This time of year small business owners who only infrequently take a glance at their financial statements may be getting a full year P&L delivered by their bookkeepers. If you put an ear to the wind, you can almost hear the moaning – “If I have this much profit, how come I don’t have any money in the bank?”
Assuming the profit is calculated properly, there are, of course, only three possible answers to this complaint. Understanding how financial statements work, may not make the answer any more pleasant but it can silence the frustration.
The first possibility is that the business spent money on assets. Capital expenditures don’t hit the P&L so cash is used up but, in return, the company has a shiny new widget machine, or more inventory, or perhaps (depending on the accounting basis) it made a sale on credit (thus generating a paper profit). And now it has recorded some accounts receiveable, A/R being another liquid asset (hopefully), just not as liquid as cash.
The company might have also reduced some liabilities. Again, this is a typical use of cash but it doesn’t show up on the P&L like payment of current expenses. The business owner may not have made a purposeful reduction of debt. It might be just the routine principal portion of a business loan or payment of certain kinds of taxes. For instance, making a sales tax payment shouldn’t normally impact the P&L because the best practice is to record net sales. A business owner with one eye on the checking account might be counting some of the collected sales as his own working capital – a terrible practice. When the payment is made -- whoosh – a bunch of cash is gone.
The third possibility is that cash went out of the company through the equity section as an owner’s draw. One would think the owner would have a fond recollection of withdrawing some of his hard-accumulated capital but sometimes memories are short. Or when personal cash was tight, the owner might have paid some personal expense and the bookkeeper dutifully booked it for what it was – an owner’s draw. Since most small businesses are “pass through” entities for income tax purposes, this contributes to mental confusion at tax return time. The entity might have no responsibility for income taxes but the owner certainly does. Guess which checkbook is used when the IRS payment is made? Again, a reduction of cash and an owner’s draw is taking place, not a reduction of profit by generating an expense.
Understanding the fundamental mechanics of small business bookkeeping is an essential skill for an owner that will lead to better planning, decision-making and less confusion and stress. Using the Statement of Cash Flows which QuickBooks can spit out in seconds is a good way to evaluate what’s happening in your business.
Some view this new vehicle as the preferred form of corporate organization for demonstrating social responsibility. To others this is just window dressing for marketing purposes. I am wary of the value of organizing as a benefit corporation for a small business that is likely to remain closely-held.
Endeavoring to do good for one's community, country, or all of humanity should be a basic instinct of every moral person. However, as a small business owner, one's primary responsibility is survival. An empty space on Main Street does nothing for the economic health of the community. Employing people does. Even if the business can feed only the owner for a time, that's one less individual requiring state support and instead providing a modest but incremental contribution to civic vibrancy.
Organizing as a benefit corporation and tying one's self to the mast of a ship that has been pointed into the wind in pursuit of sincere but challenging philosophical interpretations of social good, limits the corporate directors' (usually the same people as a closely-held small business' owners) flexibility to make difficult decisions that prioritize survival. Sacrifice for the sake of principle can be laudable but it can also be accomplished through conventional organizational structure. Benefit corporations are not opposed to profits. But their obligations can be conflicted.
Creation of profits is what breeds economic health for a society. The money earned gets invested or spent somewhere after all, and regardless of whether it keeps workers employed building yachts or selling coffee and donuts, the resulting vitality still circulates.
America is a land that produces more philanthropy than any other nation and it all originates with profits. It takes profit for companies to support the many good works of nonprofit institutions and it takes profit to ensure small business stability and survival. A productive for-profit small business owner is in a position to give back to the community, whether by cash contributions to noble causes, sponsoring the Little League team or hiring one more worker. For-profit can be an enterprise form just as socially responsible as one organized through a more confined structure. And for some business owners, quiet charitable action may be more in keeping with their own spiritual beliefs than public proclamations of intentions.
The Small Business Administration has many excellent educational programs for entrepreneurs. Inside the curriculum of several of their courses is a clever reference that I haven’t been able to identify the author of, but the turn of the phrase puts a smile on my face each time I hear it.
They teach that every business owner needs “BAIL.” And once you know the definition, you realize that, in reality, it’s a combination of resources that really can get or keep you out of jail in extreme circumstances
B stands for Banker who can help you not only obtain necessary capital but understand the prudent and efficient ways to finance your business as it grows. While one might be tempted to think of the banker as the one who “bails you out,” that can be a dangerously unlikely assumption. CEDF, of course, is not a bank. So for our clients the B stands for Business Advisor who will connect you to the lending team as appropriate and usually take your worried 11 pm call to strategize on how you’re going to make payroll.
A is for Accountant. And this is meant to cover the territory of both bookkeeping and accounting. Many accounting firms do not choose to provide bookkeeping services, but a certified public accountant is the best choice for both bookkeeping clean up (often made necessary by using a less than experienced bookkeeper), long-range financial planning and preparation of tax returns.
I is for Insurance Agent who will make sure you are carrying the proper kinds of coverage and policy limits. Catastrophes that kill small businesses include not just natural calamities but the disaster of not obtaining easy and affordable coverage for predictable, although infrequent, events.
L is for Lawyer who will consult with a business owner on what legal form to adopt and provide direction for creating operating or shareholder agreements. The relationship should continue as the lawyer is consulted about employment law issues or legal matters related to property or specific industry regulation.
Entrepreneurs love to be self-sufficient and some take this to the extreme of avoiding use of any of these professionals for the sake of reducing expenses. And then, of course, when trouble comes, there’s nobody available to “BAIL” them out.
Once in a while, the conversation between a CEDF business advisor and a client turns to the possibility of the borrower selling the business. It’s surprising how unfamiliar many small business owners are with the standard approaches for valuing a company in their industry, or any closely-held company for that matter.
Admittedly the subject is complicated, and while there are basic formulas, often individual circumstances can overtake the usefulness of any single customary approach. Probably this is one reason there is a whole industry of business appraisers, although most of their work is confined to “bigger” small businesses.
This article provides a nice tutorial for those who need to get grounded in the realities of valuation. As you can imagine, it’s not unusual for a small business owner to sometimes have an unrealistic idea of how much their operation would bring. In companies where the efforts of the owner are key to the past accomplishments and future success of the enterprise, it can come as a shock as to how little value the office furniture, old equipment, leasehold improvements of a rented space and even the customer list can bring.
A hard look at the realities is important both for personal planning and making short and long term decisions about investment, expansion, and potentially, succession. A talk with your CPA is a good first step toward evaluating the cold truth.
-- Frederick Welk CEDF Business Advisor
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