Addressing New Year Business Financial Issues

The beginning of a new year is when small business owners plan for what lies ahead and consider lessons learned from looking backward. Especially important is the imminent matter of addressing income tax for the year that recently ended. You should, however, already have a solid understanding of your tax situation by having relied on accountant advice throughout the year. Unfortunately, achieving this standard can be frustrated by lax recordkeeping. Therefore, a new year is ideal for implementing improvements.

Financial Records Precision

Dig deeply into your business financial statements of the past year. Don’t merely glance at the bottom line on the income statement. Scrutinize every number. Assure that each asset, liability and expense amount makes sense. If anything isn’t clear, find the source of questionable items.

Keeping mounds of receipts, invoices, and bank statements is certainly a hassle. Moreover, the flaws in this system are magnified by having to locate a past detail in a pile of papers. Investing in a good scanner for saving electronic copies of everything is a far superior method. If you already have electronic files, make improvements to document labeling and folder organization.

The most crucial vow for a new year is assuring that all transactions are recorded in a timely way. Details needed for accurate bookkeeping should be assembled immediately after events occur. Collecting information for tracking every business activity without delay assures that financial records are complete and accurate.

Business Planning Mastery

Planning for a new year relies heavily on data from the recent past. You don’t want to blindly make decisions for the future. The planning process is therefore delayed if you’re waiting for several weeks (or even worse, a few months) to get necessary financial statements.

Forecasting the year ahead requires knowing your present working capital and cash flow. Your financial capabilities inform you about how much you can spend. The business balance sheet shows cash available and unpaid bills if you’ve kept your records up to date. This report also conveys existing debt so you can identify possible additional borrowing capacity without burdening the company.

A cash flow statement or cash basis income statement illustrates where business revenue has been going. With this tool, you can plan for new spending initiatives. This, of course, means having a sufficiently positive cash flow. If you don’t have enough cash flow for spending on your business growth strategy, the income statement tells you the recent amounts spent in each expenditure category. This guides you toward potential areas to cut back in.

Tax Savings

Tax reduction strategies are also identified from timely and accurate financial statements. For example, your accountant can advise you about retirement plans. The contributions are tax-deductible, and the amounts going to your personal plan account are essentially payments to your future self.

Business health insurance plans can also save money. In fact, many types of benefit plans are allowed under the tax rules as business expenses. But creating and administering them comes with a cost. Determining whether advantages outweigh the costs necessitates careful analysis of business financial circumstances. So everything comes back to organized files and mastery of financial statements.

Conducting Financial Tracking of Business Phases

A fact confronting all entrepreneurs is that everything in business will not stay constant. Conditions are always changing. Although some changes arise suddenly and unexpectedly, every business goes through four general phases. The key to survival is recognizing what phase you’re in and avoiding regression.

The first phase is starting the business and funding it with personal cash. Your goal of making money can’t happen without initial working capital. This pays for things needed to accomplish the work that ultimately generates revenue. Insufficient beginning capital is a primary reason for business failure. You likely need twice as much startup funds as you thought, and phase one will probably last twice as long as you expected.

In the next phase, you’re gaining sales, but the business isn’t generating enough cash to pay all the bills. You’re still using startup capital plus spending incoming cash to fund further growth. You want to move through this stage quickly before depleting all your capital resources. In phase three, the business finally has sufficient cash flow to pay you. This is when advice from an accountant will help determine how much owner compensation the business can afford. More importantly, tax planning in this phase is valuable.

In phase four, the business can finally give you a recurring paycheck. The business still has profit after paying you. That permits the business to fund your retirement, expand or have increasing value to a potential buyer. This situation may last for years, but don’t panic when changing conditions compel stepping backwards for a while. Remember to evaluate financial statements to understand your business phase.

Time to Scrutinize Your Business Financial Details

Changing economic conditions are the greatest stimulus to urgently determining the best course of future action. To identify the most crucial matters to address, you must first know how to read and understand your business financial statements.

Assets & Liabilities

The collection of reports comprising business financial statements provides a complete picture of the cash flow and overall condition of your enterprise. Most importantly, the balance sheet is a reporting of business assets and liabilities, with the difference between these two factors being the equity you’ve built over time in your business.

Too many business owners only examine the income statement for revenue and profit. Those factors transform into a deeper meaning by scrutinizing key elements on the balance sheet. A major detail to easily spot as a red flag is higher liabilities than assets. This means your business owes more than it owns. Even if this troubling condition does not exist, you want to evaluate if your business is headed in that direction. This is simply accomplished by comparing over time the ratio of debt to equity. A rise in this metric signals potential problems ahead.

A corollary issue uncovered by the balance sheet is the expansion of accounts receivable or inventory relative to sales. Having too much in uncollected accounts receivable can mean insufficient cash for timely payment of billed expenses. Although possessing enough inventory is important, having too much wastefully ties up your cash. Trends for accounts receivable and inventory can also be assessed by ratios. These determine the number of days you have on hand of accounts receivable and inventory based on recent sales. Since these calculations demand a little experience in analysis, your accountant can help with the math. All you need for this exercise is accurate up-to-date bookkeeping.

Revenue & Expenses

The income statement is the familiar report of revenue and business expenses. Many small operations keep their books on a cash basis, meaning the income statement reports revenue when received and expenses when paid. If your enterprise is accrual-based, it records revenue when customers are invoiced and expenses when bills are received. An accrual-basis operation will, therefore, also need a cash flow statement.

Declining revenue is obviously bad. But a temporary period of falling sales can be survived with some expense reductions or borrowing money. Look for unnecessary expenditures that can be reduced or eliminated. Your business may be stuck with large costs for space and personnel, but other categories are ripe for cutting back. Lower spending for multiple small categories can add up to substantial improvement in cash flow.

Deciding whether taking on more debt is sound brings you back to the balance sheet. If your business has plenty of equity, having more liabilities will not harm the operation’s financial strength. The other consideration with borrowing is assuring sufficient cash flow for loan repayment. Finding your cash flow number, which is not necessarily the business profit, permits you to calculate the sufficiency of incoming funds to cover the sum of all loan payments. That’s another simple ratio but also a factor to consider with input from your accountant.

Have a Meeting with Yourself about Cash Flow

When you perform all the executive-level functions at your business, the important role of officer meetings, such as those at large enterprises, is overlooked. But a few intervals throughout the year are ideal for requiring your inner CFO to describe cash flow results to an empty room of imaginary executives. You’ll force yourself to articulate key money matters. This prevents them from remaining mere abstract concepts in the dark recesses of your mind.

Cash flow is different than profit. Cash flow from operations ignores uncollected revenue and unpaid expenses. These elements are identified on a cash flow statement as the changes in accounts receivable and accounts payable. You then add or subtract other factors from operating cash flow. Interest expenses and depreciation are added. Costs for depreciable assets are subtracted. Loan payments are also subtracted. Any money that’s borrowed or that you put into the enterprise as an owner adds to cash flow.

A cash flow statement is a key report, but some smaller operations already maintain cash basis bookkeeping. In those cases, cash flow from operations can be identified from the cash basis income statement, which already excludes uncollected income that’s still in accounts receivable and unpaid expenses that are still in accounts payable.

Comparing cash flow from one period to another delivers insight into the overall financial health of the business. Although rising cash flow is generally good, building too much cash may indicate excessive borrowing, not paying bills on time, or ignoring replacement of old equipment. Short-term cash flow dips are not so bad if they result from increasing revenue that’s not yet collected.

Setting, Measuring and Evaluating Business Goals

Unlike waiting and hoping for a change in unfavorable weather, adverse business conditions are within your power to alter. The process requires knowing the sources and causes of difficulties so that they may be corrected. Unfortunately, access to necessary data is often compromised by an entrepreneur’s focus on ordinary daily activities. The solution is establishing a habit of setting goals and having a desire to identify the progress you’re making.

Setting Measurable Business Milestones

Current goals should align with the larger vision you had when starting your business. Objectives for this year should be measurable targets accompanied by action steps to accomplish them. When your actions don’t produce the expected goals, making corrections is crucial.

Short-term goals are set by working backwards from your big vision. You want to decide the measures to achieve along the way to your ultimate long-term aim. Decide what spending and cash reserves you’ll need in the future to have the earnings you desire. These factors embody the planned scale of operations. Then you can set near-term milestones. Finally, you identify the routine activities that seem most conducive to reaching those milestones.

Income Statement Evaluation

Your big vision may be something out of your wildest dreams. But current goals require a dose of realism. Obviously, resources of time and money are limited. Your burden is using them optimally. The milestones are how much money you can derive from the available time. Scrutiny of the business income statement conveys not only this realized profit but also how you achieved it.

Revenue on the income statement informs you of how much you were paid for your time. Each of the expense categories reveals what you had to spend for earning the revenue. This information uncovers expenditures that can be reduced by a revision to your action steps. Changes in spending behavior can increase the profit resulting from the same amount of revenue. But altering the wrong expenses may adversely impact revenue. Continuous examination of income statement details shows you which actions are best at meeting your milestones.

Balance Sheet Examination

Evaluation of business milestones doesn’t end with the income statement. Examining the business balance sheet is also a key step for refining actions to meet your goals. Balance sheet items identify many of your milestones. For instance, the amount of assets (especially cash) that your business retained from its earnings is on the balance sheet.

Remember also to check the liabilities on your business balance sheet. Some of the cash and other assets may have been acquired with borrowed money. At the bottom of the balance sheet is business equity, which is the difference between business assets and liabilities.

In the equity section is an account for the funds you have personally withdrawn from the business. This is a negative amount that reduces the earnings retained by the business. When you have a long-term vision that necessitates reinvesting earnings, your near-term goal is building retained earnings. Evaluating a milestone for retained earnings is an example of a measurement to regularly scrutinize. When you get off target, a revised action plan is desirable.

Accounting for Small Business Debt

A business debt that you can’t collect is certainly costly, but how you account for this unfortunate situation depends on several factors. Debts are typically invoices to customers that will not be collected.

If you never received money that you expected, the loss is not the same as theft. Your business cannot lose cash that it never had. For this reason, a cash basis accounting system does not have any debt expense. Cash basis only counts income when payment is received. A cash basis business does not have any accounts receivable in its bookkeeping. Receivable amounts were never added because uncollected invoices are not yet counted as income.

Creating a receivable only occurs in bookkeeping that adds income using accrual basis. Accrual basis accounting counts a sale as income when it’s invoiced. If your business is accrual basis, the previously recorded income for an uncollectible invoice amount must be offset by a debt expense. The expense increase is balanced against a reduction to accounts receivable.

Most accounting software produces financial statements for either the cash or accrual method. Debt expense will only appear on the accrual income statement since only accrued income will include uncollected accounts receivable. The cash basis reports are unaffected. They show no debt expense because the expected income is already absent on the financial statements.

Costs associated with invoiced work represent cash lost for both cash basis and accrual basis. These expenses are captured regardless of whether customers pay the invoices you sent. But that’s an issue for your accounts payable system, not accounts receivable.

How to Determine the Value of a Major Purchase

As with any industry, accountants have their own jargon, but a general understanding about some of it is not beyond comprehension for the ordinary entrepreneur and can be quite useful as well as occasionally crucial to sound decision-making. One such area is summarized by the term “discounted cash flow.” This encompasses vital methods for identifying if a major business purchase makes sense.

Determine When the Benefit Arrives

A large amount of spending for your business could be for new equipment or a new product line or an expanded location. But it might simply entail soft costs for an advertising campaign or revamped website. The aim for any of these investments is increasing revenue. The problem is that you spend the money upfront and then wait for the cash to flow in later. Hence, the reference to “discounted cash flow” takes into consideration this time value of money. It recognizes that cash today is more valuable than the same amount of money in the future.

In fact, the expectation of receiving a certain amount of cash next year is more valuable than receiving that same quantity of cash in 10 years. The longer the length of time you expect before generating higher business revenue, the more you have to discount its value.

Present Value of Future Benefits

Identifying the present value of an amount in the future is the whole point of most discounted cash flow determinations. All the future cash flows are discounted by some specified rate. The selected rate, therefore, depends on the length of time before your large expenditure is expected to deliver results.

In the simplest case, you might use a rate you have to pay for borrowing the money to spend. For example, if you borrow money at a 5% interest rate for one year, you want to spend it on something that will generate revenue over the next year that is at least 5% more than the amount you’re spending. Most discounted cash flow calculations are, of course, more complicated than this. They typically require assistance from an accounting professional.

Calculating present value necessitates estimating the revenue expected from making a major purchase. This normally entails gradual revenue increases, which may continue for an extended period but escalate less over time. A discounted cash flow model to determine net present value applies the discount rate to each of the periods over which revenue rises.

Rate of Return

Not all discounted cash flow calculations are made using net present value. That’s because an expenditure can be quite profitable but still have a slightly negative net present value because it returns less than the discount rate.

To correct for this deficiency, accountants deploy another discounted cash flow technique known as the “internal rate of return.” This method identifies the rate that results in a net present value of zero. All the present values of future revenue will equal the money spent at the beginning. This tool is useful when the expenditure occurs over time along with the future incoming cash flow. The internal rate of return also tells you how much is an acceptable interest rate for borrowing the capital needed for a major purchase.

Limits on Tax Deduction of Business Losses

Starting a business has the obvious aim of generating income, but you might experience losses in some years. Although spending more than your revenue is particularly common in the initial year of operation, it can occur whenever unusual circumstances arise that reduce profitability below zero.

Business profits are reported on the personal income tax returns of proprietors, partners in a partnership and shareholders of S-corporations. These are the most common business structures for tax purposes. Business losses are typically deducted on the income tax returns of owners. A business loss offsets income from other sources, thus reducing your overall taxable income. However, the amount of business loss an owner may deduct is limited by at-risk rules.

This means that you must identify how you paid for a business loss. You are at risk for the amount of personal funds invested in the enterprise as well as debt for which you’re personally liable or have pledged property to secure a loan (other than property already used by the business).

You’re only allowed to deduct the losses of a business to the extent you lost your own money and are therefore at risk of not getting it back from future profits. Moreover, a loss you can deduct reduces your at-risk amount in the business for the subsequent year. Fortunately, a loss denied from not being at risk carries over to succeeding years for deduction when you are personally at risk. Determining your at-risk amount is therefore an annual process to conduct with your tax accountant.

Using Accounting Details to Develop Pricing Strategy

An early decision in the development of a business is determining how to price what’s being sold. The right price assures profit. A price that’s too high could cause consumer demand to evaporate. A price that’s too low will leave you bankrupt from expenses exceeding revenue.

Price Accounting

Settling on an optimal price is the by-product of an accounting process rather than a guessing game. The exercise begins with a general operating budget. Assess your productive resources. This includes time because you can only work a limited number of hours per month. Determine how much can be produced with the given amount of time, personnel and equipment at your disposal.

Next, identify the average monthly costs for these resources. Some expenses are fixed, such as rent, Internet service and telephone charges. Other costs are variable, such as outside contractors and owner compensation. For these, assume maximum cash outflow when the business is operating at full capacity.

The sum of all ongoing expenses shows how much income is needed to break even. The last step is identifying a break-even price for your production output. If your business provides a service, for example, the price for a month-long project must cover one month of costs. A business that makes a product determines break-even price by dividing the number of units that can be made in a month into the monthly costs.

Price Strategy

Knowing a break-even price is only a starting point. A small business typically tests various pricing strategies. This may entail charging a break-even price based on less than maximum output to gain a profit later when volume rises. A common pricing strategy is simply calculating all expenses and adding some profit. Then determine a price by dividing that figure by production output, whether that’s a typical project, a product or an hourly rate.

Of course, if you sell a common commodity or branded goods, your price is largely determined by the competition. This demand for competitive pricing means going back to your costs for assurance that profitability is viable based on market price. On the other hand, if your business can distinguish itself from competitors, careful price planning yields profit opportunities. This situation permits your enterprise to charge higher prices for greater quality even if it has a lower quantity of output.

Selling multiple types of services or products can complicate pricing strategy. If you want to explore item-specific pricing, you’re tasked with determining the costs for each thing your business sells. This means knowing the direct costs of providing each sale item plus allocating fixed costs among the various sales categories.

In most of the cases, however, a small business simply identifies an average price per product or service. Some things may sell for a higher price than their costs while others sell for slightly less than their costs. Nevertheless, identifying an average price for somewhat similar items or projects greatly simplifies pricing strategy analysis. The goal, of course, is for the average price of each thing sold multiplied by the number of sales in a period to cover costs for the period and provide some profit.

Details to Examine in Partnership Financial Statements

The best partners in a business, like ingredients in a good meal, complement each other. They are not identical, but they are not entirely opposite, either. Your business partner should bring elements to the partnership that offset your weaknesses. Going into business with someone is a big commitment. Taking it seriously means carefully reflecting on what each person contributes to the partnership.

Great partnerships are forged, for example, when one person is effective at sales while another individual focuses on production and managing the finances. In addition, certain similarities are necessary to enjoy advantages from having a business partner. Most crucial among these is that successful partners communicate clearly about goals and working toward the common achievement of them.

The indispensable tool for evaluating a joint effort by partners on a growth trajectory is an accurate accounting of business results. Financial statements must be understood together by the partners. Among the areas to examine are the capital contributions and draws of each partner. In general, these should be proportional to ownership percentages. Partners will also compare the business income to hours worked by each of them. These should be in accordance with the design when the partnership was formed.

Both partners should have assurance from the business’s financial statements that profitability is unfolding as planned. Even more important is identifying areas for improvement when profits are disappointing. This triggers a renewed focus on either sales or cost controls. Action is usually necessary on both fronts, which means a coordinated effort by the partners.