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Archive for the Business Category

Cash Flow - The Pulse of Your Business

August 17, 2008 by Ray Perez.

There are frighteningly many small business owners out there who do not understand their cash flow statement. A shocking fact considering that all businesses essentially run on cash. And cash flow is the life-blood of your business.

Some business experts go so far as to say a healthy cash flow is even more important than your business’ ability to deliver its goods and services! You may find that perspective hard to swallow, but consider this – if you fail to satisfy a customer and lose that customer’s business, you can always work harder to please the next customer. But if you fail to have enough cash to pay your suppliers, creditors, or your employees, you’re out of business!

What Is Cash Flow?

Cash flow, simply defined, is the movement of money in and out of your business; these movements are called inflow and outflow respectively. Inflows for your business primarily come from the sale of goods or services to your customers. The inflow only occurs when you make a cash sale or collect on receivables, however. Remember, it is the cash that counts! Other examples of cash inflows are borrowed funds, income derived from sales of assets, and investment income from interest.

Outflows for your business are generally the result of paying expenses. Examples of cash outflows are… paying employee wages, purchasing inventory or raw materials, purchasing fixed assets, operating costs, paying back loans, and paying taxes.

Note: An accountant is the best person to help you learn how your cash flow statement works. Please contact us and we can prepare, if needed, and explain where the numbers come from in your cash flow statement.

Cash Flow Verses Profit

Profit and Cash flow are two entirely different concepts, each with entirely different results. The concept of profit is somewhat broad and only looks at income and expenses over a certain period of time, say a fiscal quarter. Profit is a useful figure for calculating your taxes and reporting to the IRS.

Cash flow, on the other hand, is a more dynamic tool focusing on the day-to-day operations of a business owner. It is concerned with the movement of money in and out of a business. But more importantly, it is concerned with the times at which the movement of the money takes place.

Theoretically even profitable companies can go bankrupt. It would take a lot of negligence and total disregard for cash flow, but it is possible. Consider how the difference between profit and cash flow relate to your business.

Example: If your retail business bought a $1,000 item and turned around to sell it for $2,000, then you have made a $1,000 profit. But what if the buyer of the item is slow to pay his or her bill, and six months pass before you collect on the account? Your retail business may still show a profit, but what about the bills it has to pay during that six-month period? You may not have the cash to pay the bills despite the profits you earned on the sale. Furthermore, this cash flow gap may cause you to miss other profit opportunities, damage your credit rating, and force you to take out loans and create debt. If this mistake is repeated enough times you may even go bankrupt!

Analyzing Your Cash Flow

The sooner you learn how to manage your cash flow, the better your chances for survival will be. Furthermore, you will be able to protect your company’s short-term reputation as well as position it for long-term success.

The first step towards taking control of, and properly managing your company’s cash flow is to analyze the components that affect the timing of your cash inflows and outflows. A thorough analysis of these components will reveal problem areas that lead to cash flow gaps in your business. Narrowing, or even closing, these gaps is the key to cash flow management.

Some of the more important components to examine are:

Accounts Receivable. Accounts receivable represent sales that have not yet been collected in the form of cash. An accounts receivable is created when you sell something to a customer in return for his or her promise to pay at a later date. The longer it takes for your customers to pay on their accounts, the more negative affects there will be on your cash flow.
Credit terms. Credit terms are the time limits you set for your customers’ promise to pay for the merchandise or services purchased from your business. Credit terms affect the timing of your cash inflows. One of the simplest ways to improve cash flow is to get customers to pay their bills more quickly.
Credit policy. A credit policy is the blueprint you use when deciding to extend credit to a customer. The correct credit policy is necessary to ensure that your cash flow doesn’t fall victim to a credit policy that is too strict or to one that is too generous.
Inventory. Inventory describes the extra merchandise or supplies your business keeps on hand to meet the demands of customers. An excessive amount of inventory hurts your cash flow by using up money that could be used for other cash outflows. Too many business owners buy inventory based on hopes and dreams instead of what they can realistically sell. Keep your inventory as low as possible.
Accounts payable and cash flow. Accounts payable are amounts you owe to your suppliers that are payable sometime within the near future, “near” meaning 30 to 90 days. Without payables and trade credit you’d have to pay for all goods and services at the time you purchase them. For optimum cash flow management, you’ll need to examine your payables schedule.

Some cash flow gaps are created intentionally. That is, a business will sometimes purposefully spend more cash to achieve some other financial results. For example, a business may purchase extra inventory to take advantage of quantity discounts, accelerate cash outflows to take advantage of significant trade discounts, or spend extra cash to expand its line of business.

For other businesses, cash flow gaps are unavoidable. Take, for example, a company that experiences seasonal fluctuations in its line of business. This business may normally have cash flow gaps during its slow season and then later fill the gaps with cash surpluses from the peak part of its season. Cash flow gaps are often filled by external financing sources. Revolving lines of credit, bank loans, and trade credit are just a few of the external financing options available that you may want to discuss with us.

Monitoring and managing your cash flow is an important task to perform in order to ensure the vitality of your business. The first signs of financial woe will appear in your cash flow statement, giving you time to recognize a forthcoming problem and plan a strategy to deal with it. Furthermore, with periodic cash flow analysis, you can head off those unpleasant financial glitches by recognizing which aspects of your business have the potential to cause cash flow gaps. With cash flow management and analysis, you will be able to plan on how you’re going to direct your cash surplus with assurance that you will have adequate funds to cover day-to-day expenses.

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Which Form of Business Should You Use?

February 26, 2007 by Ray Perez.

Whether you’re starting a new business or expanding an existing one, the choice of a structure for the business can be vital to its success. In this discussion, we’ll briefly describe the forms in which a business can operate, and give you some of the pros and cons of the each form.

Caution: As with any decision involving legal and financial factors, the choice of form for a business should not be made without professional advice.

Sole Proprietorship

The easiest and least expensive way of starting a business, a sole proprietorship can be formed virtually by opening the business’s doors (or Website). Of course, there will be fees for business name registration, and for any needed licenses. Sole proprietorships are owned by one person, who usually also has day-to-day responsibility for running the business.

TIP: If an owner desires absolute authority over all aspects of the business, the sole proprietorship may be the optimum choice.

Possible Advantages

Sole proprietors own all the assets and all the business profits. In the eyes of the law, the business owner and the business are one and the same. With a sole proprietorship, the tax effects—profits and/or losses—flow directly to the owner’s tax return.

Possible Disadvantages

Sole proprietors have unlimited liability for all debts or claims against the business, and their business and personal assets are at risk. Second, sole proprietorships are often limited to obtaining capital from the owner’s savings, personal assets, or consumer loans. Third, sole proprietorships may not be able to attract high-caliber employees, and also cannot offer employees ownership incentives. Finally, tax-wise, some employee benefits, such as the owner’s medical insurance premiums, do not directly reduce taxable business income.

Partnership

Partnerships are usually more complicated—and more expensive to set up and maintain—than sole proprietorships.

TIP: Although a general partnership can be formed via a simple oral agreement between at least two people, it is almost always advisable to have a partnership agreement drawn up by an attorney. The partnership agreement sets forth how decisions will be made, profits will be shared, and disputes will be resolved, among other items.

With the partnership, two or more people share ownership of the business. As with the sole proprietorship, the law does not distinguish between the business and its owners.

Note: There are various types of partnerships, including the general partnership (the most common), the limited partnership, and the joint venture. We will not discuss these subcategories here.

Possible Advantages

Partnerships are relatively easy to establish; the legal requirements for a general partnership are much the same as for a sole proprietorship. Another advantage is that a partnership may have more of an ability to raise funds with its multiple owners. As with a sole proprietorship, profits and losses from the business flow directly through to the partners’ personal tax returns. Finally, if the partners are willing to share ownership, prospective employees can be attracted to the business via a partnership incentive.

Possible Disadvantages

One obvious disadvantage is that profits must be shared among the partners. And since decisions must be shared, disagreements can occur. Further, the partners will usually have to invest in the development of a partnership agreement. As for liability, the partners are jointly and individually liable for the actions of the other partners.

TIP: Partnerships, unlike corporations, do not last forever; they expire upon the occurrence of various contingencies. If it is important that your business exist in perpetuity, the corporation is the way to go.

A final disadvantage: Some employee benefits are not deductible from business income on tax returns.

Corporation

A corporation, which is a legal body chartered by the state in which it is incorporated, is considered by the law to be a separate legal entity, distinct from its owners. A corporation can be taxed; it can sue or be sued; it can enter into contracts. The owners of a corporation are its shareholders. The shareholders elect a board of directors to oversee the major policies and decisions. The corporation does not dissolve when ownership changes or shareholders die.

TIP: Although a business can incorporate without an attorney, legal advice is usually a must for an incorporation.

The corporate structure is more complex and more costly to organize than the other two business forms. Control of the business hinges on stock ownership.

Possible Advantages

For shareholders, liability is generally limited to stock ownership, except where fraud is involved. Officers of a corporation can be liable to stockholders for improper actions.

Note: Officers of a corporation can be held personally liable for certain acts or omissions, e.g., the failure to withhold and pay employment taxes.

As to funding, corporations have the advantage of being able to raise additional funds through the sale of stock. Corporations can deduct the cost of benefits provided to officers and employees.

TIP: Many small businesses are better off electing to be an “S” corporation. This election allows a business to be taxed similar to a partnership, but to maintain corporate status for liability purposes. We won’t cover the separate discussion of S corporations here.

Possible Disadvantages

Incorporation requires more time and money than other forms of business. Further, corporations must meet various formal and recordkeeping requirements—such as holding board meetings and having a corporate charter. Small, closely held corporations can operate somewhat less formally, but record-keeping requirements still must be met.

Corporations are monitored by government agencies, and thus may have more paperwork to complete in order to comply with regulations.

In the tax arena, incorporating may result in higher overall taxes.

Limited Liability Company (LLC)

LLCs have become the most popular business form for new entities, and many existing entities have converted to this form. They exist in some form in every state. They embody limited liability features of corporations and pass through characteristics of partnerships and S corps, but are more flexible than S corps.

For business law purposes, LLC members may be either passive investors or active investor-managers. Unlike with limited partnerships, active management won’t affect limitation of liability. For federal tax purposes, LLCs are treated as partnerships (unless they elect otherwise).

Note: Since LLC rules vary from state to state, a characteristic, power or rule in the state where an LLC was created may not apply in some other state where it does business.

Note: Some states do, and some states do not, authorize LLCs with only one member.

Tip: Where one becomes the sole surviving LLC member in a state that doesn’t allow single member LLCs, consider quickly incorporating (to regain limited liability) and electing S corp. status (to retain pass through treatment).

* * *In conclusion, deciding the form of ownership that best suits your business venture should be given careful consideration. Use of your key advisors is essential to the process.

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Understanding Cash Flow

February 26, 2007 by Ray Perez.

Failure to properly plan cash flow is one of the leading causes of small business failures. Understanding the basics will help you better manage your cash flow.

Your business’s monetary supply can exist either as cash on hand or in a business checking account available to meet expenses. A sufficient cash flow covers your business by meeting obligations (i.e., paying bills), serving as a cushion in case of emergencies, and providing investment capital.

The Operating Cycle
The operating cycle is the system through which cash flows, from the purchase of inventory through the collection of accounts receivable. It measures the flow of assets into cash.

For example, your operating cycle may begin with both cash and inventory on hand. Typically, additional inventory is purchased on account to guarantee that you will not deplete your stock as sales are made. Your sales will consist of cash sales and accounts receivable credit sales, usually paid 30 days after the original purchase date.

This applies to both the inventory you purchase and the products you sell. When you make payment for inventory, both cash and accounts payable are reduced. Thirty days after the sale of your inventory, receivables are usually collected, increasing your cash. Now your cash has completed its flow through the operating cycle, and the process is ready to begin again.

Current Assets
Cash and other balance-sheet items that convert into cash within 12 months are referred to as current assets. Typical current assets include cash, marketable securities, receivables and prepaid expenses.

Cash-Flow Analysis
Cash-flow analysis should show whether your daily operations generate enough cash to meet your obligations, and how major outflows of cash to pay your obligations relate to major inflows of cash from sales. As a result, you can tell if inflows and outflows from your operation combine to result in a positive cash flow or in a net drain. Any significant changes over time will also appear. Understanding this will lead to better control of your cash flows and will allow adequate time to plan and prepare for the growth of your business.

It is best to have enough cash on hand each month to pay the cash obligations of the following month. A monthly cash-flow projection helps to identify and eliminate deficiencies or surpluses in cash and to compare actual figures to past months. When cash-flow deficiencies are found, business financial plans must be altered to provide more cash. When excess cash is revealed, it might indicate excessive borrowing or idle money that could be invested. The objective is to develop a plan that will provide a well-balanced cash flow.

Planning a Positive Cash Flow
Your business can increase cash reserves in a number of ways.

Collecting receivables: Actively manage accounts receivable and quickly collect overdue accounts. You stand to lose revenues if your collection policies are not aggressive. The longer your customer’s balance remains unpaid, the less likely it is that you will receive full payment.
Tightening credit requirements: As credit and terms become more stringent, more customers must pay cash for their purchases, thereby in- creasing the cash on hand and reducing the bad-debt expense. While tightening credit is helpful in the short run, it may not be advantageous in the long run. Looser credit allows more customers the opportunity to purchase your products or services. You should measure, however, any consequent increase in sales against a possible increase in bad-debt expenses.
Taking out short-term loans: Loans from various financial institutions are often necessary for covering short-term cash-flow problems. Revolving credit lines and equity loans are types of credit used in this situation.
Increasing your sales: Increased sales would appear to increase cash flow. However, if large portions of your sales are made on credit, when sales increase, your accounts receivable increase, not your cash. Meanwhile, inventory is depleted and must be replaced. Because receivables usually will not be collected until 30 days after sales, a substantial increase in sales can quickly deplete your firm’s cash reserves.

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