Good Accounting Practices Must Be a Top Priority

Office staff doesn’t know enough about our accounting system, or accounting in general. The accounting department says they’re overwhelmed. If anyone in that department is out sick, they get really behind. Space is very limited in accounting, and they’re dealing with a lot of interruptions. We could be doing a better job with the numbers side of the business. Any suggestions?

Thoughts of the day: Pay attention when accounting says they’re overwhelmed, as their performance is essential to a healthy business. Putting accounting in an area where they can’t be easily disturbed is a really good idea. Look for opportunities to involve people from around the company in accounting functions. The more your people understand what makes the numbers work, the more they can help ensure a profitable year.

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Having Enough Cash to be Healthy

Don’t have any cash in case of emergency, to fund payroll, etc. We’re operating very close – chasing accounts receivable to get money in, and it goes right back out again. Feels like a treadmill and that we’re not making progress. We have loans to pay off, which we’re doing, and some old bills that we owe to vendors who have been very patient. Have to get out of this month to month hole. It’s exhausting. Every month we ask ourselves, are we going to make it.

Thoughts of the Day: Cash reserves are essential to having a healthy business. Working through the demands on revenue takes a plan and patience. Know what your goals are. Be honest with your vendors and negotiate terms where possible. Identify a realistic plan to work your way out of the current situation.

Every business needs cash reserves to function effectively. When sales are down, cash reserves are often what get chopped, making it much harder to manage the business. It takes real discipline to protect cash reserves. Set a minimum goal and protect those reserves at all costs, even if the temptation is to use them up to pay bills.

Money coming in from customers goes towards paying for lots of things. Cost of goods sold, overhead, debts, investments in the future, paying for taxes, rewarding shareholders are just a few of the demands placed on revenue. Put together a game plan for how much revenue goes to pay for each demand.

Some demands need to be calculated as percentages, some as fixed costs. Some demands only happen in relationship to other things. For example, cost of goods sold gets calculated as a percentage on the P&L. But it may or may not have an actual impact to cash depending on whether it’s paid for out of the checking account as it’s incurred or charged to a credit card, or if you’ve negotiated payment terms with your vendor.

It’s easy to build up debts if you’re paying for things on credit lines and credit cards, or if you’ve negotiated longer payment terms with vendors. Keeping track of how debts are building up is essential, and that’s what the balance sheet is for.

Set goals that will keep your business healthy. For example, keep 1 month cash on hand at all times. Build up cash on hand to 3 months of overhead expenses. Then build to 6 months of overhead expenses sitting in cash or cash equivalents (CDs). Once you get to this kind of savings, you’ll be able to sleep at night.

Reduce debts to no more than 2.5 times equity, and keep current assets at 2x or more of current liabilities. These two ratios will help you manage the debt load. If those ratios aren’t in line right now, commit to putting $1 towards debt reduction and $1 towards savings. This will help you reduce debts as you build up cash.

Often owners ask, “Why shouldn’t I just put every dollar towards paying down my credit cards and credit lines, instead of putting money towards cash reserves?” The answer is simple. If at any point in time your credit line is reduced or cut, or you have to pay taxes and your credit line is maxed out, you’re in big trouble, unless you have cash reserves on hand. Cash reserves give you freedom to operate, and also boost the ratios on your balance sheet. Pay attention to them.

If you don’t have enough cash to pay off everything, approach vendors who have a vested interest in your success. These are most often your cost of goods sold vendors. Ask them for terms. If you have a balance build up with them, negotiate pay-down terms on the old balance. Many vendors would rather see you stay in business and continue to buy their products and services, so long as they can be confident that they won’t get burned.

Take a close look at what volume of sales your company needs to be profitable. Is the current cash flow issue coming from a couple of down months, or is the business trending downwards overall? Is this a seasonal problem, requiring a different sales strategy to plug volume into the low months?

Figure out how much revenue your company needs in order to pay off all debts and to build up cash reserves. Set a target for shareholder distributions, allowing you as owner to receive adequate compensation for the risk you take to run and fund the company in low periods. Remember that for every dollar of debts and cash reserves and shareholder distributions, you have to net $1.33 to pay for taxes, unless you have loss carry forwards from previous years.

Face the music by putting together a plan for how to move forward. If you don’t know how to write a plan, get someone to help you. Operating with your eyes wide open will help you better manage the business.

Looking for a good book? Cash Flow Analysis and Forecasting: The Definitive Guide to Understanding and Using Published Cash Flow Data, by Timothy Jury.
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Using the balance sheet as your company’s barometer

I don’t understand what’s going on, on the balance sheet.

Thoughts of the Day: The balance sheet takes a snapshot of the health of the company at a specific point in time. Most business owners concentrate on learning how to use the Profit and Loss Statement, but overlook how the Balance Sheet can help them. The balance sheet helps to set goals for how you, as a business owner, want things to change over time.

There are three parts to the balance sheet: assets, liabilities, and equity. Assets are broken into two or three major categories. Current assets are items that are already in cash, such as a checking account, and items that can be converted to cash within 12 months, such as accounts receivable.

Liabilities represent the debts of the company. Like assets, short term liabilities are liabilities you expect to pay off within 12 months. This includes credit lines and the current year’s portion of any term loans. Long term liabilities are debts that are expected to take more than a year to pay off.

Multi year term loans and multi year equipment loans are 2 examples of long term loans. With long term loans, ideally the amount of principal to be paid off during the year is moved from long term liabilities to current liabilities. Each month, as you make payments on your loans, part of that payment goes to reduce principal. This shows up on the balance sheet as a reduction in the current portion of the long term loan. This is a little bit of extra accounting paperwork, but gives the business owner a much more accurate picture of what’s happening to liabilities throughout the year.
Equity is what is left over when liabilities are deducted from assets. The equity section of the Balance Sheet is the sum of several items, including shares issued in exchange for investments made in the business, goodwill, and retained earnings among others.
Goodwill is meant to represent intangible values, for example the value of proprietary systems and brand equity. Setting its value is tricky, complicated and requires outside expertise.
Retained earnings represents the sum of all the net income that has been re-invested all the years. It doesn’t have to be cash. It can show up as cash, inventory, fixed assets, property, etc. Business owners have a choice to make at the end of each year. They can remove net income from the business and take it home, or they can leave net income in the business and use it to boost retained earnings and equity.

One of the ways to measure progress in a business is to monitor ratios. Debt to Equity and Current Assets to Current Liabilities are 2 keys ratios to keep on top of. A good rule of thumb is to keep Debt to Equity ratio below 250%, meaning that for every dollar of equity, the company has no more than $2.50 of loans and other debts.

A good rule of thumb for Current Assets to Current Liabilities ratio is to keep above 200%. In other words, for every dollar owed, that must be paid off in the next 12 months, the company has $2 or more dollars in current assets. Companies with high inventory and concerns about how quickly they can sell it off, may want to deduct inventory from current assets when calculating the Current Assets to Current Liabilities ratio. This is known as the Quick Ratio.

Planning to sell the business one day? Accurately attending to the balance sheet throughout the years of business, and focusing on building up assets and reducing liabilities leads to more options. Ability to leverage the company and staying on top of having enough cash through the years to build a healthy company helps you build long term exit value. Retaining earnings in the company, rather than taking everything home each year puts you in control of how the company grows and helps you to build sale value according to a plan.

Looking for a good book? How to Read a Balance Sheet: The Bottom Line on What You Need to Know about Cash Flow, Assets, Debt, Equity, Profit…and How It all Comes Together, by Rick Makoujy.

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