Salesmen Want More Sales, Businessmen Want More Profit!

When it comes to pricing a product there are two factors, an accounting side that sets an absolute minimum price and a sales/marketing side that exists to push the product out the door.

Priced Out of Lingerie Milan by flatworldsedge

Do Not Let the Salesmen Set the Price!

The concern of the salesman is more sales, not more profitable sales, and so don’t let the sales dog wag the profit tale.  In fact, many business owners will have their salespeople screaming at them, “we need to lower prices!  Jennny Blow over at XYZ Competitors is undercutting us by 10%!   We’re dying in the water here!”  There are a number of fascinating studies about the incentives of salespeople and how they frequently are not aligned with the best interests of their employers.  Perhaps the best known of these relates to real estate agents and was brought to fame by the hit book, Freakanomics.  To put it in a nutshell, the salesperson wants that product out the door NOW!  They don’t have the investment  in the product that you do and don’t have the incentive to get the maximum price, they’d rather sell more volume at the minimum price.

The problem is, most business owners are sympathetic to the sales staff.  After all, many come from a sales background and are heavily involved in the sales process.  To compound the problem, they know little about accounting, don’t really understand it’s benefit and so have some young kid fresh out of school doing it or some old guy name Bernie who always stinks like stale smoke and mumbles when he talks and so you generally avoid talking to him except when you sign the checks.

The Found Money Take on Owners Who Complain About Having to Lower Prices

Wow!  Harsh words indeed.  You see, the sales person mentality is an overriding obsession with the quantity of sales.  Now, as a business owner and officer, you need to become more focused on the quality of sales.  Not all customers are created equally and, inevitably, some of them suck.  In fact, I have helped many business owners put together an analysis of their customers by profitability and ease of doing business with and they are often shocked to find that some of their customers actually lose them money!  What’s worse, these are often the very same customers that are time-sucking pains in the asses that they really hate dealing with.  And yet the business owners are essentially paying these customers to do business with them!

Why the Lower Price Often Doesn’t Sell

A low price attracts a certain customer, and this is a very different customer from the customer who pays premium.  The customer who pays rock bottom price all the time views your product as a commodity and will drop you the minute they can find a better price, whereas the customer who pays a premium does so because she believes that she is getting something special for the price she is paying.  Which of those customers is more likely to be loyal?  Which of those customers is more likely to be a pleasure to do business with?
Now think about setting a rock-bottom, low ball price in front of the premium customer.  Can you just imagine the look on their face.  To them, your price says “Hey, we don’t do as good of work and so, to make it up to you, we are charging less.”  Instead, when dealing with the customers you need to lose the focus on price altogether.  These people focus on value, not price, and you will earn their business by showing that you can deliver this value

How to Set a Minimum Price

In order to set a minimum price you need to know your gross margin for every major product that you offer.  The math is simple, the gross margin is the price that you get for each unit sold minus your cost of producing that unit (cost of goods sold, in nerdy accountants speak).  Sound simple, right?  Well, the Devil is in the details and the details here are calculating what actually is included in the cost.  Certainly any materials used to produce it, that is relatively easy to calculate.  Add to that the cost of paying employees for for working on production.  To do this, you have to know how your employees use their time.  Finally, you need to allocate overhead in some way.  Overhead are all those other costs that you need to run a business but that you really can’t attribute to the production of any particular item.
The minimum price that you can charge now involves taking that cost of goods sold and adding your desired gross margin, or how much profit you want.  Hey, you’re not doing this for free, right?  That is were your desired gross margin comes in.  You should never sell for less than this minimum price unless perhaps you have discontinued a product and are liquidating inventory.

Finding Your Ideal Price

Think about every time a big, exciting new product is introduced, from an I-Pod to a recently released DVD, what happens to the price over time?  Inevitably, it falls.  This is why you really have to get the price right out of the gate.
We have already established a floor, a minimum price that you will accept for your product, now let’s target an optimal price.  “Of course I know the ideal price, as much as I can get people to pay!” you say.   And of course you are right.  The key is to remember that it is much easier to start at a certain price and then lower it in certain situations then it is to start low and then try to raise prices.  Take a page from Ron Popeil and ask “but what would you pay?  $500? $250?, $125? but wait, there’s more!”

The Wealthy Freelancer

Start By Pricing Low?

My experience is that the new entrepreneur is often terrified of pricing themselves out of the market and seeks to gain market share by undercutting the competition’s prices.  This seems like a safe strategy, with less experience you should charge less, right?  Well, maybe, but do keep in mind the dangers of underpricing:

• It basically says to potential clients, “Hey, we don’t do as good of work and so, to make it up to you, we are charging less.”
• It sets a bad precedent for future work with that client, who will forever consider you the “discount provider.”
• In the words of a client I was pursuing, “we decided to go with Super Big and Famous Firm X because, although they charge twice as much, we know they won’t nickle and dime us every time we have a question or want something from them.”

Charge by the Hour?

Most entrepreneurs and independent professionals start off charging by the hour.  After all, most of us start our our careers as employees and we are accustomed to thinking of our time as having a price.  “Time is money,” as they say and we want to make a certain amount of money per hour.

Charge Them What You’re Really Worth!

Steve Slaunwhite of “The Wealthy Freelancer” makes a great case for a matter true to my heart, ending outdated thinking of charging by the hour and start charging by the result.

• Clients don’t want your time, they want a a job done!  They come to you because they have a need that needs met and are indifferent to your actual input of time.
• The client looks at hourly billing as a “blank check” for you and worries about the meter ticking.
• It sets an artificial ceiling on your earning power.  As you earn greater efficiencies and produce better work, your income cannot expand accordingly.

However, even though you, as a savvy professional, as charging your clients by the job you still need to track your hours spent on each project.  Your time is a finite resource and you need to manage it carefully.  Tracking the time you spend helps you to price future jobs and shows what lines of work are most profitable .  Finally, it should help you find efficiencies and show what areas need you need to spend less time on.  Two tools recommended by “The Wealthy Freelancer” are www.traxtime.com and www.freshbooks.com.

Determining What Price to Charge

Most new entrepreneurs stumble into pricing the wrong way.  They start off marketing and then get to pricing only when when they are asked about it, figuring that they will take what the client offers.  Well, often the client doesn’t really know what the “correct price” is and they are certainly not going to lead off with their best price.  Besides, nothing says amateur like not even having a ballpark figure of what you intend to charge!  So your first step, according to Steve Slaunwhite of “The Wealthy Freelancer,” is to create fee schedule for the services you offer.  The schedule should set out a range of prices for each service or product and gives you a beginning price.

“But if I don’t have much experience, how much should I charge?” I can hear you ask.  Well, in the Internet age, you should be looking up the fee schedules of your competitors and using that as a basis for how much to charge.  Adjust the price accordingly as you get experience and get a better idea of what your unique customers are willing to pay.

Don’t accept low-ball prices; if you really want the work compromise with them but get something in return, more time, money up front, a reduction in the output., a commitment for multiple purchases.  Remember that every job sets a precedent for all future work with that customer.  If you set yourself up as the bargain basement option then that is what you will always be to that client.

Fire Loser Customers!

My longtime readers know what a huge fan I am of Steve Wilkinghoff and his book, “Found Money”.  One of the highlights of Steve’s book is his “Customer Profitability Map.”  The basic premise is this, evaluate your customers by two criteria, profitability and pleasure of doing business with.  Plot them out on a grid and take the quarter that are both least pleasant to do business with and least profitable and fire them!  The quarter that are both the most pleasurable to do business with and most profitable try to cross-sell and up-sell.  At the very least, keep in close contact with them and follow what they are up to.  Meet with pleasurable but less-profitable clients and determine if there is work that could help them become more profitable.  Be wary of more profitable but less pleasurable clients.  They may be worth the hassle but keep an eye out for hidden costs and potential drains on your time and efforts.  Finally, if they should ever fall into the less profitable category, fire their asses!

I Can’t Recommend Enough

I had the honor of writing a guest article for Small Business Branding on selling your business.  It’s a lot of fun and with some great pointers to keep in mind, if even you’re not ready to sell yet.

The IRS Goes For a Cuddlier, Fuzzier Image

Hiring your business’s first employee is an important milestone for many small businesses; considered by the entrepreneur to be a sign of growth and prosperity.  Usually unanticipated is that it is a harbinger of countless frustrating hours spent working on payroll and figuring out your payroll tax obligation.

Who Pays Payroll Taxes, Me or My Employee?

Payroll obligations and taxes come in two different varieties: those that your employee pays but that you are responsible for withholding and those that you pay and are responsible for withholding.  The key here is that, no matter what, you as the employer are responsible (liable) for the proper collecting and submitting of payroll taxes and that responsibility is a serious one.  Payroll taxes cannot be discharged in bankruptcy and your Uncle Sam is the last bill collector that you would every want to cross.  So be very careful in learning your responsibilities and making sure that they are fully met

What Payroll Taxes Am I Responsible For?

Most of us have collected a pay stub and seen all the different government entities reaching their greedy fingers to steal a piece of our pay and have never really thought out what all the agencies are and what they mean to us.

• Federal Withholding is for most of us the biggest single deduction from the paycheck.  Through a Form W-4 the employee informs the employer how much they must have withheld from each paycheck.  It is the employer’s responsibility to use the W-4 to calculate how much should be deducted from the employee’s check and be remitted to the federal government.
• FICA stands for Federal Insurance Contributions Act tax and basically it means Social Security and Medicare.  The theory behind these taxes is that they are shared half and half by the employer and employee; 6.2% of wages for social security and 1.45% for Medicare.  In addition, wages subject to Social Security (but not Medicare) taxes are limited by a Social Security Wage Base which is $106,800 for 2010 but is adjusted annually for inflation.  This means that the maximum annual amount for Social Security in 2010 is $6,621.10 each for employer and employee.
• FUTA stands for Federal Unemployment Tax Act and is a tax paid by the employer; usually .8% of the first $7,000 of income.
• State and Local Taxes, as the name implies, vary greatly from state to state.  Generally, each state will charge SUTA, or state unemployment, and mandate a withholding for state taxes.

Who Do I Have to Pay Payroll Taxes On?

Payroll is a pain in the ass.  It is complicated, time consuming, creates a potentially devastating liability and causes cash flow issues for the company .  So why not just get around it?  In the past it has been fashionable to characterize people who do work for you as independent contractors, pay them the cash and just issue an 1099-MISC at the end of the year.  Not only have you freed up loads of valuable time that can be put to a productive use (for example, a three martini lunch) but you’ve also just saved yourself the FUTA and FICA taxes that you would normally be responsible for.  The employee, er, independent contractor is also happy, because they get to take home the whole check without all those pesky taxes and withholdings taken from their check.  Win-win, right?  Well guess again, Buckaroo.  The IRS has long been on to that trick and has lately launched a campaign against employers, er, contractors, that fail to properly classify those whom they hire.

Who Is an Independent Contractor?

There are no bright lines or safe harbors to determine when it is safe to actually consider a worker an independent contractor or employee, but the spirit has to do with control over the worker’s time and services.  Do you tell the worker when and where to be?  Do you either demand exclusivity of their services, or have them work certain hours so that it would be difficult to work for someone else?  Have you been paying them a consistent amount, in consistent intervals, over a protracted period of time?  All are factors that, in the eyes of the IRS, may mean that your worker is actually an employee masquerading as an independent contractor.
All this is not to say that you should immediately convert that independent contractor into an employee, but you do need to be aware of the IRS position on this and to be wary of the potential consequences should you get audited.

What Compensation Is Subject to Employment Tax?

Compensation to employees can come in various forms and be called many different names.  Whether you call it wages, salary, commissions, bonuses or something else really is irrelevant as far as determining employment taxes due; the rule of thumb is that is someone is being compensated for their time or their efforts then it is probably subject to employment tax.  Some specific exceptions carved out by law include: vacation pay, reimbursement of expenses, employee benefits, and prizes or gifts.

How Often Do I make Payments?

This depends entirely on how big your business is and how many employees are on your payroll.  Very small firms with only one employee could possibly be required to pay quarterly but most employers pay either semi-weekly or monthly.  Biz Tax Law has a great rundown on how to determine you payment schedule.  Publication 15 is our friends at the the IRS’s guide for all things related to employees.

How do I get Help!

If all this has your eyes rolling and your palms sweating then don’t despair, many entrepreneurs choose to outsource the drudgery that is payroll to specialists so that they can concentrate on what is really important, running a successful business.  There are three main options, based upon your willingness to pay and the complexity of your payroll.

• Using special software like Intuit Online Payroll - no, software can’t actually do the job for you but it can significantly save time and hassle by automatizing the process.  The best packages also provide support so you have a resource when the inevitable oddball transaction comes up.
• Hiring an accounting firm – most accounting firms (like us!) that have a concentration in working with entrepreneurs will also have a payroll outsourcing function that can take most of the dirty work off your hands.  These usually specialize in small and medium size enterprises, under 100 employees.
• Hiring a payroll outsourcing firm - Paychex is the big dog on this block with almost 40 years of experience handling payroll for medium and larger sized businesses.  Generally the most expensive, and often the most complete, option available.

Please leave your questions or offer your solutions below. As the WebCPA and the author of WebBizFinance.com, my job is to help you grow your business and solve your business finance and accounting problems!

Tyler Wells, C.P.A.

Everyone wants more income, but way too many business owners and managers don’t really fully understand the concept of net income and what it means to their business.  Learn the simple trick to fully understanding and preparing your income statement.

Money Makin' Inc.

Other Names:

The Income Statement is also often called a Profit and Loss Statement, and, less commonly, a Statement of Operations, an Earnings Statement, or an Operating Statement, depending upon the industry or geographic area that you operate in.  For our purposes, they are all one and the same.

What It Is

“C’mon Tyler, this is a waste of time; everyone knows what an income statement is!”  I can hear your argument now.  Well, knowing what it is and understanding are two different things, so have a little patience.  Let’s start by looking at Wikipedia’s definition of the income statement as

“a company’s financial statement that indicates how the revenue (money received from the sale of products and services before expenses are taken out, also known as the “top line”) is transformed into the net income (the result after all revenues and expenses have been accounted for, also known as the “bottom line”). It displays the revenues recognized for a specific period, and the cost and expenses charged against these revenues, including write-offs (e.g.,depreciation and amortization of various assets) and taxes.”

Clear as mud?  Here is another way to look at it.  If you remember from our lesson on the balance sheet and on retained earnings, the balance sheet represents, at one given moment in time, a company’s assets (everything it owns that has value) less its liabilities (everything it owes or that will cost it money in the future) to get at its equity (the net value of the company).  What the income statement does, together with the statement of owner’s equity, is to tell the story of the change in a balance sheet over a period of time.
Let’s boil this down to the simplest level, and ignore everyone out there who is screaming out exceptions that really don’t apply to most of you as entrepreneurs and owners of small businesses.  Your Net Income (the bottom line of your income statement) must be equal to the increase (or minus the decrease) in your assets over the year minus the increase (or plus the decrease) in your liabilities plus any cash paid out to the owner.

Now think about this, increased assets make you feel happy, right?  After all, they represent items that have value to the business and that should, in the future, bring you money.  Increased liabilities should make you a little uneasy.  Your liabilities are money that you will have to pay out someday, which will make you unhappy.  I hate paying money, but I sure love getting it!  Maybe that’s why my wife calls me a cheap sonofabitch.  Now, your distributions are money that you have already taken out; and so they gave you happiness at some point in the past.  So really, net income is your overall increase in future happiness, less the increase in future unhappiness and plus the amount you have already taken out in past happiness!

Why important

The income statement is the single most important vital sign of the health of your business.  If income is good, then more assets can be put to use for the business and more money can be distributed to the owners.  The flip side is that when income is negative, which means that you have a loss, then you will have less money to take out of your business as distributions and you will have to support your operations by either selling off assets or by increasing liabilities.

What It Looks Like

If you have accounting software, like QuickBooks, then you will get a basic presentation as part of the package.  In virtually all businesses, the income statement starts with sales and ends with expenses.  If your enterprise is either manufacturing or retail related, then the basic presentation is Sales – Cost of Sales (also called Cost of Goods Sold) = Gross Income – Sales Expense, Operating Expense, and all other expenses + income not from ordinary operations (such as the gains on the sales of assets besides inventory or interest income) – expenses not from ordinary operations (including taxes, although I would consider taxes pretty ordinary) = Net Income.

Oh my God!  I’ve just totally turned geeky-accountant super-nerd on you guys!   Look, presentations vary wildly from industry to industry and from one set of accounting standards to the next.  If you need to present the statements to others then you’ll probably end up getting an accountant to put them together, anyway.  So just put them together in the way that makes sense for you and helps you find the information that you need.

What is Revenue

Now that we know what the net income must be, let’s take a peek under the hood to see some of the gory details.  The basic income statement is divided between items that have made you money or will make you money in the future, income or revenue, and items which have cost you money or will cost you money, expenses.  As you may imagine, we want to keep close tabs on those warm, fuzzy revenues so that we can nurture them and make them grow and thrive.  Therefore, we group the revenues together and lump them at the top of the page.  Your revenues can further be divided by important products or divisions to provide the readers of the income statement with more information.  Finally, some items are always segregated from the general revenue items due to their unusual nature, including unrealized gain or loss on assets, realized gains or losses on assets, interest income, and other items.

What is an Expense

Expenses are the Devil, prying money from your pockets either now or in the future.  Every business has to deal with the Devil in order to operate, but we want to keep track of these deals so that we know how much of our soul we still have left!  As you may imagine, we further segregate expenses into sub-categories.  Cost of Goods Sold (also called Cost of Sales) is the money you spend to purchase or make the product that you sell.  General and Administrative Expenses are more peripheral items that pop up in the course of running a business.  Your accounting software, wages paid to the janitor or the secretary, Internet service for the office, basically anything that can’t be directly attributed to the purchase or manufacture of your product.

How to Prepare Your First Income Statement

If you are using QuickBooks or another accounting program then it is seemingly easy to put the income statement together.  The problem with most of those programs is that they can’t tell you when you put garbage in them.  So you will want test your income statement by following the steps below.
Step One: Make sure your balance sheet is up-to-date and accurate.
At the end of the year I go down my balance sheet line by line and make sure every amount makes sense to me.  In fact, that is the first step of an auditor if you get your statements audited.  I like looking at at least two periods side by side, since inconsistencies are more apparent that way.  Make any adjustments that you need and move on to Step Two.
Step Two:  Calculate Your Retained Earnings
I’ve already written about this in detail in another article, but basically your retained earnings are the bridge between your balance sheets for the current and prior periods.  Any change must be reflected in retained earnings, which is in return the product of your income plus any contributions in capital and less any distributions of capital.  So if you can get the correct number for any capital that you took out (other than wages, which will go onto the income statement and for which you will pay payroll taxes) or put into the business then you can isolate the effect of net income.  Can you figure those out?  Good, then any remaining change in net assets must be due to net income.  Now you have your net income and, if you are using an accounting software, you should check your number for net income with the number that you just calculated.  If they don’t match, well, you’re screwed and I can’t help you anymore.  No, just kidding, you’ll have to adjust your income on the income statement to match.
Step Three: Fill In the Blanks
Now plug the number that number into the bottom line of your income statement and start filling in the details.  When you have everything in but it doesn’t total up then just plug the difference, if it is minor enough, into some sort of Miscellaneous Expense or Miscellaneous Income account.  Don’t worry your accountant does that all the time!

Please leave your questions or offer your solutions below. As the WebCPA and the author of WebBizFinance.com, my job is to help you grow your business and solve your business finance and accounting problems!

Tyler Wells, C.P.A.

It didn't have to come to this

If I am filing bankruptcy, can I also discharge any taxes I owe? I get this question way too much these days and it is never pleasant. Neither, unfortunately, is the answer, “maybe.” Like anything that has to do with our government, the rules and limitations for discharging your tax debt through bankruptcy are complicated and are most likely to benefit you if you carefully examine your options, plan ahead, and hire some professional help.

Income Tax Rule

In order to eliminate your tax liability through bankruptcy, it has to clear the following hurdles:
Be more than three years old – the three year clock starts ticking on the date the tax return for the year in question was due; so April 15, 2010 for 2009 taxes. Note that this is the minimum time in which you can include taxes in your bankruptcy and that certain circumstances could extend this even further.

• Be filed at least two years ago – the date that you file the bankruptcy petition must be at least two years after the date that the tax return was filed. This is relevant if you filed an extension, were late to file, or just plain failed to file a return. The motivation here is plain, get those damn things filed! Even if you don’t have enough money to pay the taxes due it is almost always better to file without paying then not file at all.
• Have not received an assessment from audit adjustments or amended returns in at least 240 days. This could be extended by an Offer in Compromise (see below). Basically, this means that your return was amended, either by yourself or by the IRS, and additional tax was assessed because the original return was incorrect.
• No fraud or evasion – as you may have guessed, your rich Uncle Sam gets pissed off when people try to deceive him, and so fraudulent returns or tax evasion can mean that your debt is not dischargeable in bankruptcy.

Two Bankruptcy Options

Chapter 7 – “The Full Monty,” and what people usually mean when they say
bankruptcy, Chapter 7 is when everything except certain exempt assets are sold and then the money is divided up between your creditors.
Chapter 13 (11 for businesses) – or “reorganization,” is when a plan is made for you to repay your debts under court supervision. Essentially, Chapter 13 allows you to put together a plan with all debtors and then set up a system of repayment. As part of the bankruptcy some of the amounts due can be reduced or new terms can be established.

Limitations of Bankruptcy

Taxpayer Beware: the above rules only pertain to federal income tax due. State
taxes are a whole different ballgame and will have to be resolved on a state by state basis. In addition, the following taxes cannot be eliminated in a bankruptcy:

• Self-Employment Taxes – this one can be particularly tricky because so many
• entrepreneurs just get their self-employment taxes lumped in with the rest on their 1040s and don’t really think about them. However, you’ll have to separate these if you are considering filing bankruptcy to see how much of your tax is really potentially dischargeable.
• Payroll Tax Withholding - Like self-employment taxes, you can’t discharge your payroll tax withholding in a bankruptcy.
• State Sales Taxes – ditto
• Various Other Taxes That I Have Forgotten to Include – No, those are not dischargeable either.

Options to Bankruptcy

Most taxpayers who owe federal taxes will at least consider the alternatives
to bankruptcy, if only because there is no way in Hell the IRS will let you get by three years before assessing you for taxes due.

• Installment Agreement - like any other creditor, the IRS can, at its discretion, put taxpayers on payment plans to help them settle their debts. Note, however, that interest and penalties will still apply and so it is in your best interest to pay the amount due as quickly as possible.
• Collection Due Process - a CDP can be filed with the IRS to protect your right to go to court and is filed after you have received a Federal Tax Lein or an Intent to Levy. Basically, with a CDP you are signaling your intent to dispute the assessment. File to protect your right to go to court.
• Offer In Compromise – Make a deal with the Devil and ask the IRS to reduce your burden by accepting partial payment. The IRS may decide to accept an Offer in Compromise if there is some doubt about the legitimacy of the amount you are purported to owe, if there is no doubt as to the legitimacy of the payment but there is no way you have the ability to cover the payment, or if you have the assets to cover the payment but there are some remarkable extenuating circumstances that convince the IRS to have mercy on your soul, like you’re abducted by aliens and have to pay the ransom.

What does this mean if I am behind on my taxes and I owe the IRS money?

In theory, people in economic trouble shouldn’t really owe taxes because they don’t have much income. However, as with just about everything in life, there are 5,001 potential outcomes that could result in your owing taxes and not having the cash to come up with the payment.

1. Step One: File all returns. Remember that you will have to have filed at least two years before filing for bankruptcy if you hope to have your taxes discharged, so make sure that you are up to date.
2. Step Two: Protect your spouse. If the tax burden, and accompanying inability to pay, is the result of the activities of one spouse then consider filing married filing separate to protect the other spouse.  This usually happens when one spouse is an aspiring Donald Trump or Oprah Winfrey while the other is a mild-mannered librarian.
3. Step Three: Is the inability to pay due to a permanent or temporary change in fortune? If your business was wiped out and folded sometime between the beginning of the year and when your taxes are due then you are a prime candidate for some sort of deal with the IRS. On the other hand, if you can’t pay your tax bill because you already spent the money without budgeting enough for taxes then you are most likely a candidate to get on some sort of payment plan.
4. Step Four: Pull the trigger. Either way, don’t duck the issue and hope that it will go away. Take the bull by the horns, get your returns filed, and then seek some professional council on how you can get the situation resolved.

Please leave your questions or offer your solutions below. As the WebCPA and the author of WebBizFinance.com, my job is to help you grow your business and solve your business finance and accounting problems!

Tyler

The balance sheet boldly declares where a business stands at a given moment in time.  From the balance sheet, a financially sophisticated reader can learn an immense amount of valuable information about a business and its viability.  That is why potential investors and lenders will almost always ask you for a copy of your financial statements, including the balance sheet, income statement, statement of retained earnings, and statement of cash flows.  This is also why you, as a savvy entrepreneur, need to understand the information presented on them.

Why It Is Important

The principal reason your business’s balance sheet is so important to you and to any potential investors or lenders is that it is like a photograph of your business.  It tells how the business is put together, what its principal resources are and where any potential dangers lie.  Like any portrait it is incomplete, in that it only shows one fleeting moment in time, and therefore is most useful in conjunction with the income statement and by comparing several balance sheets over a period of time.  Ahh, this is where the real story begins to unfold!  The clever entrepreneur becomes the Sherlock Holmes of the balance sheet and astutely looks for trends over time and checks ratios and balances to see which direction the company is headed in and to look for any potential to cut costs or perform more efficiently.

Why Small Businesses Are Different

If you are a small business owner or entrepreneur then you need to be able to read and understand your balance sheet because, first, it is through your financial statements and other numerical data that you collect that you really get to know your business.  Michael Gerber, the best selling author of the E-Myth Revisited, says it much better than I ever could as “because without the numbers you can’t possibly know where you are, let alone where you’re going. With the numbers, your business will take on a totally new meaning. It will come alive with possibility.”  The very first step you will ever take down that road to really knowing your business is through examining and understanding your own balance sheet.

Second, your balance sheet is how anyone that you will ever want to do business with will understand your business.  Think about getting a loan, the first thing your banker wants to see are your financial statements and the first page of your financial statements is your balance sheet.  Why is it first?  Perhaps because it is the most important.  Now think about your situation; you’re applying for a loan or a grant or you want to do business with the federal government or an investor is thinking about either coming on board or buying you out and you present your financial statements to them.  They open them up, turn to page one, and there is your company laid bare, open to them.  And they ask you questions; “why is this line a negative number, how did you arrive at the valuation of that line, what are the terms of this liability.”  Don’t you want to be able to confidently look them in the eye and answer those questions?

What Makes Up a Balance Sheet

Hopefully, you have been exposed to some basic accounting and understand the concepts that some numbers in accounting are recorded as debits and some numbers as credits.  These numbers are often represented as positive and negative numbers and the balance sheet, as its name suggests, must balance, i.e. the negative and the positive numbers must total zero.  In addition, the basic formula for accounting is Assets = Liabilities + Equity, and any US balance sheet will be organized into exactly three sections with at least two subtotals, for assets and for liabilities and equity.  Using the basic algebra that we learned in Ms. Arithmatic’s 6th grade class, we can shrewdly deduce that the two subtotals must be exactly equal.  So far no problem, because if your balance sheet doesn’t balance then you have much bigger problems then simply worrying about understanding your financial records.

How Assets Are Valued

Great! you’re thinking, let’s start with the assets!  Well, I love an enthusiastic learner and so I will oblige.  To put it very briefly, assets are the total of everything your business has that has some sort of value to the business.  This could be cash or real estate or stocks and bonds or machinery and equipment or accounts receivable or other moneys due to you.  It could also include inventory, which is product that you have produced but not yet sold.  So to summarize assets are usually either cash, something that you have bought, something that you have made and that you expect to sell, or something that is owed to you.

Clearly then, if you want to make your balance sheet you must have a list of your assets and how much each is worth.  The rub lies in the worth, or valuation of the assets.  “Hmm, you think, I bought this asset ten years ago at 10 grand, I added 5 grand in improvements to it, it would cost me 20 grand to replace it and I could get about 18 grand on the open market for it, so what value should I put down for it?”  Clever question, my dear reader!  Well, as you may have assumed, we accountants have put a great deal of thought into these issues and we continue to think about and tweak the ways we value things to this very day.  If you want the exact answer to just about every accounting question then it is there for you, for free but in techno-accountant babble, at http://asc.fasb.org/.  However, most of you don’t want to do all that work, you want a quick and easy rule of thumb that works 90% of the time without you having to leave this article, and that is exactly what you will get.  The key here is conservatism, we are much more worried about overvaluing an asset then we are at undervaluing.  Therefore, the rule of thumb is that assets are valued at the lessor of cost (what you paid for it) or fair market value (what you could get if you sold it right now).  Now, there are additional considerations, like depreciation for buildings, machinery, and equipment, and the value of receivables and other moneys owed to you, but that is the general rule.

How Liabilities Are Valued

The next step is to make a list of items that your business owes or obligations that it has.  This could be money that you owe to your suppliers for products and services or money that you owe to your employees for services performed or money that you owe to the government for taxes or or money that you owe to the bank or another lender.  It could even be money that the business owes to you, as an owner.
Remember what I said before about conservatism?  Well, this counts for liabilities as well, only in this case the concern is that liabilities are undervalued or, even worse, unrecognized and unrecorded.  The general rule of liabilities is that they are included at amortized cost which should be equal to the amount owed on them at that moment in time.  This usually presents less of a challenge than the valuation of assets because most long term assets, like loans, have explicit terms that spell out exactly how much you owe on them at any given moment in time.

How Equity Is Valued

Depending upon the type on entity (Corporation, S-Corp, LLC. etc.) that you use the equity portion of the balance sheet can use different terms, but really there are two kinds of equity: capital that you put into the company (stock, contributed capital, etc.) and the earnings of the company (retained earnings).  The capital that you contribute is usually pretty straightforward.  If you contributed something other than cash, such as real estate, machinery, or your interest in another business then use the rules for the valuation of assets, the lessor of cost or fair market value.

Retained earnings is a whole different ball game.  Remember what I said back in the beginning about the formula for the balance sheet?  That Assets = Liabilites + Equity?  Well, if you’ve filled everything else out you only have retained earnings left, and, using a little bit of algebra and adding some detail to the preceding formula, retained earnings absolutely must equal Assets – Liabilities – Contributed Capital.

Now, it’s fine to do the math and plug the number to get started, but as you go forward your retained earnings will develop a new relationship, with the income statement (also commonly called the profit and loss statement).  Basically, the relationship is net income + any contributions to capital – any distributions of capital (dividends) = the change in retained earnings for the period.  So retained earnings becomes the bridge between the balance sheet over two consecutive time periods (usually a year).  For more information on calculating retained earnings see the link to my blog post on retained earnings.

What the CPA or Auditor Does

You’ve done a fantastic job getting your balance sheet set up and keeping it going, but at some point you’re going to show it to someone, a banker, a supplier, a potential business partner, and they are going to take one look at the work that you have so proudly and lovingly put your heart into and they will say, “what the Hell is this crap?”  Don’t take it personally (you need their money, after all) just understand that there are standard ways to present present financial statements and set rules to follow.  In order to make your statements comply with these rules and to give them an air of authority you will have to hire a Certified Public Accountant, or C.P.A., and have them compile, review, or audit your financial statements.  What this means is that the C.P.A. takes your statements and then makes some cosmetic changes in order to present them in the form proscribed by US Generally Accepted Accounting Principles or, if appropriate, one of a number of alternate forms, and then issues an opinion on them.  The opinion will vary depending upon the type of engagement you hired them to do.  The standard opinion for a compilation is “we took this pile of crap and made it pretty, but we’re not saying that it makes any sense” while the standard opinion for an audit is “sure, we took a look and everything seems OK, but please don’t sue us if we’re wrong!” while a review falls between the two.

Shenanigans

If you’ve watched the news at all over the past five years then you are aware that not all balance sheets are what they are painted to be.  Enron and WorldCom are the biggest examples of out-and-out fraud, but more recently the big Wall Street firms, like Lehman Brothers, have come under fire for inadequate or questionable accounting practices.  How does this all happen?  Well, let’s go back and revisit the assets and liabilities sections of this article and rethink what I said about conservatism.  If assets are valued at higher than they should be, or liabilities lower, the difference must come through retained earnings in the form of income.  So, most accounting frauds are a resulting of overstating assets, usually inventory for industrial firms or investments for banking and Wall Street firms, or by not including certain liabilities on the balance sheet.

Please leave your questions or offer your solutions below. As the WebCPA and the author of WebBizFinance.com, my job is to help you grow your business and solve your business finance and accounting problems!

Tyler

Time to Count Some Beans

What is Return on Investment for a Small Business?

If you have experience as an investor then your are familiar with return on investment as being the amount you earn on your investment over the amount that you paid for it.  So when you shop around online to get a half a percentage higher interest rate on your savings account you are looking for a higher return on investment.

How Do I Calculate It?

For your small business, the concept is the same, return on investment is a measure of what you get out of your business divided by what you have invested in it .

The key word here is measure, the return on investment formula is a tool to help you measure how efficient your business is at generating profits.

Why Is It So Important?

Your assets are the resources that you have put into your business, your investment.  When you calculate return on investment you are concerned with two things: first, the opportunity cost of your resources, and second, the trend of your business’s return on investment over time.

Opportunity Cost

The opportunity cost of your resources basically answers the question; “would I be better off putting these assets to a different use.”  Think back to the example of a savings account, if the return on investment from your business isn’t beating the interest you would get if you sold your assets and deposited the money in a savings account, then you’re pretty much screwed.  Either you have to take drastic action to improve the ROI or you should find a more effective use for your assets.

Change Over Time

The trend of your ROI over time is the canary in the coal mine; a steady and increasing ROI means a strong and healthy business while a negative or decreasing ROI is usually a precursor to a long, slow, and painful death for your business.

“Hidden” Assets

When you start your business you are often a one-man band, you are not only the Chief Executive, Sales, and Financial Officer but also the delivery boy, the maintenance man, and the head of productions.   As such, you get a huge amount of time wrapped up into your business and this creates what Steve Wilkinghoff, in his amazing book for business owners Found Money, calls “hidden inventory.”  It is hidden because it is not captured by traditional accounting but it is crucial to achieving success in a small business.  If you are a lawyer and a client hires you to handle a certain legal issue and you go to work at it but then, after putting say 20 hours into the project, get called aside to do a second project and leave the first on hold then you have hidden inventory.  The time that you invested in that project should be billable to the client but you can’t bill them until you’re done.  So there you have hidden inventory, it is the work in process that can’t be collected upon until the job is done.  The danger for the small business owner, who often is a one-man (or woman) show, is that they build up this hidden inventory, and work like crazy to do so, but are too slow at bringing it to the point of billing and thereby run into the trap of too much work and not enough money.  Estimate how much hidden inventory you have and add this hidden inventory to your assets when you calculate return on investment.

What is an adequate return

As we already discussed, if you have another investment immediately available to you (like a certificate of deposit or a savings account) and it offers a higher return on investment than your small business then you should feel really, really, uncomfortable.  I will tell you that so many times I have seen businesses borrow money with a higher interest rate than their return on investment and I just to take them gently and tell them to go spend that cash at the casino, because it is about that bad of an investment.  Your small business should generate for you several times the ROI of just about any investment you can readily find.  Why, because it is very risky investment.  1 million and one things could go wrong and you will find yourself back to square one, only this time you will owe tons of money.   So, the higher the risk the higher the required return you should require.

Please leave your questions or offer your solutions below. As the WebCPA and the author of WebBizFinance.com, my job is to help you grow your business and solve your business finance and accounting problems!

Tyler

Big Dollars For My Biz

Take the Initiative

The fact that you have a valuable business for sale, something millions dream about but never get around to doing, means that you are the type of person that takes charge and gets things done. So don’t stop now, merely hanging a “For Sale” sign on your door, or even hiring a broker, and then sitting back and waiting for things to happen isn’t going to cut it when it comes to selling your precious asset, you will have to go out there and make this happen. Start by thinking of who you’re potential buyer will be. A-list blogger and online entrepreneur Yaro Starak sold his first web business to some of his best customers, who loved his business so much that they didn’t want to risk it falling into less friendly hands. Think about your competitors, about business owners in the same industry who may wish to expand into your industry, and businesses in parallel industries that could find useful synergies with your own. For example, if you have a camping supply store then a synergy might be someone selling adventure travel and vacations; the two have a significant overlap in customers and could try to cross-sell their customers. Don’t forget to market to trade and professional organizations, if they’re appropriate to your business. I know that the AICPA (Bean Counters of America Association) has a special area on the web site for CPA practices for sale. In case you’re wondering, I’m going to build my own up to the eight figure neighborhood before I put it up for sale.

Importance of Financial Records and Other Information

When you sell a pound of alpaca wool or a barrel of North Sea Brent Crude the exchange is pretty easy; the buyer knows what she is getting and what the current price for it is. Your business, however, is not something that you can drop on your foot, but rather a process or a system that (hopefully) generates cash and profits for its owner. To show prospective buyers what the value of the business is you will need a narrative, which is a one page summary of what your business does to make money, and some supporting numbers, usually in the form of financial statements and tax returns. If you have traditional financial statements then that’s great but you also want to put together a summary of several years statements (if indeed you’ve been in business that long) in a tabular format so that any prospective buyer can easily see what the trend for your business is. Also, in many industries, such as with a website or online store, you will have important non-financial numbers to compile and include in your summary. For example, if your web site is an important element of your business then a number of metrics, such as unique visitors, become important to the businesses potential value to a buyer. Remember that many potential buyers will already be in your business and will by looking for synergies with their own businesses that may increase the value of what you have to offer, so don’t make them have to hunt for this information, tailor your approach to your potential buyer. SCORE has an excellent check list on what you’ll have to prepare before you sell.

Brokers, Accountants, and Lawyers

Your accountant absolutely must be informed of your intent to sell, the earlier in the process the better, and be kept up-to-date at all times. The timing and structuring of the sale can have enormous tax consequences. Remember, due to taxes a $50,000 sale isn’t really worth 50 grand to you; sometimes it’s worth much, much less. Your lawyer needs to be brought in once you have an interested buyer and before you begin to discuss terms. Your lawyer’s job is to structure the sale so as to protect you as much as possible from fraud, default, and negligence from your buyer and to limit your liability during any interim period.  The use of a broker will vary depending on the industry and the expected price of the sale.  Whether you use a broker or not, don’t expect to be able to just hand the job off to them and then forget about it.  From my experience and from what I have been told the majority of businesses get sold through good luck, good timing, or the owner’s hard work.

Online Marketplaces

In the new global age you can buy or sell almost anything online, including your small business and a number of sites have come up to help you connect to a buyer. The online option isn’t just for online businesses, according to the general manager of one of the largest online marketplaces, bizbuysell.com, restaurants were actually the single largest category of business that they sell. Other larger players are imergeadvisors.com and bizquest.com. The market is still relatively young and fragmented, so you might peruse all three to get an idea of their individual strengths and specializations. Also, it is great fun and enormously beneficial to see what the owners of similar businesses are asking and what information they are providing.

Ebay also has a section for selling businesses and websites and, as of today, it had 17 thousand businesses listed, although 12 thousand of those were web sites. My suspicion is that Ebay’s format would be inadequate to sell a more complex business, in which communication between the owners, the sellers, and their supporting professionals is essential, but it does make for some interesting comparisons. Plus it is really fun to look at some of the remarkable stuff that people are trying to sell.

Be Prepared to Negotiate

The old saw in business negotiations is “I’ll let you name your price if you let me name my terms.” What this means is that the structure of the sale is as important as the price of the sale. If you are only interested in cash up front then be very clear and firm on this to potential buyers. When one of my first and best clients, my Dad, passed away he had a number of valuable assets that my mother was not able to or interested in running. I was living in a foreign country at the time but managed to come back for a month and half to help settle things and helped my mother sell off some of these assets, mostly real estate related at a time when real estate was still very hot. It was fascinating and eye opening to listen to the pitches of some of the potential buyers and creativity of some of the terms that they offered. One of the most popular propositions was that one of the assets be put into a partnership owned by my mother and the buyer and then the “buyer” (Mom’s new partner) would contribute their labor and expertise to convert the asset into a more lucrative form (i.e. subdivide or build a building for lease, what Dad had already planned to do with it) and then would share the profits with Mom. The chances are that you are going to get offers that are a combination of cash and credit and in some cases may require your continued involvement. Don’t hesitate to bump up the price if the terms aren’t to your convenience and do not hesitate to walk (run) away from any deal that might put you into business with someone of questionable moral character.

Please leave your questions or offer your solutions below. As the WebCPA and the author of WebBizFinance.com, my job is to help you grow your business and solve your business finance and accounting problems!

Tyler

Health Insurance

Being self employed is fantastic!  There is no one to tell you what time you need to be at work or what you have to wear or to pay for your health insurance and for half your payroll taxes.  What?  Gotcha!  Many new entrepreneurs overlook the need for health insurance and just how much it will cost them when they strike out on their own.

You MUST Have It!

Right after I got out of college I shook the dust of Indiana off my feet and headed down to someplace really fun, Miami.  I had a fantastic time working odd jobs and trying new things out for a year until, one visit home my father gave me one of those fatherly lectures; not about finding a career but about finding health care!  “What if something happens to you, what do you think your mother and I would do, just let you die or suffer?  You know we would spend our every last dollar trying to save you, is that something you want on your conscience?”  Grief stricken at the thought of my parents staring at my lifeless body in a casket, contemplating their future with no son and no money, I went to grad school for finance, ended up in accounting, and the rest is history.
“So what?” you shrug.  Well, no one ever thinks it is going to happen to them but it always happens to someone!  So, if you don’t get health insurance for your sake, do it for your mom, she’s worried sick!

Mom & Dad

“Alright,” you grumble, “but where do I get health insurance that won’t cost too much?”  Try starting with dear old Mom and Dad.  You see, with the new Obama-care health insurers are mandated to offer health insurance to all children up to age 26, irregardless of whether they are in school or not.  In fact, most of the big insurers, including United Health Care, WellPoint, CIGNA, and Blue Cross & Blue Shield are already in the process of implementing this.  Also, a few states already require that insurance be available for children up to age 26, or even older.

Spouse’s Job

Hey, this is one of the reasons so many self employed are married to school teachers; they can still get the good benefits that way!  An obvious resource but one that shouldn’t be overlooked.

Day Job

So what if the significant other doesn’t have a job or their current job doesn’t offer health benefits?  Well, head over to your nearest Starbucks, Whole Foods Markets, or local government branch and pick them up an application!  There are some employers who still have a reputation of providing quality health benefits at an affordable price for their employees .  Better yet, pick up two applications because you may want to consider getting a day job yourself until your business takes off.  Check out employers with flexible or alternative hours that will leave you time to work on your business after hours.  Hey, once I even worked as a parking lot attendant and could have worked on my business even as I got paid (and insured) on my regular job.  Of course, I squandered that time studying.

Trade organizations

If you’re too old (or an orphan), not married, and don’t think that a second job would work for you than the next step is to look toward any trade organizations that you might be a member off that might have a health insurance package.  Also try your local chamber of commerce, AARP if you’re over 50, and the Small Business Services Bureau.  A fabulous resource is Health Insurance Info Net by the Georgetown University Health Policy Institute that gives up to date information on a state-by-state basis; including sections for small business and the self employed.

Insurance broker

It is the insurance broker’s job to help you find the right insurance package for your needs and the option shouldn’t be overlooked.  Just do remember that, as with any broker, your interests and those of the broker are not always in alignment and therefore shop around first to get an idea of what your other options are.  Comparing health plans is tricky, because there are so many variables all of which will be important to different people.

COBRA

If you’re leaving a job to go out on your own, don’t forget to get signed up for COBRA before you go.  COBRA basically gives you the chance to continue your current insurance, under your now ex-employer, for up to 18 months after you leave that employer.  This buys you time and allows you the chance to shop around some.  With COBRA, however, you pay 100% of the cost of your coverage, so no employer subsidy.  Do not let your insurance lapse!  When you eventually pick up a new insurer you don’t want the to say whatever you need taken care of was a pre-existing condition.

What’s your experience with health care?  Did you find it a difficult part of the transition from being employed to becoming an entrepreneur?

Please leave your questions or offer your solutions below. As the WebCPA and the author of WebBizFinance.com, my job is to help you grow your business and solve your business finance and accounting problems!

Tyler