OPEN LETTER TO CONGRESS FROM SMALL BUSINESS OWNERS

Get over yourself. We don’t care about the debt; we don’t care about taxes; we don’t care about abortion or marriage—it’s the economy stupid. Debt ceilings, taxes on millionaires—none of that matters—we need JOBS. The “job creaters” are consumers—they could be on welfare or they could be middle class—people who spend their money, not millionaires. People spending money create jobs. Tax policies don’t create jobs; taxes just pay for government. Social issues don’t create jobs; they just help people in need. Government waste is no worse than big corporation waste. Over-taxation is no worse than $8 million CEO’s or obscenely rich fund managers. We need the average person to have a good job so they spend money and our business can flourish.

NOT ONE SINGLE BILL HAS BEEN PASSED IN TWO YEARS THAT EVEN ADDRESSES JOBS. There is time for everything else—where is the legislation to create jobs? The Republicans were thrown out in 2008 because they didn’t create jobs; the Democrats were thrown out in 2010 because they didn’t create jobs—can we throw you all out in 2012?

There is not a single small business owner in the country who has said to him or herself, “I don’t think that I am going to hire and try to make more money because my taxes are too high. Or because I can’t choose what kind of light bulbs I can buy. Or because there is a Planned Parenthood Clinic in town. Or because there wasn’t a war resolution.” Get over it and get the middle class good jobs. Or good bye.

Accounting 101 For Business Owners

This document is a basic primer for business owners with no accounting background (or particular aptitude!) Have your own Income Statement and Balance Sheet in front of you while you read this. Pick out the different parts on your statement as they are presented.[1]

Your financial statements

A company keeps two basic financial statements—an Income Statement (also known as a Profit & Loss Statement or P&L) and a Balance Sheet. These should be produced internally for your review at least monthly. To understand the difference between the Income Statement and a Balance Sheet look at a photograph on your wall. What do you see when you look at that picture? You see the “things” that were in front of the camera lens at the moment that the picture was taken. Imagine that instead of a camera the photographer had had a video recorder. What would you see then? You would see the “activity” that took place during the period of time that the camera was on. Your Balance Sheet is the photograph; your Income Statement is the video.

Balance Sheet

The Balance Sheet is a summary of the things that your company owns (things including debt) at a particular moment. It can change the next moment if you sell something that you own or bring in more “something.” The Balance Sheet has 3 parts: Assets; Liabilities; and Shareholder’s Equity. Assets are anything that you own. Liabilities are anything you owe. Shareholder’s Equity is a subtraction problem. Imagine that you have a house worth $250,000 and a mortgage of $200,000. What would be your equity? $50,000. You obtain this by subtracting the value of what you have from what you owe on it. This is how your Shareholder’s Equity is obtained. It is as “real” as the equity in your house. The report is called a Balance Sheet because it has to “balance.” In other words, the Assets minus the Liabilities equal the Shareholder’s Equity. Conversely, Shareholder’s Equity plus Liabilities equal Assets. It “balances.”

Your Assets and your Liabilities are sub-divided into two parts—Current and Long Term (or Fixed). An Asset is anything that you own. A Current Asset is an Asset that in the normal course of business would be converted into cash in the next six months.[2] Current Assets will include: Cash (obviously cash is already “converted” to cash); Accounts Receivable[3] (you will collect your AR from your customers in the next six months); Inventory (you will convert it into product which will sell); and you might have one or two other categories. The total of your Current Assets indicates how much cash your company will have to use in the short term.

 

A Fixed Asset or Long-Term Asset are those things that you own that in the normal course of business would not be converted into cash—desks, chairs, computers, trucks, equipment, etc. Most of these Assets are not sold, rather they wear out and therefore each year your accountant lowers their value. This is depreciation.[4]

A Liability is anything that you owe. A Current Liability is a debt that you have to pay in the next six months. A Long-Term Liability is a debt that you don’t have to pay in the next six months.

Who Cares?

You should care because the Shareholder’s Equity is akin to the equity in your house. It is the “book value” of your company. One of your objectives should be to increase the Shareholder’s Equity of your company. Other than yourself (and shareholders) there are three other people who care—buyers, bankers and bonders (the three B’s). Potential buyers care because your Balance Sheet details the things that they are buying. Bankers care because it gives an indication of whether or not you can repay a loan (see Current Ratio). Bonders care because they need to make sure that you are solvent enough to complete a bad project.

Current Ratio

If you take only one thing away from this discussion of your Balance Sheet, learn to understand your Current Ratio. Review our definitions above. One category indicates how much money your company has scheduled to come in during the short-term. Another category indicates how much money your company has going out in the short-term. The Current Assets show the money coming in[5] and Current Liabilities shows the money going out. To calculate your Current Ratio, divide your Current Assets by your Current Liabilities. Obviously we want to have more money coming in than going out (and so does a bank before they lend you money!) Therefore if you divide your CA by your CL you want the quotient (answer) to be greater than 1.0. If it is a decimal below 1.0 then you have more money going out than coming in—this is one of the tests of insolvency. In most companies a Current Ration of 1.5 to 2.5 is best but it varies so be sure to discuss this with your consultant. Although your bank will not tell you this, your Current Ratio can also be too high. As a business owner you would prefer to have a lot of Fixed Assets as these are the things that make you money. Equipment, trucks, computers, etc are tools that drive the business. You really don’t make money off of Current Assets—cash, receivables, inventory, etc. However banks want to see a lot of Current Assets (very high Current Ratio) to assure them that their loan payment will be made.

Income Statement

Most people pay more attention to their Income Statement because at the bottom it shows your profit or loss. We all know that we want profit so we look there first. As the Balance Sheet is divided into three parts, the Income Statement is divided into four[6] parts: Sales (or Revenues, or Income); Cost of Goods Sold (or Direct Costs); Overhead (formerly General & Administrative Costs); and Profit (or Loss).

Most small businesses keep their books internally. They make entries with each transaction and classify them according to the type of expense or income. Their program then automatically generates the Income Statement and Balance Sheet reports. Unfortunately GIGO applies—garbage in; garbage out. The reports are good enough for your accountant to take the data and do your taxes but generally not good enough for managerial purposes.[7] After we explain your Income Statement, you will understand some of the managerial purposes that it can serve if it is properly structured. As the transactions are entered they are placed on the reports according to your Chart of Accounts. Your Chart of Accounts determines which of the sections of your Income Statement or Balance Sheet the transaction is found. If you Chart of Accounts is inaccurate, your financial statements will not help you run the business.

Your Income Statement is not developed by the computer—it is built through your actions. This is a critical concept. Every time that you make a sale or pay bills, your are “building” your Income Statement.

REVENUES = the total amount of all of the invoices that you give to customers.[8]

COST OF GOODS SOLD = the direct cost of providing the good or service—the things that you bill the customer for. Included are the Labor, Materials and other costs that you would not have if you did not do the job (or make the sale). In a sense Direct Labor is a good thing—you have paid someone to produce your product which you sold to make money.

MARK UP = is the amount that you have charged your customer in excess of what it cost you to produce it. This amount is then applied to Overhead and Profit.

To summarize, every job (or sale) you make pays the cost of producing the product or service (COGS), allocates some of the mark up to overhead and some of the mark up to profit.

Your Chart of Accounts must put each transaction in the proper section. Labor for example must be divided between COGS and Overhead. A company without an accurate Chart of Accounts cannot properly price their product.[9]

As I have shown, your Income Statement is “built” through your transactions. It is produced in the following format:

REVENUE

– COGS

GROSS PROFIT (subtract COGS from Revenue)

– OVERHEAD

NET PROFIT

Your Overhead is your fixed costs. These are expenses that you will have even if you don’t make a sale. (The expenses that you have because of the sale are COGS.) Your GOGS is a percentage of the Revenue. Your Overhead is fixed. Gross Profit is the amount of each dollar that comes in that you are able to spend on Overhead and Net Profit. For example if you sell a product for a dollar that costs you 50 cents, you have a gross profit of 50 cents or 50%. You now have that 50 cents to apply to Overhead and Net Profit. Since your Overhead is a fixed amount, your break even is the number of 50 cents you have to bring in to pay that fixed overhead. If your overhead is $100 it takes $200 of sales to break even.[10] Therefore your break even is your fixed Overhead divided by your Gross Profit percentage. Knowing your break even is not optional—how else can you develop a rational sales and marketing plan? And without accurate numbers how can you determine your pricing structure?

Budget and Cash Flow

Your Income Statement is used to develop your Budget. Your Budget tells you what you can afford; your Cash Flow Forecast tells you when you can afford it. The Budget is critical in pricing and in developing excess-profit based incentives for your employees. Your Cash Flow Forecasting is how you run your business. You need to have developed a six-week cash forecast that shows your expected cash balances at the end of each of the next six weeks. There are virtually no generic software programs which adequately budget or project cash flow.

 

Profit Plan

 

There are four “expenses” that have to be paid out of Net Profit. Therefore each company has a certain minimum, mandatory percentage of profit that they require in order to remain viable. The net profit must be enough to pay: (1) your debt service; (2) new asset purchases; (3) the amount of cash you plan to retain; and (4) your taxes. The funding of your Profit Plan for these four items is for break even purposes just another expense.

 

Summary

In order to have financial control of your company you must have an accurate Income Statement, Balance Sheet, Budget and Cash Flow Forecast. These are tools required for Pricing, Sales and Marketing Plan, Employee Accountability and Incentives, Cash Management, and other managerial uses.


[1]You may notice that in some cases your statements may not match the presentation. These are adjustments that should be made in your chart of accounts. Until these adjustments are made, much of the analysis of your financial statements is impossible.

[2] Much of this document is an over-simplification. It is accurate enough for our purposes.

[3] This assumes that you are keeping your books on an accrual basis and not on a cash basis. Your internal books should be kept on an accrual basis as this more accurately shows your true financial position. You can keep your internal books on an accrual basis for your management and allow your accountant to file your taxes on a cash basis which is often more advantageous. The difference is when you post income and when you post expenses. On a cash basis you post income only after you have the cash and post expenses only when you pay them. On a cash basis you would not have AR or AP. In an accrual basis you post income when you have earned it and expenses when you incur the obligation. This creates AR and AP.

[4] Note that the government allows you to “expense” your depreciation. This means that you are able to reduce your income by the amount that your assets reduce in value. (In reality there are tax schedules that dictate how fast your Fixed Assets “wear out” or in other words how much of a deduction you are allowed to claim for tax purposes.) This creates a “book value” for your asset which is often different from the “market value” and is almost always different from the value of the asset to your operations. For example, a truck might depreciate over 5 years. This would allow you to deduct one-fifth of the value of the truck each year from your Income Statement for tax purposes. On your Balance Sheet the value of the Fixed Asset would reduce by one-fifth each year until it reached zero after five years. Obviously the truck would still have “market value” (you could sell the truck for something) and obviously the truck would have value to your operations, but for tax and Balance Sheet issues, it would no longer have any value.

[5] This ignores your operations and just gives you the current status.

[6] In some instances it is appropriate to add a fifth part to segregate selling costs.

[7] The best analysis of this is found in “Minding My Own Business” by Dirk Dieters available on The Fremont Group web site from the publisher (best price) or on Amazon.com. The relevant section discusses “managerial accounting.”

[8] This of course is on an accrual basis.

[9] Every company has a “product.” In a typical service business that “product” is a unit of time. The charge for that unit of time determines the price.

[10] Now you should be able to see why you must have a proper chart of accounts. Without it you cannot properly compute your break even—nor do some of the other critical management calculations.

Good Debt; Bad Debt

I often hear the goal of a business owner as “I want to pay off my debt.”  When questioned more closely the source of this goal is the frustration and perceived risk of having debt and the debt payments.  The idea that the owner would make more money if he didn’t have the debt is a little illusory—the debt also helped build the businesses.  What is good debt?  There are two criteria in answering this question—the type of debt and the use of he debt.  Is owning a home a good thing?  Of course and few of us would own homes if we had to save the money and pay cash, but would it be a good thing to put the purchase of your home on a credit card?  Long-term assets need to be purchased with long-term debt. The converse is also true—don’t pay off your credit card with a home mortgage.  Short-term assets need to be purchased with short-term debt. So the first criteria is to match the type of debt to the type of purchase.  The second (and probably more important criteria) is the use of the debt funds.  A good use of debt in a business is to finance growth (inventory, cash flow, etc.) and to purchase assets that produce income in excess of their cost. Obviously we don’t want to use debt to purchase non-income producing assets (like toys) for a business.  Be careful about using debt as a tax plan.  Businesses that run their business with the objective of minimizing taxes are missing the point—the business needs to be run for a profit.  Of course all debt—even good debt—brings with it risk.  One reason the owner gets the big bucks is to make the decisions that balance the use of the debt with the risk.