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Whose Income is K-1 Income Anyway, Mine or My Business’?

Posted on October 23rd, 2017

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

A client of ours who is contemplating applying for a mortgage loan to buy a house, recently asked me if their business profit can be considered part of their personal income. My short answer to this question was, “Well, theoretically, yes.” But then it occurred to me how confusing these tax laws are to small business owners, particularly those who are taxed on this income personally, even though they may never have actually received the cash themselves in their personal bank account.

This client like many small businesses, files their business tax return as an 1120-S, “S-Corporation,” wherein their business profit is taxed on their personal tax return. For tax purposes there are several advantages to filing taxes this way (which is a topic for another article). But it certainly does create much confusion for both small business owners and some kinds of lenders.

So, I provided the following clarification to our client:

“To clarify, your profit is treated as income to you on your personal tax return, regardless of whether you actually “distribute” cash to yourselves. Then Cash distributions are reflected on your Cash Flow Statement.  What we do is show the payments you make to yourselves during the year as “loans” from the company to you, and then at the end of the year, reclassify them as “distributions” based on your final profit.

“Some businesses cannot afford to distribute their profit to the owners because it’s needed to finance sales growth (i.e., increased accounts receivable and inventory), pay back business loans, etc., and (knowledgeable) lenders look at these kinds of things.

“In your case, you are not affected by these issues because you receive customer deposits up front which pay your material costs, so you are able to pay distributions to yourself.  But this might have to be explained and proven to the lender depending on the lender you’re talking to.  In a bank, you would want to be dealing with a “business banker.”  If you’re dealing with other kinds of lenders, they may be strictly “consumer” lenders who may not understand business financial statements.”

And once again, there is a huge difference between “business profit” which you look at to evaluate the performance of your business, and what is considered “taxable income” to the IRS.  I’ve written numerous articles about this in our blog. But the really sad thing is, the banking industry today relies heavily on tax returns for their own underwriting convenience. Consequently, many of today’s small business lenders have also lost sight of these important differences, which in my view, has done a disservice to their small business customers.

Related Articles:

Profit vs. Taxable Income

Securing a Small Business Loan: Part I – Establishing the Relationship

Securing a Small Business Loan: Part II – Positioning

Securing a Small Business Loan: Part III – The Application

 

 


The Ratios: Which are the Most Important?

Posted on October 9th, 2017

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

Of course, the short answer to this question is, “they all are.” But there are a couple of calculations I like to look at most, because they capture just about everything else.

The first ratio I like to look at is “Debt Service Coverage.”  Although not all businesses have debt obligations, a common reason for outsiders to request financial statements is to determine how much debt a business can afford to repay. This in turn is first a function of the company’s profitability, as loan payments ultimately must be paid from the company’s cash flow from operations, of which “profit” is a critical component. There are several ways of calculating Debt Service Coverage, but a commonly used formula is as follows:

Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”)
Total Principal + Interest Payments

So based on the above formula for instance, if a company’s Debt Service Coverage Ratio is less than 1:1, say due to the fact that it is incurring (accrual) operating losses, it’s an indication that the company cannot repay its debt obligations out of internally generated operating cash flow (and therefore a reason for its loan request to be denied).

Then taking this a step further, another measure I like to look at is Net Working Capital,  or more precisely, the changes to net working capital from accounting period to accounting period. Although we’re talking here about the company’s current assets and liabilities, an important concept that must be recognized, is that what actually causes a change in Net Working Capital, are changes in the company’s fixed and non-current assets, and its long-term liabilities.

Using the breakeven scenario from one of my recent articles (“What is My Monthly Breakeven Point of Sales?”), this mathematical phenomenon is illustrated below:

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The above type of analysis is often shown in audited and reviewed financial statements (which unfortunately these days, small business owners never see as banks are now relying more heavily on tax returns.  But to me, this type of analysis is extremely valuable as it captures the effects on working capital of all of the other financial indicators in one place that I’ve written about, including: profitability and profit margins; growth funding; liquidity and turnover ratios; debt service coverage; and, funds management (i.e., the matching of sources and uses of funds).

For purposes of this article, I have rearranged the traditional format a little to make more clear what’s happening in terms of the sources and uses of funds.  Note how the changes in fixed and long-term sources of working capital are included in the analysis of the working capital components as either a “source” or a “use” of funds.  (Usually, these are shown as a net change at the bottom.)

The point is, in this example, one can more clearly see how operating losses, or any of the other above fixed and long-term financial activities, have a major impact on the business’ short-term working capital position, and possibly as a result, the owner’s personal cash position.

 

Related Articles:

Profit vs. Cash Flow Revisited: “The Matching Principle”

Analyzing the Components of Cash Flow

Larry’s Debt Repayment Strategies, Inc.

The Effect of Sales Growth on Cash Flow

The Relationship Between Turnover Ratios and Cash Flow

 

 


Profit vs. Cash Flow Revisited: “The Matching Principle”

Posted on October 1st, 2017

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

In two of my previous articles, “Profit vs. Taxable Income,” “Profit and Cash Flow Made Easy,” I explained the difference between Profit and Cash Flow.  However, from time to time I find that some clients still have difficulty in grasping this concept of accrual accounting.

In a nutshell, accrual accounting has to do with the “Matching Principle” of accounting, as further explained in this article from the Accounting Coach: “What is the Matching Principle?.” Simply stated, accrual accounting involves the matching of revenues and their related costs within the same accounting period (i.e., a month), NOT for instance, when materials are purchased in one month and customer payments are received in another. The first scenario tells you your profit, the second tells you your cash flow.

An awareness of the above differences is critical to understanding your business’ operating performance.  For instance, assume your cash flow seems very tight.  What is the most appropriate corrective action?  Is the solution to cut expenses, or, is it to improve turnover of accounts receivable or inventory?  Understanding these differences also affects your ability to accurately plan your company’s future profitability, and the funding required to support future growth.  In other words, understanding these differences is critical to your company’s very survival.

Related Articles:

The Effect of Sales Growth on Cash Flow

The Relationship Between Turnover Ratios and Cash Flow

What is My Breakeven Point of Sales?

Financial Planning, or Business Turnaround – Your Choice