Larry’s Fairy Godmother Strategies, Inc.Posted on July 23rd, 2016
Outsourced Accounting Department, Inc.
In a recent article, “Larry’s Debt Repayment Strategies, Inc.”, I demonstrated how operating losses, combined with rapid sales growth, can produce a negative cash flow, requiring Larry to borrow on an “asset-based” line of credit in order repay other debt, not a good thing. But there was yet another phenomenon in his cash flow projections that could potentially create an even bigger problem than merely “robbing Peter to pay Paul.”
Note in the below analysis that borrowing under the company’s line of credit resulted in an “Over Advance” situation from months 6 through 11. So what does this mean? It means that the “formula advance” (in this case, 85% of the company’s eligible accounts receivable established by the company’s lender), will not be adequate to fund the company’s total cash requirements during these months. So during this period, the company will likely fall behind with trade creditors, or on loan payments, and possibly may not even meet payroll.
Of course if the lender doesn’t have such formula restrictions on their line, no problem, right? Except for one thing – even if Larry is fortunate enough to find a lender like this (which I call “the greater fool”), when he does get into a cash bind, he’s going to find that his lender is very unsympathetic to his problem. Instead, they’ll blame HIM for their own lax lending policy that helped create the problem in the first place, and then further compound his problems in all of the various ways that lenders do.
So, what is Larry to do? In this case, as indicated below, the company’s “Cash Flow From Operations” is projected to be negative for most of the year, and that’s before its debt service requirements. So in order to keep everyone current and stay afloat, the only alternative Larry really has is to turn to who I call his “fairy godmother,” that being Larry himself. In this case, it means that Larry should postpone paying himself back the funds he has previously lent to the company (see original “Monthly Cash Flow Statement” above, and revised below).
Note that by leaving the owner’s funds in the company, it takes pressure off of the company’s line of credit to support its cash flow requirements, thus leaving more than adequate borrowing availability on the line. This is precisely why lenders often require that the repayment of loans from the shareholder be subordinated to repayment of the lender’s loan – it’s to make sure the business has adequate funds to operate and keep it out of financial trouble.
So the moral of the story is, the next time you think about taking “your” money out of your business and replacing it with bank debt, just remember who its “fairy godmother” is likely to be when it needs money again.
The Difference Between Your CPA and a Controller: “M-1”Posted on July 4th, 2016
Outsourced Accounting Department, Inc.
Most small business owners are conditioned from day one to understand the importance of engaging the services of a CPA or other tax professional. However, what they often do not understand is that they have hired someone to prepare their tax return at year-end, using accounting information they obtained from the client’s books, and then re-entered it into their own tax software for tax purposes.
A major factor in the focus on tax returns is that over the last couple of decades, with deregulation of the banking industry and the emergence of “mega-banks,” banks have moved away from requiring statements prepared in accordance with Generally Accepted Accounting Principles (“GAAP”), and toward requiring tax returns only for smaller commercial loan deals. In effect, these loans are now treated more like consumer loans, which was done mainly to minimize the amount of back-room financial analysis in order to operate more efficiently.
The underwriting justification for the above is that since tax returns are the numbers reported to the IRS and are (usually) prepared by a CPA, they are therefore “reliable.” But the truth is, the CPA firm is only compiling the information from the client’s books; they are not offering any assurances as to the accuracy of the underlying accounting, only that they have put it in the right “bucket” for tax purposes. So in the event of an audit, the burden of proof is still on the business owner, NOT the CPA.
The other potential problem here is threefold:
- The client’s books are often not adjusted so that they are consistent with the “book” income in the M-1 book to tax reconciliation in the year-end tax return, which is where your internal “profit” is reflected in your business tax return.
- And when your books are adjusted by the CPA or tax professional, chances are they are often adjusted to “mirror” the tax return. And as I’ve discussed in previous articles, “Profit vs. Taxable Income,” and “The Difference Your Method of Accounting Can Make #2,” taxable income is not the same thing as profit.
- Further, as discussed in my recent article, “Larry’s Debt Repayment Strategies, Inc.,” “Profit” is what is necessary to pay back a loan.
So, the banking industry has not done small business owners any favors, as they are now under the impression that they must maintain their books for tax purposes. But this is not true. There is a major difference between the role of your outside CPA firm (see Google Review comments from a CPA firm with whom we do business), and how your books should be managed internally by a controller, bookkeeper, or outside bookkeeping firm, and the M-1 adjustment is what gives you the permission to “have it both ways.”