Financial Statements 2: The Balance Sheet

The Balance Sheet is where you see what your business is really worth. After you've finished recording all your activity for the month - income AND expenses - the leftovers, profit or loss, get carried to the equity section of the balance sheet. Remember the parts of the balance sheet: Assets, Liabilities and Equity (sometimes known as capital, other times known as net worth). When you incorporate, the money left in the business is referred to as retained earnings. We can look at that more later.

As I mentioned before, assets are the things you own. Start with your bank account and go all the way through "Property, Plant & Equipment" also known as fixed assets. Fixed assets are things that have an extended useful life. Assets are broken into levels of liquidity. Cash accounts, receivables - money you are due to be paid for things you have sold - , prepaid items like February rent paid in January, or insurance premiums for the coming 3, 6 or 12 months, investments in certificates of deposit, stocks, bonds and annuities and even inventory are considered liquid assets. It's easy to squeeze the useful money out of the people holding these things. These would be people like banks, customers, brokerage houses, etc. Fixed assets are things like filing cabinets, desks, power equipment, vehicles, production machines, billboards, construction equipment, sound systems, and of course, the building and land where your business is located (assuming you own it, rather than rent or lease it from someone).

Liabilities are things you are responsible to pay to someone else. I've mentioned buying office supplies on account from a local supply store. Other examples are your credit card, the oil company you use for heat, advertisers you use, payroll deductions - for payroll taxes withheld or for employee benefits. These are short-term, or current liabilities. You can easily pay them. Long-term liabilities are your mortgage, car loan, loans from individuals or companies that you will repay over several or even many years.

Finally, we get to equities or capital. After you close your monthly or yearly books, the profit or loss gets moved into the owner's or partners' equity or else into retained earnings. If your business is a sole-proprietorship or partnership, another account is closed into the equities as well. It's called a drawing account. If you or one of your partners takes money or materials of any sort out of the business for personal use, it gets recorded in that individual's drawing account. This is a "contra" account. Here's an example: If you, at the end of May, had equity of $10,000 and you needed $3,000.00 on June 10th to cover expenses at home, you can write yourself a check from the business and put it into your personal account. This check gets recorded in your drawing account in the business. At the end of June, you'll close your books and (not counting that month's profit or loss) end up with equity of only $7,000.00. This is how sole proprietorships pay their owners. In a new or slowly growing business, this is difficult to manage. Eventually, this will smooth out as your profit grows and the business becomes more self-funding. Then you will be able to plan how much you can regularly take out of the business to pay yourself without hurting the cash flow within the business.

After all this activity is netted together - Assets minus Liabilities, the remainder is the equity: the value of the business. even though you may not have a lot of cash, you can have a lot of equity because you may have used than money to buy new or better assets or to pay off loans. In any event, this is what you want to see grow. If you do keep your business equity low, you may be taking a lot of money home and building the value of your home.

That's a lot to digest. Study this and get it clear in your mind and you will have a good foundation to help you figure out how to keep your business developing and becoming something that not only provides for you, but can also benefit others - like employees. Or, if you run it well enough on your own, you can use the profits for charitable or philanthropic purposes.

Have a good one. Keep in touch and let me know if you have questions.

Gary

Financial statements: The income statement

The income statement is know by a couple of other names. The "Profit and Loss Statement", the P&L (from the previous name), or the "Operating Statement". This statement has two primary sections. First is the income section; second is the expenses. Let's take a look at each one. Then we'll hit one more - "Other Income & Expenses".

Income - also known as Sales or Revenue - consists of your earnings from your day-to-day activities. Depending on the kind of business you're running, you may several sources of income. A mechanical contractor's primary income may come from construction contracts. Additional sources may be equipment or parts sales, repair to people's equipment, system maintenance contracts. Each will be evaluated for its profitability as part of the business when the P&L is reviewed.

Expenses are the costs you incur as you buy things to run your business. Your operating expenses are the field labor, materials you buy to put into your products or projects, items you buy for resale, supplies you need to display what you're selling, etc. Overhead or administrative expenses are the costs of paper supplies, legal & accounting fees, phone service, depreciation, etc.

Once the income is totalled and the expenses are totalled, expenses are then subtracted from the income, with the answer being your profit or loss. This is called your "Net Operating Income".

As your business grows and changes, you'll analyze your expenses to determine if you're spending too much in one area or another. These managerial decisions to make changes will help you make more profit which can be used to build the business by making improvements or buying additional equipment or be taken home for a nicer vacation for the family. You'll likely develop departments to break the business down into more manageable pieces so you can see more easily where your money is going.

After your profit is figured, you may have income or expenses that aren't part of your regular business. An example of "Other Income" would be interest income or proceeds from an insurance settlement. "Other Expenses" might be income earned from crafts placed on consignment in your showroom.

These activities are handled the same way as your regular income and expenses, with the calculation of "Net Other Income (or loss)". "Other income or loss" is added to, or subtracted from, your regular income for a Net Income. This figure is what is used to calculate your income tax. The amount you take home is not a business expense, so it is part of the profit of your business. As a result, it is still taxed.

The thing about profit is that you juggle how much you are willing to have so you can balance how much tax you'll pay vs. how much you'll take home to live and how much you'll leave in the business to you can add value to the business and/or promote it to generate more revenue.

That's enough for tonight. Write back with questions or comments.

Gary

Who'll take care of the books?

One decision you'll find yourself faced with is if or when you should turn your bookkeeping over to someone more qualified. While the anticipation of self-employment has it's thrills, the "work" of keeping the books can frequently be intimidating unless you are already familiar with business operations and record keeping. Consequently, you'll want to try to assess whether you ought to do this on your own or pass (or should I say...delegate?) this to someone more equipped for this kind of work.

There are several routes you can go. Some require more digging than others. If you have an acquaintance who is comfortable with establishing and maintaining an accounting system, find out if they will be willing and able to handle your books for the kind of business you'll be running. Don't look for the cheapest person you can find. You might get what you pay for. This person has to be willing to put the time you need to understand your methods and also point you away from risky practices and habits. In addition, you will need to listen to this individual as an advisor, especially if he or she has a lot of expertise in accounting and business management.

Another source is an independent bookkeeper. This person, presumably, has been through enough clientele to be able to set up your books and report your income and expenses properly for tax purposes. While many of these people work out of their homes as a sideline income, others have their own offices and run a suitable practice to meet your needs quite well.

Option #3 would be to use a CPA or public accounting firm. If you know someone with these credentials who will offer you a bargain of a service, jump at it. My opinion is that if you are intent on a large start-up or are assured through your business planning that you will grow quickly, you should choose a CPA. If you expect to operate out of your garage or "second-rate" business space for several years before you think you'll really take off, save yourself some money early on and search out a capable friend, wife, neighbor or established bookkeeper and work with them until you are knowledgeable about what reporting requirements come up and how you will manage them as a business owner. Then you can progress to a more sophisticated bookkeeper.

One last possibility is to hire someone as an employee who can keep your books. This person will be a master of many skills until you have enough business to split some work off to another employee. You will want to check this individual's background so you can be sure they are able to handle numerous office tasks as well as your bookkeeping. If you aren't big on doing the paperwork, this person will be invaluable at keeping you organized. He or she must be able to handle your financial activity - for business and personal reasons - and report on how you are doing as time progresses.

You don't want to get to the end of the year and have to figure out how on earth you're going to sort through all your papers and do your tax return by the ominous April 15th. Anyone keeping your books must be able to prepare for this - even if it's you - to save stress, worry, interest and penalties.

Have a great day. Keep in touch.

Gary

Coming up: The parts of accounting

In series of new posts, you'll get to read more about the different key parts of the accounting system. Each will be addressed separately. Here's the primer, briefly re-visiting earlier material.

ASSETS: These are the things you own. They include cash, money people owe you value carried from a business purchase, investments, buildings, furnishings, tools, vehicles and more. There are also things called "contra-assets" that offset, or count against the value of certain assets.

LIABILITIES: This is the money or other things you owe to other people. Accounts payable - your regular vendors that let you buy things and send you a bill to pay later, taxes, withholdings from employees, loans, mortgages, etc.

EQUITIES: This is the "net value" of your company. Equity is also known as capital. This is where the term "capitalist economy". It is reflected as owners, partners' or stockholders' equity. When you get to this part of the financial statements, you see what's left after all other claims against the business have been taken into account.

REVENUE: This is any income your business receives as a result of trying to get paid for goods or services. Occasionally, a business receives payment for reasons outside of its normal activities. This is called "other income". Interest earned on a bank account is an example.

EXPENSES: These are what you pay for running your business. Expenses will run from pipe you use in a plumbing business to the coffee you use in your company kitchen. Like revenue, this has a classification of "other expenses".

Come back soon. Class will continue shortly.

Gary

Accounting basics

Debits and credits. These, and the five parts of the Chart of Accounts are the core of the accounting process. Here is how they operate. To go back to high school algebra, remember what Mr. Math Geek said so often you got tired of it: "What you do to one side of an equation you must do to the other." Here is what he is getting at. If you're not a numbers person, think this one through so you understand it.

If you have a simple equation of 2+3 = 4+1, you know both sides equal 5. Naturally, if you add 3 to the first side and not the second, you're saying 8=5. This isn't true. So, to make this a true statement, you also have to add 3 to the second side. 8=8. True statement! Mr. Geek would be proud. If both numbers effect the same side of the equation, the net of the two must equal zero. Using the same example: 2+3= 4+7-3-4+1. Combine your figures on each side of the = and you still have a true statement: 5=5. Now to accounting....

The accounting equation works off the same idea, using the five parts of the Chart of Accounts. It's set up like this:
Assets = Liabilities + Equity + Revenue + Expenses
To complicate things, Mr. Pacioli, the father of accounting, said we have to use debits and credits to make this work. What throws people off is that is some instances a debit increases an account and in other instances a debit decreases an account. In the diagram below, a + means an increase and a - means a decrease. Take a look!

The equation: Assets = Liabilities + Equities + Revenue-Expenses
Debits increase assets and expenses and they decrease liabilities, equities and revenue.
Credits to the exact opposite. The decrease assets and expenses and they increase liabilities and expenses.

This is the foundation for that familiar term "Double Entry Accounting. Every transaction has both sides - debit and credit - or your equation won't remain true. Here is an some example.

** You took $50 cash from the business out of your pocket and put gas into your car. This is an increase to your expenses and a decrease to your cash. The result: Debit expenses (increase) and Credit cash (decrease, since it's an asset). You have both sides of the entry and you effected both sides of the accounting equation with the same amount, keeping it in balance and keeping it a true statement. Often, if you can identify what one half of the entry, you can figure out the other half. Another example is buying something on account (charging it so you can pay for it later). You need copier paper, so your local supply store says "I'll send you a bill you can pay in 30 days." This purchase goes on your books as a debit (increase) to the expense (office supplies) and a credit (increase) to accounts payable. Later, you send the payment and credit (decrease) accounts payable) and credit (decrease) cash.

More to come later. Time to go to bed.

Quick review

Just a brief entry tonight. Let's go over what you've read so far.

You want to do something you know well and you want to do it for yourself. So you decide what type of entity you'll have: proprietorship, partnership, corporation, etc. You'll register a fictitious name, get a Sales Tax license, an employer ID (FID/EIN/FEIN/whatever) if you will be having employees in the near future, and open a bank account.

Plan your workday, week and month around how your industry operates. Plan on where you'll operate your business and plan the setup of your books or recordkeeping. Plan how much you'll charge to make enough money for the business AND to have enough to pay yourself. Plan how much revenue you'll need to make the profit you need to take home to cover the bills and feed the kids. Plan how much money you'll need to bring in to meet all your expenses and still be able to take some home.

Ready, set, ADVERTISE. Word of mouth is the best method, but, unless you have some great connections or friends with some connections, you'll have to build your reputation from the ground, up. Think about where people will look for what you sell or do and start shopping for the best advertising price to reach your audience. Once you build your customer base, word of mouth will help you out.


Until next time..........



Gary

Accounting - Ahhh! My home sweet home

It's time to start recording all your income and expenses. Good grief! Receipts! Checks! Invoices! Payments! Bills! Mileage! ENOUGH ALREADY!!! Yeah, it's time for administration and paperwork. What does "audit trail" really mean, anyway?


Hmmmm. This may take a few entries so you don't get lost in the details all at one time. Let's start with a chart of accounts. Before we do that, we'll need to hit a few accounting terms.


Your financial structure is made up of five parts. The first three make up the balance sheet. They are the ASSETS, LIABILITIES AND EQUITY (often referred to as CAPITAL). These things are the results of what your customers paid you for and the expenses you had to pay with what your customers paid you. The other two parts are the REVENUE (INCOME or SALES) and the EXPENSES. All of these are what go into your chart of accounts. Now, let's look at each of these, one at a time.


ASSETS: What you actually own. You own your cash, your "Accounts Receivable" (work you have done for people but not been paid for yet) your shop tools, your desk, copier, inventory, etc. There are a couple of things that get counted against these but they aren't important at the moment. An example, in case you are familiar with the term, is Accumulated Depreciation.


LIABILITIES: Remember that desk you use? Well, if you put it on a credit card, the amount you owe the credit card company is a liability. If you bought pens, pencils and copier paper from Smittie's Office Supply and he said you could pay for it later, that's a liability too. These are called "Accounts Payable". Did you buy a car under the name of the business? That's a liability as well. It's called a "Loan Payable".


EQUITY: Add up your Assets and make note of the total. Add up your Liabilities and make note of the total. Subtract the Liabilities from the Assest and the result is your Equity. A quick note about the equities... when you write a check to yourself for personal expenses, you take it out of cash. This gets listed in an account called "Owner's Drawing". This gets subtracted from the earlier equity figure. The result is your final equity figure.


REVENUE: This is all the money you have earned for your work or for the things you have sold. As your business gets larger, you will probably have several kinds of revenue.


EXPENSES: These are the different groups of things you have paid for to keep your business going. They might be things like gas and mower blades for a lawn care business. They could be paper and ink for a printing company. Both of these businesses will have administrative costs like paper supplies (business cards, bank fees, insurance) as well.


Add all of your revenue/income together and make note of the total. Add all of your expenses together and make note of the total. Subtract the total of the expenses from the total of the revenue and the answer is profit if the number is positive and loss if the number is negative.


Don't panic if the number is negative. At least you won't owe income tax on it.


The Chart of Accounts groups all of these different categories in the order I listed them. Some accounting packages use account numbers for a Chart of Accounts. Others are written to use only account names. Each account has a balance. All of the account balances in your Chart of Accounts make up your trial balance. That's for another accounting discussion. All of these balances are what make up the figures on your financial statements. If you decide to go to the bank to take out a business loan of any kind (like the car you bought), they will want to see your financial statements (sometimes referred to as "financials") so they can see if they are making a safe investment by loaning money to you and expecting to earn interest on what they loan you.


OK. Go take something to ease your headache and write back with questions.



Gary

Business planning

In preparing to start your own business, it's easy to jump in with minimal cash and say "I can do this!!!!" Been there, done that. It can work. It did for me. I didn't get rich in the process, but I learned a few things about myself in the process. Even so, there was some advance planning that helped me get where I was going. Since a quick start is often on a shoe-string budget, developing a business plan can seem pointless. Still, knowing a variety of parameters and goals will go a long way in helping you determine if "hanging out a shingle" is a smart idea.

Begin with knowing how much you want to make off of your venture. In one instance, I had been laid off and needed to replace the income I had lost. I brought home a certain amount and knew I had to net that much after business costs and income taxes. In addition, I wanted a measurable raise from what I had been making. I started with my hourly equivalent since that included the income taxes withheld from my paycheck. As a rough number, you can figure 25% of your gross earnings are held for income taxes (again, based on living in Pennsylvania). In addition, the Federal government makes you pay the second half of social security taxes if you make a profit as a sole proprietorship of more than $400.00 at the end of the year. That's an additional 7.65% you'll need to include in an hourly rate just to come out even.

Your operating costs - those caused directly by you doing your business... cutting grass, shining shoes or manufacturing widgets, you will charge to be reimbursed for, with a mark-up. Other costs, known as overhead and administrative costs, have to come out of the mark-up you include in your pricing, both for labor and for materials.

Once you know how much you need, you can start setting goals of how much revenue (sales or income) you need to target. This can be determined on a weekly, monthly or annual basis. From knowing your personal situation, you will be able to decide more easily if taking off on your own will be a workable idea. Even now I think about a lot of things I'd like to do. When I consider how much money I do or don't have, what my knowledge level is about the idea, what my family situation is, and how my personality fits the requirements of what I'd like to do, I can decide if it will work or not. Here's an easy example for me: I like using computers. It may be different kinds of software, different ways to develop spreadsheets, learning a different way of showing things in a spreadsheet. What I know I couldn't do for days on end is writing programs.

Getting back on track, though, there is another level to business planning. That level is much more sophisticated, detailed, time-consuming and thorough. It is called developing a formal (or written) business plan. There are quite a few of these on the internet. More than likely, if you will be financing the start-up - or a part of it - of your business, any rational bank or banker will want to see a business plan to assure themselves you are a safe investment for them to deposit their money for a safe return on their investment. This is a superb tool that will help you define your business, target market, market demographics, long- and short-term goals, financing structure, and more. The end result will help you prepare for a more structured, organized business. Be prepared for one thing. Many people who go into self-employment do so knowing what they do and loving it to the death. The caveat to that is to realize that there will be the drawback of having to do the paperwork and the administrative side of a business as well as the exciting part of plying your trade or practicing your profession.

That's all for this entry. Please write and ask questions. I'll be glad to answer questions and to use your questions for future posts.



Gary

OK! Now what?

So you decided to get your business going. Great! No more boss to answer to. No departmental conflicts and no supervisors wondering why you didn't get more done. You know what you want to do because you've done so much of it. How do you make it run?


Start with some structure. Decide what hours you need to work. When will your customers be available? What time will you need to get ready to work? To do this, you'll need to plan how your day will be spent. So much for getting ready for the day, then it's off to do the business. When the day's done, it'll be time for the paperwork. What facilities will you need to run your business? Your basement, den, back yard or garage? A new building? Rented shop space? Storefront in a location that will be available to plenty of customers?


More structure comes with budgeting. This is big because it impacts everything else. You'll determine where you work and how you build your business and how quickly you can expect it to grow. Remember: one important thing of building a business is to build value into the business which comes back to build value for you. When you budget, you don't limit yourself as is often the concern of a lot of people. Ideally, budgeting gives you a profit target to reach so you have money to take out of the business to live by and also to leave in the business to buy equipment or to use in other ways to enhance or expand the business. The trick to budgeting is figuring out realistic cost and sales projections so you can know ahead of time what profit you will end up with so you can feed your family and buy your own store instead of renting from someone else.

Many business owners aim for a sales target but don't know where their expenses are going to come in. As a result, they don't know if they will have extra money until after the end of the month.

Thanks for reading. Watch for the next entry.

Start-up thoughts to consider

When you're ready to start a business, it's typical to wonder just where to begin. There are, of course, lots of things you try to figure out. First, decide what form of business you'll run. The easiest to organize is the sole proprietorship. Others include partnership, corporation (S-corp, C-Corp) Limited Partnership or Not-for-profit. These all have various tax implications and advantages and more complicated steps to get started. These can be addressed at another time. Starting a business can be done simply by using your name. In Pennsylvania, if you choose to give your business a name, you will have to register the name as a "fictitious name" with the state. Once this is decided, open a separate bank account that will handle your business activity. The first question I see coming to mind is "How do I get my money out of the business to use for personal, day-to-day expenses like buying my groceries, etc.?". The ideal method is to write yourself a check from the business account to deposit into your personal account. In the recordkeeping for the business, this gets recorded into a ""Owner's drawing" account. You might take money out by using a debit card or check card. That will work the same way. This simplifies things for tax purposes and for being able to keep your accounting records easier to understand and to work with.

If you expect to have employees right away, apply for a Federal Identification Number. This is done with a form SS-4 which can be found be searching http://www.irs.gov/ . Complete this form and submit it to the address indicated in the instructions. You will get a response from the federal government telling you what number you've been assigned. The number is known by FID, FEIN, EIN, Tax Number and others. This number is not the same as your state's Sales Tax number. This is handled with a form from your state. It will probably come from your state's department of revenue.

Once you have these things in the works, plan on the ways you want to keep track of your expenses. I'll discuss these in more detail in another post. To begin, though, you'll use categories based on items directly related to how you'll actually be making money. These are called "operating expenses". The rest of your expenses will be related to "administrative costs". These are things like bank charges, office supplies, postage and others. Leave a reply and I will answer questions you might have about how to group expenses.

If you will be buying things to re-sell or that will become part of something you will be manufacturing, you will need to get a Sales & Use Tax license (in Pennsylvania) from the department of revenue. This is a subject for another post. Yup, I expect to be writing a lot!

That's all for today. Let me know if this is useful. I'll post as I come up with relevant topics and as I get questions coming in. Have a great venture!!!!