Small Businesses Need Risk Assessments, Too

Mitigating small-business risks essentially entails making judgments founded on the best information. Because guaranteed security is never possible for an entrepreneur, effective management of risk should be your most important goal. Therefore, you will need to adopt a system that delivers the information necessary to drive sound actions that will minimize your risk.

Informed decisions are required at small enterprises as well as in large organizations. Even though you’re a one-person operation, you can still create a basic risk assessment system. Some risks are intangible, such as harm to reputation or brand. But many can be measured quantitatively. Risk management planning focuses on avoiding the tangible risks that can imperil the functioning of your business.

Types of risk

Determining whether your financial house is built on sand or rock begins by considering the types of risks your business is exposed to.

Topping the list of risk variables to consider is your company’s current financial situation. Have a system for maintaining contemporaneous financial data that you compare to targeted projections. Know your trends for sales and profit margins, and identify the causes of fluctuations to determine if there are any red flags that could potentially trigger a business crisis.

When taking on an expansion or a new opportunity, always determine the expected risks relative to the rewards. Growth requires capital, which often means taking on debt. Compare the borrowing costs – in addition to the increased expenditures for growth initiatives – to anticipated future benefits.

What can’t be controlled are external risks, such as market conditions and industry trends. If a quantitative financial assessment reveals adverse results, the culprits could be these external risks. Although they’re beyond your control, you can still position your business for the new conditions with revised cash flow projections.

Conducting a risk assessment

Reduce the complexity of risk assessment planning by considering some basic questions. Begin by determining the direct as well as indirect risks imposed by a new project, new customer, new product, or new strategy. Next, consider the possible adverse consequences and how serious these consequences could be; know the extent of your worst-case scenario. Only you can decide what amount of risk is right for your business.

After assessing potential consequences and the financial effect they would have on your business, develop countermeasures to protect your vulnerable spots. The main element of a risk assessment plan is what to do when any potential threat morphs into a problem that could seriously impact your business. Ensure that you have action plans ready for each risk, should it become a reality.

Solid financial data is critical to risk oversight

Finally, risk management hinges on knowing in advance when one of these potential threats is about to become a danger. In risk oversight, it’s accurate, up-to-date financial data that will give you this heads-up. There’s no substitute for reliable real-time financial statements and your ability to interpret them. In doing so, you can be vigilant in evaluating risks so that your business thrives rather than topples.

Good News: You Can Survive a Temporary Cash Crunch

Bad news: you’ve been hit with a surprisingly high tax bill this year. Good news: That means profits were higher than expected!

More bad news: The cash drain after paying the taxman may have triggered a cash crunch. More good news: Several mechanisms exist for surviving this temporary crunch.

In this scenario, the solution starts with a well-crafted cash flow projection. The forecast quantifies the impact of your survival measures.

Predict how new initiatives alter your cash flow: Making cuts in operating expenses is the first tool in the entrepreneur’s kit. But don’t engage in a broad slash-and-burn strategy. Make prudent reductions that don’t cripple ongoing sales and service. A key area for saving precious cash is delaying capital expenditures, such as new equipment or upgrades to existing machinery.

Evaluate accounts receivable and inventory: When money conditions are tight, this step is vital. Needed cash can be generated by offering discounts to customers for paying early or by selling excess inventory at reduced prices.

Make sure these are limited-time offers rather than permanent changes to your business policy. And convey the message that you’re offering rewards to customers, not that you’re experiencing cash flow difficulties.

Examine the liability side of operations: Look into restructuring debt with lower monthly payments. Ask for concessions – such as extended payment terms – from vendors. Communicating frankly with creditors is the best way to show that you value the continuing relationship and want to assure them that they will be paid. This is the good news they want to hear.

When Repairs Are Not Expenses ….

Bookkeeping that records every payment for property repairs as an expense is just so much fiction. Cash outflow isn’t always found on the business income statement – also known as the profit and loss statement. In fact, it’s the balance sheet that reveals whether money was directed to decreasing debt or increasing assets.

Expenditures for so-called capital goods appear on the balance sheet as fixed assets. These items – such as equipment and buildings – are different from ordinary operating expenses on the income statement.

But “capital goods” can also include repairs to existing fixed assets. The cost for these expenditures is depreciated over time rather than immediately appearing as an expense on the profit and loss statement.

Small-business operators are frequently faced with deciding whether a cost is a repair expense or a depreciable capital expenditure. And this can prove a sizable burden.

Repairs

Improvements to existing fixed assets constitute a new capital expenditure when the cost is sufficiently high for capitalizing and the improvements extend the useful life or functionality of the fixed asset. These are distinguished from repair expenses, which constitute minor alterations. Capital improvements are generally structural – such as a new roof for a building. More cosmetic costs – like painting – are expensed as repairs.

Distinguishing between a repair and a capital improvement is complex. Tax authorities have released some general guidelines to help. A capital improvement is an expenditure for the “betterment,” “adaptation,” or “restoration” (B.A.R.) of the property. Determining whether any of these conditions applies requires comparing the condition of the property when it was purchased – or when the last work on it was performed – to its condition after the new expenditures.

Detailing B.A.R.

“Betterment” ameliorates a deficient condition in property and adds to a property’s capacity, size, or quality. “Adaptation” changes a property to a new use that’s different from the original, and “restoration” returns property to its efficient operating condition. “Restoration” also applies to any major component of a property that contributes to the property’s substantive function, which can make identifying a capital improvement tricky. It means, for example, that replacing the motor necessary for a machine to run properly is a capital expenditure, even though the entire machine is not being replaced. Work performed on smaller assets – such as machinery – is commonly a capital expenditure. A component critical to the usefulness of equipment is very likely a capital improvement when replaced – unless the cost is minimal.

Large properties – like buildings – are more likely to incur repair expenses. Tax rules require dividing a building into multiple property units; the entire building is not a singular property, but rather each system in the building is considered separately. So replacing the air conditioning compressor might be a depreciable capital improvement, since the ventilation system is viewed as a distinct property unit.

Uncovering whether expenditures are repairs or capital improvements isn’t easy. The best way is to consult a tax expert when these costs are incurred so that purchases are correctly recorded.

Financial Advice to Avoid on the Road to Success

Be wise when seeking financial guidance. There’s a massive amount of advice out there, and some of it may lead unwary business owners off track instead of setting them on the road to success. Here’s some advice to avoid:

Raising money without a goal: One suggestion deserving of the dustbin is money-raising with no goal in sight. Money is a means to an end; save your money-raising efforts for specific expenditures.

Spend to make: Likewise, disregard the suggestion that you must spend money to make money. This may be true in the short term, but habitually spending big is likely to land you in trouble in the long run. Operating on a tight, well-designed budget forces you to make efficient choices and innovate rather than throw money at your difficulties.

Multiyear projections: Then there’s the advice on preparing multiyear financial projections. Because small business operations tend to be unpredictable beyond next year, projecting too far into the future wastes time.

Bigger is better: Perhaps the most important advice to ignore is that by charging lower prices than competitors, you can build a large organization and make more money. But a low-price strategy results in low profit margins, and only very high-volume enterprises can function successfully on low margins.

Small businesses are generally successful at serving niche markets rather than tackling larger markets (and more competition). There’s no rule that says you must be big to be highly profitable.

Your best way to avoid bad advice? Trust your accounting pro to steer you in the right direction.

Determining the Value of Large Expenditures

Whether your enterprise will thrive or struggle often hinges on decisions surrounding large expenditures. An owner’s purchase of an asset – such as equipment that will be functional for many years – typically entails a substantial sum of money.

These types of long-term assets are referred to as “capital expenditures.” They are not recorded as expenses on the income statement. Rather, they appear as assets on the balance sheet. Determining whether the cost for a capital expenditure is worthwhile necessitates a capital budgeting analysis to assure efficient allocation of resources.

Does it make sense

Your capital budgeting process begins with a ranking of large purchases in order of priority. This is how you decide when projects will be undertaken and how much capital is needed to accomplish them. Although some capital expenditures are urgently required to maintain operations, discretionary purchases are generally ranked based on their profitability.

Several methods are available for evaluating profitability of capitalized purchases. The most common ones – those followed by sophisticated business managers – are “net present value” and “internal rate of return.” Both processes consider cash flow over the entire length of a project and discount future cash flow to reflect the time value of money.

These methodologies contrast with the simplified payback model, which measures the amount of time required for recouping an investment. This non-discounted approach unrealistically regards future dollars as having the same value as current dollars.

Failure to consider profitability over the long term is another drawback to the payback model. A fast payback ultimately might not generate much profit, while a slow payback could disguise a vastly profitable undertaking over the life of the investment.

Quantifying the benefit

Discounted cash flow models are frequently used to identify the current value of a major purchase. The net present value method estimates all the future cash inflows and outflows. For example, cash inflow is the revenue expected from investing in a new piece of equipment, and cash outflow is the cost to purchase, maintain, and operate the equipment for generating that revenue.

The net cash flow over future periods is then discounted to a present value. Financial calculators and printed present value tables show the amount of value today that’s equivalent to future incoming cash. This is accomplished by assuming a discount rate reflecting the greater quantity of money we would accept in future to bring us the same happiness as would a lower sum today.

A positive net present value indicates the equipment will earn more than the discount rate. But even if the figure is negative, the equipment may still provide profitability (although likely not as much as avoiding the purchase and holding onto the money for the future). You can identify the rate of return for an investment by finding a discount rate that arrives at a net present value equal to zero. This internal rate of return determination is helpful for ranking expenditures in order of importance.

Confusing? Contact your accountant to help you understand how to value your capital expenditures.

Business Credit Cards Help Record Company Purchases Accurately

The system used by a small business owner to record credit card purchases is a measure of whether the entrepreneur is efficiently tracking expenditures or living under a pile of unfiled receipts. A credit card dedicated solely to business use is the definitive solution, and a reason why the more efficient tracker is successful.

You can establish a credit card account for your business with accounting software. Charges are recorded like checks drawn on a bank account; each charge entry automatically creates a liability on the company balance sheet for credit card payable. This credit card liability is therefore owed by the business. Note: be sure to categorize personal expenditures on the card as “owner distributions.”

You can reduce the incidence of errors by assuring that payment of the credit card bill applies to the liability account. Simply writing a check for an expense category called “credit card payments” is incorrect. The expenses are already recorded when each credit card charge is entered. Enter all credit card charges so the sum appears in the balance sheet liability account for credit card payable. Then apply payments sent to the credit card issuer to that liability account.

If you use a credit card for some business purchases but mainly for personal expenses, don’t create a credit card liability account for the business. Instead, have the business reimburse you and record the expense categories being reimbursed as if the company had paid them directly. Then pay the credit card bill with personal funds. And come out from under those piled-up receipts.

Monitor Your KPIs at Least Twice a Year

The midyear financial assessment is a common practice among entrepreneurs who have successfully navigated both the ups and downs of their small business. They know that regularly assessing accounting measures will validate management decisions and uncover areas for improvement.

Fortunately, evaluating your financial data isn’t difficult when you know where to find the numbers that are crucial to your own small business.

The key performance indicators (KPIs) you will need to monitor reflect the nature of your operation: does your success depend on increasing sales, maintaining profit margin, collecting accounts receivable in a timely manner, or turning over inventory promptly?

Knowing the ratios that measure these factors allows you to make informed decisions throughout the year. And by watching these ratio trends, you’ll avoid being blindsided by circumstances that could have been foreseen – and prevented.

Reviewing revenue

The rate of sales growth is especially vital in a young enterprise. Greater sales volume is needed to ensure your resources are fully utilized. Measuring the sales increase in a recent period – such as sales in a calendar quarter compared with those in the previous quarter – is the first step.

Then compare that rate of increase against the rate measured in earlier periods. Eventually, revenue will flatline, as all your resources are being utilized to their full capacity. Until then, you’ll want to maintain your growth rate or find out why it has slowed. Later, the addition of more resources – such as staff – may be required to accommodate continued growth. As sales increase, profits should keep pace. Ideally, your profits should rise at a rate that is the same as or higher than that of your revenue.

Identifying inventory

Inventory turnover of items acquired for resale is an often overlooked but important measure. From the balance sheet, identify the cost of inventory currently on hand, and divide that figure by the cost of inventory sold in a recent period, which is found on the income statement. This is the inventory turnover.

For a clearer picture, multiply inventory turnover by the number of days in that period. This yields the number of days’ worth of inventory you have on hand based on recent sales. In this calculation, you will be looking for low numbers as an indication that your cash management process is unfolding as it should; you should have only sufficient money tied up in inventory as is required to meet upcoming sales.

Referencing receivables

The process of invoicing your customers after a sale doesn’t generate cash flow; the payment must be received. Meanwhile, the business has bills to pay. By measuring the accounts receivable turnover, you can determine whether the collections process is functioning in a timely way. Do this by dividing the current accounts receivable on the balance sheet by sales from a recent period from the income statement.

Then multiply receivables turnover by the number of days in the period to find the average number of days customers take to pay your invoices. When this number is consistent or diminishing over time, it’s a sign your cash flow management system is effective.

Details Matter in Tax Accounting for an Asset Sale

There are so many variables surrounding the sale of a business asset that it can be confusing.

Money received from the sale is only one element in the transaction; it’s not simply added to income as if you were selling a small item that was categorized as an expense when originally acquired. The cost of a fixed asset, such as equipment or a vehicle, is expensed over time as depreciation.

Understanding how this difference appears in financial statements helps you identify the underlying details for your tax accountant when the asset is sold.

The original cost for a fixed asset and the part of that cost already expensed as depreciation over time form an interlocking network with the sale proceeds. The difference between the asset’s cost and its accumulated depreciation is carried on the balance sheet as a net book value. A sale price that’s greater or less than book value is recorded as either a gain or a loss.

Book value is what the business is giving up in the sale. The asset’s original cost and accumulated depreciation are moved from the balance sheet to the income statement as a cost of sale.

The selling price is recorded on the income statement as sale proceeds. Both the cost and proceeds typically appear in the same account as gain or loss; however, your tax accountant needs both figures for accurate reporting.

Finally, repaying the asset’s loan doesn’t impact the gain or loss; it affects the amount of the sale price received as debt reduction rather than as cash.

Monitor Your KPIs at Least Twice a Year

The midyear financial assessment is a common practice among entrepreneurs who have successfully navigated both the ups and downs of their small business. They know that regularly assessing accounting measures will validate management decisions and uncover areas for improvement.

Fortunately, evaluating your financial data isn’t difficult when you know where to find the numbers that are crucial to your own small business.

The key performance indicators (KPIs) you will need to monitor reflect the nature of your operation: does your success depend on increasing sales, maintaining profit margin, collecting accounts receivable in a timely manner, or turning over inventory promptly?

Knowing the ratios that measure these factors allows you to make informed decisions throughout the year. And by watching these ratio trends, you’ll avoid being blindsided by circumstances that could have been foreseen – and prevented.

Reviewing revenue

The rate of sales growth is especially vital in a young enterprise. Greater sales volume is needed to ensure your resources are fully utilized. Measuring the sales increase in a recent period – such as sales in a calendar quarter compared with those in the previous quarter – is the first step.

Then compare that rate of increase against the rate measured in earlier periods. Eventually, revenue will flatline, as all your resources are being utilized to their full capacity. Until then, you’ll want to maintain your growth rate or find out why it has slowed. Later, the addition of more resources – such as staff – may be required to accommodate continued growth. As sales increase, profits should keep pace. Ideally, your profits should rise at a rate that is the same as or higher than that of your revenue.

Identifying inventory

Inventory turnover of items acquired for resale is an often overlooked but important measure. From the balance sheet, identify the cost of inventory currently on hand, and divide that figure by the cost of inventory sold in a recent period, which is found on the income statement. This is the inventory turnover.

For a clearer picture, multiply inventory turnover by the number of days in that period. This yields the number of days’ worth of inventory you have on hand based on recent sales. In this calculation, you will be looking for low numbers as an indication that your cash management process is unfolding as it should; you should have only sufficient money tied up in inventory as is required to meet upcoming sales.

Referencing receivables

The process of invoicing your customers after a sale doesn’t generate cash flow; the payment must be received. Meanwhile, the business has bills to pay. By measuring the accounts receivable turnover, you can determine whether the collections process is functioning in a timely way. Do this by dividing the current accounts receivable on the balance sheet by sales from a recent period from the income statement.

Then multiply receivables turnover by the number of days in the period to find the average number of days customers take to pay your invoices. When this number is consistent or diminishing over time, it’s a sign your cash flow management system is effective.

Details Matter in Tax Accounting for an Asset Sale

There are so many variables surrounding the sale of a business asset that it can be confusing.

Money received from the sale is only one element in the transaction; it’s not simply added to income as if you were selling a small item that was categorized as an expense when originally acquired. The cost of a fixed asset, such as equipment or a vehicle, is expensed over time as depreciation.

Understanding how this difference appears in financial statements helps you identify the underlying details for your tax accountant when the asset is sold.

The original cost for a fixed asset and the part of that cost already expensed as depreciation over time form an interlocking network with the sale proceeds. The difference between the asset’s cost and its accumulated depreciation is carried on the balance sheet as a net book value. A sale price that’s greater or less than book value is recorded as either a gain or a loss.

Book value is what the business is giving up in the sale. The asset’s original cost and accumulated depreciation are moved from the balance sheet to the income statement as a cost of sale.

The selling price is recorded on the income statement as sale proceeds. Both the cost and proceeds typically appear in the same account as gain or loss; however, your tax accountant needs both figures for accurate reporting.

Finally, repaying the asset’s loan doesn’t impact the gain or loss; it affects the amount of the sale price received as debt reduction rather than as cash.