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That’s A Wrap
Close Out The Year With Smart Financial Strategies
By Don Sadler
Whether you’re an entrepreneur who launched a business this year or a longtime self-employed professional, the end of the year is a crucial time for gauging the financial success of your micro-business. It’s also a critical time for deciding how to manage your profits so you give your company—and yourself—the best financial advantage.
Here’s what you need to know as you prepare to close out 2010.
Financial Statements
Any discussion of year-end business finances must begin with a discussion of financial statements.
“Every business owner should have at least a basic understanding of business financial statements,” says Lisa Aldisert, president of Pharos Alliance Inc., a management consulting firm in New York City that specializes in business strategies for growing companies.
If you file a corporate tax return, you must create financial statements. If you’re a sole proprietor
filing a Schedule C, financial statements aren’t required, but they can be invaluable financial management tools.
Financial statements typically consist of three main components:
BALANCE SHEET: This is simply a snapshot of your business’s financial position at any given time. It reflects what your company owns (assets) versus what you owe (liabilities). Current assets are the resources that can be most quickly converted into cash, such as cash reserves, accounts receivable and inventory. Current liabilities are the short-term expenses necessary to finance the operation of your business, such as accounts payable, payroll and taxes.
INCOME STATEMENT: This tells you how much money you made (or lost) during a given period of time—usually a month, quarter or year. It subtracts all expenses and taxes from revenue to show net income. A close analysis of your income statement can reveal more than just a profit or loss.
“A quarter-to-quarter or year-to-year comparison of the numbers tells more than just looking at the numbers in isolation,” says Aldisert.
At the end of the period being measured, net income is added to retained earnings that are not paid out in distributions.
“The higher the level of income, the more is added to retained earnings,” says Aldisert, “which increases the overall value of the company.”
Of course, many micro-business owners take excess earnings and reinvest them in the company to purchase equipment, add staff or invest in other areas that support growth.
CASH FLOW STATEMENT: This statement ties the balance sheet and income statement together by reconciling the changes in balance sheet positions from the beginning to the end of the period being measured (usually a year).
The cash flow statement reveals your business’s critical cash flow cycle—the cycle of cash conversion from inventory to sales to receivables and back to cash again.
“By monitoring the cash flow cycle, a business owner can benchmark everything from a slowdown in collection of receivables to an increase in inventory turnover,” Aldisert explains.
Earnings And Distributions
Determining profit and loss for your business is a relatively simple process. The next step is determining what to do with the profits your business earns.
“One of the most important things small-business owners must learn is how to manage the earnings from their companies,” says Aldisert. “The key is to devise a strategy for proactively managing your earnings—both for the financial health of your company and to meet your long-term personal goals.”
Aldisert lists four questions you should ask when devising your earnings management strategy:
- Do the needs of your business require reinvesting earnings back into the company?
- If not, should you still keep earnings in the business or create a distribution for yourself?
- How do you handle the timing of paying for large expenses?
- How does your plan tie into your long-term personal financial strategy?
“Managing earnings is largely tax driven,” says Aldisert, “and there can be distinct strategies based on your legal structure. Also, if you have cyclical or seasonal cash flow, you’ll need to account for timing.”
The economic environment makes a difference, too.
“When the economy is strong, your strategy will typically differ from what you’d do during a slow economy,” says Aldisert.
For example, during today’s uncertain economy, micro-business owners would be prudent to hold higher levels of cash reserves (or excess cash) since sales cycles tend to slow down. If you don’t have the luxury of cash reserves, go through each of your expense items and scrutinize every cost. It’s important to stay on top of your cash outflow.
You must determine for yourself what constitutes excess cash—whether it’s an amount equal to one month’s worth of expenses or a minimum amount needed for working capital.
“This is based largely on whether your sales are level, as well as the seasonal and cyclical aspects of your cash flow,” says Aldisert.
A common earnings management strategy is simply to “zero out” your cash at the end of your fiscal year by distributing excess earnings to yourself.
“Small-business owners are unique in that their businesses are usually the cornerstone of their personal wealth, so you need to consider the impact on your personal financial strategy.”
Poor earnings management is one of the biggest reasons for the failure of fast-growing businesses, says John Barrickman, president of New Horizons Financial Group, a consulting firm in Georgia that specializes in small-business lending.
“Owners focus on top-line sales growth and assume that as long as sales are growing, they’re successful and can take money out of the business,” Barrickman says. “But when companies are growing, most profits need to go back into the business to support that growth.”
The worst thing you can do is to have no plan for earnings.
“Managing earnings should be discussed in detail with your CPA or other tax professional,” Aldisert says. “They are experts in what you can do to maximize cash flow, minimize tax liabilities and return the highest amount to you as the owner.”
Don Sadler is a freelance business writer who is busy working with his CPA to formulate year-end financial strategies. Reach him at don@donsadlerwriter.com.