7 Questions Small Business Owners Should Ask Themselves When Considering How to Set-Up Their BooksPosted on March 28th, 2016
Owner / President
Outsourced Accounting Department, Inc.
Some business owners view their financial statements as something that is necessary for tax purposes and don’t really understand what the numbers mean beyond that. However, the real value of financial statements lies in their interpretation for business decision making and financial planning, and for most businesses, this is Accrual Accounting. So when might you need this kind of information?
Ask yourself these questions:
- “I seem to be making a decent profit, but where did the cash go?” This is a matter of understanding the difference between “profit” and “cash flow.” A company can be very profitable, but its funds are tied up in accounts receivable, inventory, fixed asset purchases, etc., all of which are balance sheet items and reflected on the Cash Flow Statement, NOT the Profit & Loss Statement.
- “How much profit do I need to make in order to pay myself what I’d really like to make, and how do I get there?” When a product or service is sold, the Gross Profit is the difference between what it was sold for and what was paid for it. For financial reporting purposes, this relationship is referred to as “matching” of costs and revenues, and for most businesses, is accomplished only through “accrual accounting.”
- “What do my sales need to be in order to produce the kind of income I’m looking for?” Initially, this is a “breakeven sales” question, and in order to calculate it, fixed operating expenses are divided by the “Gross Profit Margin” (Gross Profit divided by Sales). But first, one must know that the Gross Profit Margin is accurate (see # 2 above), as the slightest difference in the assumed Gross Profit Margin (i.e., denominator) can make a huge difference in the final sales number you come up with.
- “How much money do I need to produce that level of sales?” As a business grows, its accounts receivable, inventory, and sometimes its investment in plant and equipment also grow. To the extent that the business cannot fund the growth in these assets from internally generated profit and cash flow (see # 1 above and #6 below), it must borrow from outside of the business. Here again, accrual accounting is critical, otherwise receivables and inventory will not even appear on the balance sheet.
- “Where does that money come from?” The real question here is, can growth in the above assets be funded internally, or does it need to be sought outside of the business somewhere, and if so, where, the owner’s personal cash reserves, a lender of some kind, or an investor? The answer to this question in turn then depends on exactly what kind of asset is being financed (i.e. accounts receivable, inventory, plant and equipment), and the perceived financial strength of the business as indicated by its financials, as the types of lenders and investors vary in terms of the type of assets they will finance, and their appetite for risk.
- How much debt can I afford? This is the same question prospective lenders and investors will have, and in a word, the answer is “Profit” (which by the way, is also an extremely important component of “Cash Flow” that all lenders and investors say they are looking at.) A Loss, is instead a cash drain which, over time, threatens not only a default on the loan, but the very survival of the business itself. It is also important to be able to demonstrate a historical trend of profitability, so using accrual accounting consistently from the start is just as important.
- “Where do I want my business to be a few years down the road, and how do I get there?” Of course, this is first more of a marketing question, but assuming the goal is to sell the business, its value is usually based on some multiple of historical “earnings”(profit). So in financial terms, the “how” part of this question is by doing all of the above.
Just some things to keep in mind if you ever start thinking about where you want to take your company few years down the road, and the kind of information you will need for both you and outside professionals to get a true picture of your business (good or bad).
The Difference Your Method of Accounting Can Make #2Posted on March 21st, 2016
Outsourced Accounting Department, Inc.
In my first article on this topic (“The Difference Your Method of Accounting Can Make”), I talked about a private ambulance company that was able to obtain significant bank financing, improve receivable collections and cash flow, and solve an employee turnover problem while simultaneously reducing labor costs, all by simply using the proper accounting method to evaluate their true financial situation. In this article I will talk about what can happen when the wrong accounting method is used.
To provide a little background, over the past fifteen to twenty years, as banks have gotten bigger and bigger, the banking industry has gotten away from requiring financial statements prepared in accordance with Generally Accepted Accounting Principles (“GAAP”), the underlying premise of which is to “match” revenues with their related costs (Accrual Accounting). Instead, for its own convenience, the banking industry has gone to using tax returns, credit scoring, and what’s called a “global, debt service coverage ratio” to measure a small business’ ability to repay a loan. Basically, this means that if the company’s and its owner’s combined tax returns show a lot of income, and the owner has a high credit score, you’re in! If not, you’re out!
The problem with this loan underwriting approach is that while a business owner can utilize legitimate tax methods to reduce his or her business income for tax purposes, using this same information may very well work against them when applying for a business loan. And since banks no longer require GAAP financial statements for “small” businesses, owners don’t request them from their CPA firm because they don’t understand why they need them, and they don’t want to pay for them.
A case in point: A while back, a client of ours found out what happens when your bank relies on your tax return to support your line of credit. As a matter of practice, our firm always prepares the company’s internal financial statements based on GAAP, and then at year-end, if our affiliated CPA firm also prepares their tax return, they also prepare GAAP financial statements to accompany them. However, in this case, the client used another CPA firm who simply took our financials and converted them to cash basis for tax purposes, and a tax return was all the bank required to support the company’s $500,000 line of credit.
For the record, we did strongly recommend to their CPA that he also prepare compiled financial statements in accordance with GAAP using our internal numbers. However, as his firm was strictly focused on tax preparation services, he told our mutual client that he knew the bank’s management, and that he didn’t need GAAP statements. Then the CPA made some major accounting adjustments for tax purposes that made it appear that the company had distributed a large amount of money to the owner all in one year, and paid off a stockholder loan that was subordinated to the bank’s loan. In fact neither of these were true, and compounding the problem, this was at a time when the company’s “taxable income” (cash basis) was already way down. The outcome? The bank panicked and terminated the company’s half million dollar line.
Sadly, the owner had already taken corrective action based on the internal numbers we provided to him, which painted a true picture of what was going on in his business and reflected the measures he had taken. Had the proper financial information also been provided by their CPA on an accrual basis, it might have instilled more confidence on the part of the bank’s management in the business owner, and perhaps the outcome would not have been quite so drastic. But instead, the bank had no idea what was really going on in the business, and this is what banks do when they don’t know what’s going on. Lesson learned – the hard way!
“Profit” vs. “Taxable Income”Posted on March 15th, 2016
Outsourced Accounting Department, Inc.
Recently I had a small business owner say to me, “I used to have a partner who was very smart about business finances – he said you should never show a profit in order to keep from paying taxes.” To which I replied (as his company was not doing so hot), “Well, your partner was not as smart as you think he was.”
Not that minimizing taxes is not important, it is of course. But what many small business owners don’t understand is that the way you prepare your books for managing your business, and the way your accounting firm reports your income for tax purposes, are two entirely different methods of accounting, and both are entirely appropriate for their intended purpose.
Over the last couple of decades, for their own internal efficiency reasons, there has been a trend in the banking industry to rely on tax returns to evaluate a company’s profit and cash flow, particularly for smaller companies, so tax preparation is the only type of accounting service many small businesses now require from their outside CPA firm. The problem with this is that small business owners these days really have no idea of whether they are making money or losing money, and therefore, the real underlying components of their cash flow (or lack thereof).
Below are a few of the major differences between the two methods of accounting.
Accrual vs. Cash Basis Accounting
|Account / Financial Measure||Accrual (“Book”) Basis||Cash (“Tax”) Basis|
|= All invoiced sales||= Cash /AR collections; gross income is distorted.|
|2) Cost of Sales||Recorded at time of sale||Recorded when paid|
3) Gross Profit Margin
|Reflects true mark-up, more consistent from month to month.||Not meaningful, very erratic from month to month.|
|4) Expenses||Recorded when incurred||Recorded when paid|
|5) Net Income||
Reflects true “Profit” needed to evaluate performance from month to month.
“Taxable Income,” not meaningful for evaluating business performance.
The difference between the above two methods is then merely reconciled in the tax return (only) via what’s called an “M-1 adjustment“ at the bottom of the balance sheet page. So there is no need to adjust your books to look like your tax return. In fact, you shouldn’t, and you should not allow your accounting firm to adjust your books this way either. That’s for their own convenience, not what’s best for your company.
Obviously, knowing whether your company is making money or losing money is critical to its survival, as hidden operating losses will erode the company’s cash flow, liquidity, and ultimately, the owner’s personal cash reserves. So be sure to set your books up properly to enable you to evaluate how your business is performing. (For further discussion on this topic, see our other articles in our blog, “The Difference Your Method of Accounting Can Make,” and coming soon.)
The Difference Your Method of Accounting Can MakePosted on March 14th, 2016
Outsourced Accounting Department, Inc.
A while back I was doing some consulting for a well established private ambulance business that was having trouble getting approval for a $30,000 bank loan to buy two wheelchair transport vehicles. When I met with the owner, I asked to see the information that she gave to the bank. It was a classic situation I see with many small businesses – using cash-basis tax returns to provide to the bank, and in this case, with multiple entities and extensive intercompany transactions – such that no one could tell how the business was really doing by looking at the financials. At the same time, another business adviser was using this same information and advising her that she needed to let go of several paramedics — the life blood of her company, because her direct labor costs were “too high.” And ironically, management had been complaining about not being able to attract and retain quality employees from the local labor market.
The first thing we did was go back two fiscal years and recast the accounting on an accrual basis as I discussed in my recent article, “‘Profit’ vs. ‘Taxable Income’,” and then combined the businesses for financial reporting purposes and eliminated the intercompany transactions. The end result revealed a company that exhibited strong earnings, but slowly turning accounts receivable creating a severe strain on cash flow. Moreover, when we compared our numbers to an industry study we obtained from the ambulance association, we discovered that as a percentage of revenues, our direct labor costs were actually lower, not higher than the industry average. At this point, we slammed on the brakes to review exactly what was going on.
Next, and perhaps most amazingly, we did a survey of the labor market and discovered that the company’s wage rates were far below the competition, which explained why the company was having a difficult time attracting and retaining quality employees. And the employees that were left had found ways to get around this by helping each other to abuse the company’s overtime policy. The remedy? We gave the employees an across-the-board pay raise and simultaneously cracked down on overtime abuses, and in the end, everyone came out ahead.
The final outcome of all of this was almost as unbelievable. First we wrote a business plan based on the revised numbers and obtained approval in only two weeks for bank financing totaling $650,000 (after previously having been declined for only $30,000 as stated above). This included a working capital line of credit, and a revolving line of credit to enable the company to purchase vehicles with just a phone call to the bank. We then looked into the accounts receivable turnover issue and discovered a production bottleneck in the billing department, which was quickly addressed and eliminated by bringing in temps to catch up our billing, and then addressing some personnel issues in the billing department.
None of this would have been possible without first correcting the company’s method of accounting and financial reporting. And by the way, the company’s method of reporting for tax purposes was left unchanged.