Solving the Mystery of Financial Statements

Business owners often limit their examination of financial statements to a single report. They rely solely on a statement of incoming revenue and paid expenses, commonly known as the profit and loss report, or P&L.

Making the best decisions for a business, however, depends on recognizing the limits of P&L evaluation. Many vital numbers depend on the type of P&L you obtain as well as other complementary financial information.

Accruing Information

Some businesses operate on a cash basis. Customers pay at the time a sale is made. But many enterprises invoice for services and are paid at a future date. The true output for your business is the amount invoiced. The P&L you want, therefore, is accrual basis, which shows the total invoiced sales. And it will have the accrued but unpaid bills for expenses. Conversely, a cash basis P&L only shows the expenses already paid.

An accrual basis P&L reveals how effectively your time was deployed to realize a profit. The obvious number is the bottom-line profit that represents the amount by which revenue exceeds expenses. A few key ratios will unlock the context of the profit figure.

The most helpful profitability ratios depend on your industry. Some businesses depend mostly on personnel for their output. These businesses should measure profit as a percentage of employee hours. Other enterprises are primarily impacted by the quantity and type of equipment. They should determine the profit as a percentage of capital investment in fixed assets.

Comparing these ratios for various periods conveys the trend in business profitability. You will find out if working more hours or an investment in new equipment is delivering the improved results you expected. Be sure to consider seasonal factors. Contrasting your ratios from recent months to the same period in prior years is usually the best process.

Cashing In

The detail you’re missing, however, when examining the accrual basis P&L, is the cash impact of your operations. The companion of the accrual basis P&L is a cash flow statement. This report adjusts your accrued profit by showing changes that affect business cash. The cash flow statement is crucial to identifying how easily your business can pay its bills in the near term. A growth trajectory is nice to see on the accrual basis P&L, but it can trigger a cash constraint. Your business must pay its bills on time, even if your customers are late in paying your business.

Cash flow will be negative if you recently acquired new customers who are slow in paying your invoices, while you have paid the costs to acquire and serve those customers.

Your business cash flow may also be negative if you recently invested in new equipment. Eventually, these expansion efforts should pay off with rising cash flow. You merely need assurance that your company has enough cash to sustain a period of negative cash flow. Fortunately, cash flow statements tell you the amount of negative cash flow, and indicate when the trend is turning positive.

Use these financial statements to monitor and maintain healthy growth for your business.

If you need assistance, a financial professional can walk you through how to set these up and use them to foster ongoing business success.

Three Expenses to Examine to Eliminate Wasteful Spending

Are you spending more than you have to? Unnecessary expenditures chip away at your profit margin. Keep a close eye on the following three areas to control overhead costs and boost your bottom line.

1. Office Space: Rent is expensive. Selecting the right location and amount of space is very important. For example, although a retail business benefits from a visible site on a main boulevard, the owner doesn’t need a large private office. Some enterprises don’t need any space at all. Many small operations have only personnel who work remotely. Keep in mind, if you don’t meet clientele at your office, an expensive location on a main avenue is unnecessary.

2. Staff: Even if a freelancer costs a bit more per hour than an employee, you may still save money. Employees are paid regularly regardless of how much work has been assigned to them. Freelancers are only compensated when your business needs them. For routine daily matters, employees are the answer. But a company can manage with freelancers to perform special projects for customers or to complete multiple nonrecurring tasks. Moreover, you have to provide employees with supplies, office space, and equipment, as well as administer payroll taxes. Not so with freelancers.

3. Non-Essential Services: Knowing the difference between DIY roles and outsourcing is vital. If you have the time to clean your office, for example, you don’t need a janitorial service. An extended service contract isn’t needed for things you can fix yourself. But don’t jeopardize your future merely to cut short-term costs. You may, for instance, be capable of troubleshooting a problem with your internet router, but tackling unfamiliar territory like preparing financial statements or income tax returns is best left to finance professionals.

How to Separate Business and Personal Finances

The two biggest hassles for most entrepreneurs are accounting for expenses and paying taxes. It’s not a coincidence that these things are inextricably linked. Business expenses lower your taxable profit.

Failure to capture all your business expenses results in overestimating your profit and overpaying income tax. But mixing personal expenditures with your legitimate business costs creates bookkeeping confusion and may trigger scrutiny from the tax authorities.

The fact is, not all business purchases are paid from the company checking account. You likely use a personal credit card and spend some cash. Especially complicated is adding to your bookkeeping a home office or business use of a personal vehicle.

Adhering to specific accounting procedures ensures you take the correct tax deductions for using personal funds or credit cards for business costs, as well as for contributing personal items to the business. Use the following principles to guide your accounting practices.

You Are Not the Business

Think of your business as something separate from yourself. In fact, this is exactly the legal structure if your business is a corporation or partnership, or an LLC treated as one of these entities for tax purposes. When you spend money on your credit card for business, simply turn in the receipts for reimbursement by the company. Of course, the business doesn’t need to actually reimburse you as it would an employee. Since you’re the owner, these personally paid items count as capital contributed to the enterprise.

Personal cash used for business must be accounted for by promptly providing receipts for reimbursement or, rather, capital contributions. Holding these for too long is a mistake because they could be misplaced. Or you might not remember what exactly was purchased, which means the expenses cannot be properly recorded in the correct bookkeeping category.

An even better practice is having a dedicated credit card for business purchases. Remember, just because you have a card for your business doesn’t mean everything you buy is a tax-deductible expense. Personal uses of the dedicated business credit card become capital distributions from the business. These make your company poorer. You don’t want an investment in a business that’s losing wealth.

Things for You and the Business

Special tax rules apply to business use of your personal vehicle or home. Don’t expect reimbursement or capital contribution credit for all your gasoline purchases simply because you drove around for business.

Actually, you may be cheating yourself out of a larger tax deduction by not having the crucial record of business miles driven. Fuel is only one of the expenses considered when using the standard reimbursement rate established each year for business miles driven.

Home offices may or may not be tax-deductible expenses, depending on several circumstances. Track your home expenses separately from business costs. A calculation is made at year-end based on those amounts and the percentage of your home used regularly and exclusively for business.

Lastly, when you make a major business purchase with personal funds, especially if money is borrowed, advice from your tax accountant is vital. The entire cost, along with any loan, must be recorded in your bookkeeping records. Also, the accounting for tax purposes is very precise when you acquire some things that are used both professionally and personally.

Building an Emergency Fund for Your Business

Every business needs a rainy-day fund, but a commitment to action for accomplishing this objective is often elusive. Waiting to see how much money is left for your virtual piggy bank after paying all the bills is not a viable solution. There’s never enough unless you take steps to control spending.

An effective method to build a cash reserve is to make a place in your budget for the emergency fund as if it were another vendor bill. Adding this cost of doing business may seem impossible at first. But close examination of your recent spending categories is certain to reveal some areas for expense reduction.

Look at the trends in your business spending. Are some types of expenses rising? Buying more is common when a business starts generating a little more revenue. Finding your previous spending level and returning to it merely requires inspection of historical expenses. Perhaps your vendors’ prices have increased. This is an opportunity to negotiate volume discounts, find different vendors, or raise your own prices.

Most important of all in creating an emergency fund is putting aside the additional income you make from an extraordinarily profitable month or period of the year. Completing a particularly large project or seasonal phase means you have more cash to retain for future lean periods.

Keeping a separate bank account is usually best to avoid the temptation of extra spending. This same account functions as a place for those ongoing deposits of small fixed amounts every month until the inevitable disaster strikes. When it does, your rainy-day account provides the perfect protection.

No Accounting Degree? No Problem

Small-business owners don’t need an accounting or financial background to use a few key numbers to help their company thrive.

To keep the business on the right path for ongoing success, entrepreneurs should regularly examine central measures in their company’s financial reports. This basic information can transform routine operations into productive actions.

This review begins with an assessment of overall profit trends as well as an examination of the profitability of specific products or projects. To do this, you must first ensure that the data being reviewed is providing useful and accurate information.

Keep in mind that you don’t have to be a numbers person to recognize whether you have solid financial reports. But before you can review what your figures convey, they must be understandable. If your bookkeeping procedures and formats are off track, evaluating them won’t help. If your books need a bit of organization, start with classifications.

Classify for Clarity

Your bookkeeper needs sufficient information to properly categorize all expenditures and revenue. Expense accounts should be grouped in a fashion that makes sense to you. You may want to generate reports by classification for various projects or product lines. This requires clearly identifying the classes for all amounts spent or earned. Some types of businesses may have recurring projects for ongoing clients. If you’re one of these, each client may be a classification.

Having the right classification system and the procedures for providing category information to your bookkeeper allows you to create functional income statements. Examine the report by class to ensure that all sales have been properly classified. Confirm that all expenses are appropriately applied to the correct classes.

Now you can easily identify the profitability of projects, product lines, or specific clients. Better yet, you can generate an income statement that compares the period that recently ended with the same period a month ago or a year ago. This gives you the opportunity to quickly see trends in revenue categories and types of spending.

Balance for Better Business

Accurate bookkeeping relies on double-entry accounting. This is a system where every increase in cash is the result of a balanced increase in either debt or profit (from adding revenue). Every decrease in cash is triggered by either a decrease in debt or less profit (due to an expense). The only exception is that some cash decreases may add a different type of asset other than money, such as equipment or other property.

Regardless of what classification applies to incoming or outgoing cash, your bank account is always impacted. Making sure you’ve captured all bank transactions is simply a matter of reconciling your bookkeeping with your bank statements. Asking your bookkeeper for this reconciliation report ensures that all transactions are recorded and reconciled.

The company balance sheet is therefore an important report to inspect. This is the summary of your assets balanced against your liabilities owed and your business capital. The latter includes your investments plus cumulative profits you have not taken out of the business.

Obviously, your aim is to keep enough cash and incoming receivables to cover upcoming bills owed. And don’t let debt vastly overtake capital.

This ongoing evaluation of financial statements will provide the foundation needed to build a solid business that consistently delivers outstanding products and services.

How to Account for Renovated Business Space

When small businesses lease office or retail space, unusual bookkeeping measures are inevitable. Additions or changes to rented space create unfamiliar accounting situations. Untangling the tax treatment for these scenarios typically triggers a cascade of questions regarding improvements, depreciation, and repairs.

Improvements: The tenant, rather than the landlord, generally pays for customization of rented space. As a tenant, you cannot designate your cost for changes to rented property as an expense. Rather, the amount spent appears on the balance sheet in an asset account called “Leasehold Improvements.” These include structural modifications such as adding walls or plumbing. The costs are depreciated over time.

Depreciation: Each element of improvement should be separately identified along with its cost. Depreciation periods vary depending on whether the improvement is floor covering, part of the building structure, or an appliance attached to the building. In most cases, the depreciation recorded for company bookkeeping is the same as the standardized amount established under tax law. When you move prior to the end of a tax-allowable period, the not-yet-depreciated improvement costs are written off upon abandonment.

Repairs: Minor repairs and maintenance are exceptions to depreciation as leasehold improvements. You may expense the cost to fix a floor tile or paint a room. Routine maintenance that makes the building fit to occupy counts as an expense on the income statement of your business, but a landlord will often pay for these measures. In addition, when the landlord pays for some of the tenant finish-out, that part of the leasehold improvements cost isn’t counted as a depreciable cost for your business.

Financing a Purchase? Follow These Accounting Basics

Accounting for financed asset purchases is likely the most complicated bookkeeping procedure to untangle.

Where should you start? To avoid missing vital details in your books, you must record the entire cost of an asset, including the part you pay in the future as loan payments. This allows you to deduct asset costs appropriately and sidestep future errors when recording loan payments.

Use the following procedures to keep your books in order.

Lingering Liability

Loan payments do not belong on your Income Statement, which includes revenue and expenses. Repayment of loan principal applies to a liability on the Balance Sheet. Only the interest portion of a loan payment is recorded on the Income Statement as an expense.

For this structure to function correctly, the loan liability must appear on the Balance Sheet when the money is initially borrowed. Without this element, you have no Balance Sheet liability to reduce as the loan principal is repaid.

Judicious accounting of your loan payments ensures that the liability account on your business Balance Sheet precisely matches the lender’s record of what you owe. Periodically reconciling the loan balance on your books to a report from the lender is as essential as reconciling your checking account balance to a monthly statement from the bank.

Capitalized Curiosities

Most costs of doing business are recorded as expenses on the Income Statement. However, a capitalized cost is a special exception.

Capitalized costs are assets such as equipment, furniture, machinery, buildings, and improvements to rented business space. Some of these items, however, may cost so little that they are accounted for as expenses. Rely on your tax accountant to determine the cost threshold that requires you to capitalize a purchase.

Capitalized costs are recorded in an account on the Balance Sheet. The amount spent is deducted over time as depreciation. When this happens, your financial statements simultaneously document depreciation expense on the Income Statement and a reduction of capital costs on the Balance Sheet.

Financing Formalities

Cash that leaves the business bank account for a purchase is recorded as either an expense on the Income Statement or a capitalized asset on the Balance Sheet. Accounting software automatically deploys this double-entry process.

Since capitalized costs are typically larger than ordinary expenses, their purchase often involves borrowed money. Funding from a lender must be identified along with the amount spent by the business. Paying a capitalized cost with borrowed money does not change the amount paid for the asset. You depreciate the total cost, regardless of how much company cash is spent at the time of purchase.

Journal entries are used with computer bookkeeping programs to record the full cost for a capitalized asset along with the borrowed part of that purchase, which creates a new liability. Consequently, business owners must provide bookkeepers with all the information about the cost for an asset purchase and any loans incurred to buy it. This will allow for accurate accounting of your financed purchase.

Fact or Fiction? Small-Business Myths Debunked

Not all advice is good advice. To succeed, entrepreneurs must discern what counsel is sound and what is pure fiction. Following are three of the most common myths that can lead small-business owners astray.

Tax myth: Topping the list of management mythology is the notion of increased spending to reduce taxes. It’s true that the timing of expenditures sometimes yields beneficial tax consequences. But this does not mean that unnecessary costs are a good idea simply because they’re tax deductible. Especially disastrous is borrowing to pay for things that don’t add to business productivity. Burning $1,000 to obtain a $300 tax deduction simply results in a $700 net cost.

Image myth: Some people encourage frivolous spending on things the customers never see. For instance, retail stores need visible locations with plenty of parking, but a fancy office suite will not impress clients who interact with a business remotely. In addition, despite the importance of reliable transportation to jobsites or a decent car for client meetings, frequent upgrading to the latest model is wasteful. Remember, image cannot replace performance.

Payroll myth: Perhaps the most important myth to dispel is that you should always reinvest in your business before paying yourself. Instead, focus on operating a profitable business. If you have invested the right amount to launch the enterprise, it should provide some amount of compensation for your work. Always plan to pay yourself something first and expand with what’s left. If you aren’t getting paid for running a profitable operation, you’re only reinvesting in an unprofitable endeavor.

Managing Your Margin with Changing Costs

Successful operation of a small business hinges on managing two types of expenses: fixed and variable. As the names imply, fixed expenses are stable amounts that must be paid routinely. Variable expenses, on the other hand, constantly change depending on your sales. Here’s what you need to know about both:

Fixed Expenses

You have to pay fixed costs regardless of your revenue. For instance, telephone and internet are essential business costs. Bills for these expenses are paid even if you have no revenue for the month. Rent and payroll are other common fixed expenses for a small business. Every entrepreneur should also plan for some amount of recurring personal compensation. You don’t want to run your business without reward for your effort!

Variable Expenses

Controlling variable expenses is key to constructing a workable design for business success. Why? The management of these costs is necessary to fund your recurring fixed expenses.

Typically, variable costs should rise when revenue increases and decline when revenue decreases. The obvious category to examine for these trends is the costs of goods sold on your income statement. Examples of these variable inputs are materials, parts, and components necessary to complete business sales.

These variables directly impact your gross profit margin (revenue minus cost, divided by revenue). The goal should be to maintain a constant gross profit margin by properly managing your expenses. To do this, you must ensure that variable expenses rise and fall in step with revenue, so your costs don’t throw off the equation.

Semi-Variable Challenges

Of course, maintaining steady expenses can be challenging when costs are variable by nature. And in some cases, the expenses are semi-variable.

Labor is the main expense that falls into this category. While direct labor related to customer interaction is typically variable, general office personnel may be needed regardless of sales volume, and administrative wages are almost always a fixed cost.

General overhead expenses can also shift from fixed to variable. For example, you might choose to spend more on marketing and advertising if sales take a downturn. You may also divert some of your direct labor from other projects to beef up marketing efforts.

Market prices may also change, taking control of costs out of your hands and limiting your spending decisions. Entrepreneurs must adjust to changes in cost of materials and labor as they occur. The obvious course of action is to increase or decrease sales prices in response to new costs.

Eye on the Margin

Accounting for all these fluctuations is crucial to identifying optimal use of your resources. Remember, revenue minus variable costs is what’s left to pay for fixed expenses. You must know which expense categories are genuinely changing with shifts in revenue in order to effectively monitor costs and make necessary adjustments.

This will allow you to calculate a modified gross profit margin that provides a realistic look at your finances. You can multiply this gross profit margin by your expected revenue to calculate how much you will have to pay fixed expenses and how much will be left over to grow your business.

A financial professional can help you navigate these numbers and suggest steps to further the success of your company.

How Much Is Enough? 3 Keys to Pricing Strategy

Pricing strategy is a major consideration when launching operations, and it’s also an ongoing challenge for small-business management. Numerous factors are at play when setting a price for a new offering or adjusting prices for existing lines of business. To meet pricing challenges, focus on three key areas.

1. Efficiency: Business success is dependent on more than simply selling superior products or services. You must provide something that represents the best value. This means delivering what you offer in the best possible and least costly ways. It means taking steps to make prices fair to both you and the customer. The first step is to make a careful assessment of internal business processes. Could you improve the efficiency of your procedures? Be sure to look at general business functions that don’t directly affect customers. Having cost-effective organizational methods ensures a focus on output quality and customer service.

2. Costs: Fixed and variable costs directly affect pricing. Identify these costs and consider the costs incurred for each sale or service. Manufacturers must look at the cost for producing a number of units. Service businesses must consider labor expenses for the time needed to complete a project. Derived from these calculations is a price per unit/service that covers both production costs and overhead expenses.

3. Competition: What are others charging for similar products and services? Comparing your determined price to the prices charged by competitors is essential. If you decide that you offer something extra or distinctive, keep in mind that customers must perceive your added value to justify a higher price than your competition.