. Operating cash flow is the most important for judging whether the core business generates cash.

A practical example: a business invoices 100,000 in December on sixty day terms. It records the sale and the profit, but no cash arrives until February. If payroll is due in January, profitability will not pay it. You have to manage both.

The three statements are the income statement, the balance sheet and the cash flow statement, and they are linked.

The income statement shows revenue and expenses over a period, ending in net profit. That profit feeds into the balance sheet as retained earnings, increasing equity. The balance sheet is a snapshot of assets, liabilities and equity at a point in time.

On the cash flow statement, net profit is the starting point for operating cash flow, then adjusted for non cash items such as depreciation and for changes in working capital. Capital expenditure appears under investing, and loans or share issues under financing. The closing cash on the cash flow statement must equal the cash line on the balance sheet.

The key relationship is that the balance sheet must balance: assets equal liabilities plus equity. If it does not, something is misstated.

Working capital is current assets minus current liabilities. It measures the short term liquidity available to run day to day operations.

Current assets include cash, receivables and inventory. Current liabilities include payables, short term debt and accrued expenses. A positive figure means the business can cover its near term obligations. A negative figure can signal trouble, though some models, such as subscription businesses collecting upfront, run negative working capital deliberately.

It matters because even profitable companies fail when they cannot pay bills on time. Working capital reveals how long cash is tied up. The cash conversion cycle, days inventory plus days receivable minus days payable, shows where it is stuck.

I improve it by collecting receivables faster, managing inventory tightly and negotiating supplier terms, without damaging customer or supplier relationships. It is a key input to cash flow forecasting.

Gross margin is revenue minus cost of goods sold, divided by revenue. It measures how much is left after the direct costs of delivering what you sell, such as materials, hosting or delivery.

Net margin is net profit divided by revenue, after all operating expenses, interest, tax and depreciation. It measures overall profitability.

The difference is what sits between them: sales and marketing, research and development, administration and finance costs. A company can have a strong gross margin and a weak net margin if it overspends on overheads, or a modest gross margin and healthy net margin if it is very efficient.

I look at both. Gross margin shows the underlying economics of the product and is useful for comparing businesses in the same industry. Net margin shows whether the whole operation makes money, and trends matter more than any single period.