How Much – and When – to Pay Yourself

Let’s face it, every entrepreneur wants (and needs) to get paid. This is the foundation for a sustainable business trajectory.

The difficulty comes in deciding how much your business should pay you. Although there’s no specific formula that covers all cases, the following standard factors can help you make this all-important decision:

Timing

The first element to consider is timing; your compensation as owner must not negatively impact the health of the business. For instance, in the early planning stage, the company has no revenue but probably has lots of start-up expenses. At this point, it doesn’t provide cash to feed you; rather, you are feeding it.

When your operation is generating revenue, sustaining the momentum is paramount. In the first six months or so, the business builds cash for expansion, so you don’t take any distributions in that time period. However, after six months, you need to take a distribution; after spending all your time and resources, it’s crucial to your psychological well-being that you pay yourself something.

You are the most important – and possibly only – employee of your business. Even small recurring compensation demonstrates that the company exists to reward individual effort. This also means that predictable owner distributions become part of the business cash flow along with general operating expenses.

The amount

After a bit of history with your business, you’re able to build a financial forecast. This considers your available resources – especially money – and predicts future revenue along with expenditures. Your owner compensation is one of the cash outflow categories. The budget should allow your pay to be adjusted based on other required costs for business operations.

Not all of the outgoing cash is for recurring overhead expenses. For instance, if your company sells products, funds are needed to replace inventory. Likewise, a service-oriented business may need parts or materials for the projects expected in upcoming months. Or maybe you’ll require extra cash for necessary travel or subcontractors. The company bears these costs prior to getting paid by customers.

The key is remembering that your primary concern is the strength of the business, and you need to have a cushion of cash to reinvest in it. However, one of the costs of conducting operations is your labor. While you don’t want to bleed the company dry, some amount of recurring compensation is reasonable. Find that amount in the company budget and pay yourself consistently. As you reinvest cash for growth, the cash cushion should rise, allowing you to take larger distributions in the future.

The people

Do you have investors or have you borrowed from financial institutions? Investors generally want to know that you are being paid by the business, and will usually set your salary ceiling along with performance goals. Lenders, too, want to see owner compensation as an indication you have an incentive to grow the business. Note that demonstrating sufficient cash flow for debt repayment is easier if your historical compensation is a consistent amount; variances complicate lenders’ abilities to evaluate cash flow.

How to Prevent Common Cash Projection Mistakes

Cash flow is vital to the financial stability of every business – from the smallest to the largest. Therefore, every entrepreneur should become familiar with the cash flow statement.

Forecasting cash flow is a necessary foundation for future planning, enabling you to measure actual results against goals: meeting specified targets validates your initiatives, while missing targets identifies where improvement is needed.

However, a number of common errors with cash flow projections will result in poor strategic decisions. For example, projecting operating income is often the cause of cash flow blunders. This top line of the projected cash flow statement should represent a realistic profit forecast based on available resources.

The best starting point is a separate projection of revenue and expenses, and subsequently, an examination of changes in receivables and payables. This is accomplished by using figures for the average number of days that receivables and payables are outstanding. Cash flow is different from income because of the lag between sales and collection, as well as the lag between receiving a bill and paying it.

Other cash flow variables are investments and financing. These do not appear on the income projection, so they appear on a cash flow forecast. Investment in a new asset – such as machinery or equipment – subtracts cash. Financing these purchases by borrowing adds to cash.

Those entrepreneurs familiar with the components of cash flow statements can recognize the forecasting limitations, and they will seek professional accounting assistance to overcome these limitations.

Your Vigilance Can Prevent Accounting Issues

As a business gets rolling, a myriad of factors can combine to create accounting issues. Although perfect accounting is as mythical as the unicorn, it’s important for business owners to adopt a strategy of keen bookkeeping oversight. The alternative is certain to result in mistakes, which can jeopardize the progress of your business.

In fact, losing track of your financial data is bound to result in inaccuracies that can cripple an operation. Sound basic procedures go a long way to promoting business success.

Receivables reconciliation

Matching customer payments to invoiced work is clearly a crucial objective for every enterprise. The proliferation of accounting software to aid in this process has been both a blessing and a curse. The blessing is that less time is spent finding invoices and comparing payment amounts. No more verbal quotes and hand-written invoices; accounting software permits simplified tracking of unpaid invoices and eliminates disputes. Moreover, summary financial statements of income and costs are compiled with no additional steps.

Its curse is that it results in a false sense of comfort that the computer accurately records what’s transpired. In fact, accounting applications only record what a human enters. You must scrutinize reports regularly to ensure that transactions are posted to the correct accounts.

For example, entering a received payment and not applying it to an invoice-or to the correct invoice-results in erroneous statements of income and costs. Prevent this by monitoring accounts receivable aging reports to be sure payments are posted to the correct invoices. An accounting program should produce “cash basis” financial statements, which by definition will not indicate any balance for accounts receivable-unless an error has been made.

Payables problems

Another bookkeeping goal is paying bills received from vendors. Accounting software facilitates the entry of a bill and subsequent payment. But correctly applying payments to existing bills in the system may be problematic: for example, matters are distorted when someone pays a bill by company credit card and then pays the credit card bill. Failure to follow the exact steps in these events will render inaccurate reporting of income and expenses. This solution rests with examining accounts payable reports; a “cash basis” balance sheet should not contain any amount for the accounts payable account.

It also makes sense not to enter loan payments as bills to pay. The indebtedness is already in the bookkeeping system and is reflected as a liability on the balance sheet. Loan payments, therefore, need not impact the accounts payable process. Simply record a check and apply respective amounts to the separate accounts for the liability and interest expense.

You can reliably compile business income and expenses by setting high standards of accuracy for accounts receivable and accounts payable. Tax professionals will know if accounting software mistakes have been made in these areas, and won’t permit income tax reporting of spurious data.

However, it’s difficult for your accountant to locate errors that occurred over long periods. In order to eliminate problems later, it’s important to quickly find bookkeeping mistakes and immediately correct them.

Misconceptions about Business Vehicles and Taxes

There are many misunderstandings around tax deductions related to business vehicles. One common one is that a business automatically receives a tax deduction for vehicle costs just because the vehicle serves a business purpose.

Usually, the vehicle is only partially used for business; often it’s the business owner’s personal automobile. Although it may be titled in the company name, expenses for a personal/business use vehicle aren’t considered business expenditures. Deducting vehicle costs as automobile expenses is actually an inflated deduction, and it may disguise wages that are actually subject to payroll taxes.

A genuine company vehicle is used almost entirely for commercial purposes; however, incidental personal use, such as driving home after work appointments, is acceptable. Routine commuting is considered non-incidental personal use.

Personal use of a company vehicle is a form of compensation to the user; in allowing an employee to use a company auto, a value for personal use miles will be added to his or her reported taxable wages. (Rates per mile are set each year by income tax authorities.) Similarly, a business owner’s personal miles will be added to his or her wages or profit distributions. Therefore, your mileage records and those of your employees must separate business miles from personal miles.

Rather than using company vehicles for personal purposes, it’s easier for the company to reimburse the owner/employees at the standard mileage rate when using their personal vehicles for business purposes. The general standard practice is not to title any vehicles used for personal purposes in the company name.

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.