Most small business owners run their business from the income statement alone. This can be a critical mistake, in that you're missing important pieces of the picture. These missing pieces can mean the difference between staying in business and going out of business. The Income statement can show profits, while your cash flow is still negative. This will leave you wondering why you can't pay the bills. Your project time tracking and billing software must be able to show you all of the pieces of your financial puzzle.
When you look at the Balance Sheet, and then the "reality check," which is what I like to call the statement of cash flows, then you can see the entire picture. You can see where a profitable business may be short on cash flow, and thus, question about the company's ability to continue as a going concern.
Now that we're looking at the entire picture there is a lot more we can, and should do. We need to approach the use of our financial statements from a very strategic place. This is what Wall Street companies do. Why shouldn't you build your business on Wall St.'s dime for free?
We do this by using the information already provided by your project time tracking and billing software.
For now we are going to focus heavily on the Balance Sheet. The first step, after making sure you have profits, is to keep them. This means we need to employ a strategy of increasing equity. Since your equity is a function of your assets minus your liabilities, then great care should be taken into account when investing in assets for your company.
Before you purchase anything, you should have an estimate of how much return the asset you purchase will bring. Assuming you're going to finance the asset, you want to make sure the Return on Asset (ROA) will be at least as much as the depreciation plus the interest expense. Otherwise, your equity is being reduced every month by these amounts. What's more is that in most cases, you won't even see this until year end, because most businesses only book depreciation at year-end. In fact, most businesses book it in the following year, when they get the entries back from their CPA. By that time the bookkeeper books the entry, and no one pays any attention to what is happening here. It's worse than you think.
Depreciation for tax purposes is accelerated. This is good for taxes, but not so good for your balance sheet. Your net income takes a hit for the depreciation expense, and that lowers your net income, and consequently your equity.
There's a solution. First book your depreciation based on straight line, for financial books purposes. Your CPA can still use their accelerated method for tax purposes. They have to track what is called a schedule M-1 adjustment. This accounts for the difference from books to tax.
Next we book the depreciation monthly, not annually. This let's us see the entire picture all year long, and not just after year-end when the taxes have been done.
Now we're running our business like they do on Wall Street!
This is why it is so important that you have an idea of what your ROA will be. Assuming this will be sufficient to cover the interest and depreciation, then you buy the asset, and you finance the asset, because that's better for cash flow.
Next, paying the debt off at an accelerated rate will lower the interest expense, and thus Increase your equity.
The other thing we want to watch closely is your liquidity. We use the current ratio, which looks at current assets minus current liabilities. This is a measure of our ability to pay off debts with liquid assets.
You'll notice in the video demonstration that paying off the debt faster increases liquidity.