Getting to the Bottom Line
The Small Business Owner’s Guide to Financial Success
Know Thyself
Most small business owners are not entrepreneurs. This is not an insult. It’s just categorical, as an entrepreneur is just one type of business owner. Most small business owners shouldn’t want to be entrepreneurs. But unfortunately, we have romanticized the notion of the entrepreneur while we’ve confused its meaning. We tend to think that calling a small business owner an entrepreneur is a sign of respect or badge of honor recognizing their risk and hard work. But actually, all small business owners take risks and work hard, and entrepreneurs are just one type of business owner.
To simplify, I think of business owners in three types:
- Entrepreneurs
- Small Business Owners
- Service Professionals
Entrepreneurs create a business as an asset in their personal wealth portfolio. Entrepreneurs sell their businesses or franchise them, or whatever the strategic opportunity is at hand. They create and own a business as an investment, like stocks or property. This doesn’t mean that they are not passionate about what they are creating. Often they are some of the most passionate people you’ll meet. But the businesses they create are something outside of themselves. They are not creating their own job and lifestyle as tied in with that business, not in the same way as a small business owner.
A small business owner creates a business to work in and on. This business defines the owner’s life and lifestyle. A small business owner creates a coffee shop in order to be a coffee shop owner. Coffee is their focus, and working on and in their coffee shop is their lifestyle, likely their life’s journey. Yes, they will want to sell the business and have it live on beyond them eventually, but it’s not the same as designing and building a business to be handled as a branded asset from the start.
The third type of small business owner is a Service Professional. This could be a CPA or a guitar luthier or a sales broker or a carpenter or an attorney or a software engineer, or whatever. But this person is not creating a business, per se. They are creating their own career in a profession. They will provide a needed service and be paid to do so. Service professionals often do hire support staff, but the business is basically a support system for the professional.
It’s critical to understand where you fit among these three categories of business owners. Of course, the truth is that you probably see yourself in at least two of these categories. That’s normal. It’s an oversimplification, for sure, to put oneself into a category. But think about where your heart is. What are you really doing and creating here? If you did what you’re doing now for 10 years, where would you be? Where do you want to be? What do you need to change in order to be there?
You must envision yourself in the future, so that you can make the decisions that are necessary to steer you in that direction. We all know this on some level. If you are walking, you can walk fast or slow, but the bigger question is where are you going? If you’re just out for a stroll for the experience of walking, fine. But you can enjoy walking and go somewhere that you would like to go as a result of the effort. It’s your choice.
As Stephen Covey wrote, “Begin with the end in mind.” You can’t imagine every detail of your future, but you can see where you are going clearly enough to set out and feel good about the direction you set out in. Thus, you need to understand if you are approaching your business as an Entrepreneur, a Small Business Owner, or a Service Professional. Having clarity around where you fit into these will guide you in your decisions for developing your business.
This article is written for the small business owner and service professional. It is not targeted as much to the entrepreneur.
Fundamental Business Accounting
“If you can’t measure it, you can’t improve it.” Peter Drucker
To be successful in owning a small business, you will need a fundamental understanding of basic business accounting. There are three accounting reports that you will need to understand to be able to manage your business effectively from an executive level.
- Income Statement (Profit & Loss Statement)
- Cashflow
- Balance Sheet
Your Income Statement is going to show you if you are making money. For any date set, it shows you how much money you brought in, how much money you spent, and therefore how much money you made (what’s left after the spending). This document should be reviewed and studied at least once per month, if not more frequently.
The Cashflow document is going to show you timing for the future. It shows you when expenses are hitting and when your revenue is coming so you can make sure that when the bill arrives you have the cash to pay it. This document should be reviewed every week.
The Balance Sheet will let you know how you are currently overall vested in the business from a financial perspective. It shows your assets in the company and your debts against the company. It is basically your company’s net worth (so to speak). This document can be reviewed less frequently, maybe quarterly.
Of these three critical business accounting documents, we are going to be discussing the Income Statement. Actually, the phrase “the bottom line” refers to the bottom line of your income statement. Take all the money you made minus all the money you spent in order to do it, and whatever is left is the bottom line.
Basically, in its simplest form, an Income Statement looks like this:
Revenue – Expenses = Profit
Or written another way:
Revenue
– Expenses
___________
Profit
So, your Revenue is all the money your business collected from whatever source. Your Expenses are any spending that you did in the process. The difference (what’s left) is your Profit.
What if your Profit is negative? In other words, what if you spend more than you make? Well, it is all too common that people spend more than they make, but let us dispel a misguided notion here and now. People think small businesses say things like, “Well, we were over budget this year, but that’s alright we’ll do better next year.” No. Only large businesses have the luxury of such comments, and it’s because their budgets are being subsidized from other internal budgets. Here’s the cold hard reality of the small business owner: For the business to be in the negative means that the owner had to put in the money to cover the negative amount. The money came from somewhere. It was your personal savings, you took on more debt, you didn’t get paid (again)… the money has to come from somewhere. It’s not pretend money. You can’t just be in the negative. The money is coming from you one way or another. And believe me, it’s no fun to work longer and harder than anyone, not get paid for it, and then at the end of the month have to take money out of your home equity or personal savings to put into the business, just to keep the business going. “Feed me, Seymour, feed me,” as they say.
So, if you want a sustainable business, you must have an Income Statement that shows you that you are making more money than you are spending. It’s that simple.
Revenue Streams
Any business will have multiple categories or streams of Revenue. For example, a coffee shop may have these Revenue Streams:
- Beverage Sales
- Food Sales
- Merchandise Sales
So, when you do $100 in sales (Revenue), you may have done $30 in beverage sales, $50 in food sales, and $20 in merchandise sales. Thus, to increase your Revenue you have to either grow one of these Revenue Streams or add additional Revenue Streams, like Catering or Event Tickets.
A heating and air company’s Revenue Streams may look like this:
- Residential Maintenance Programs
- Commercial Maintenance Programs
- New Construction Projects
- New Unit Installations in Existing Construction
- Product Sales
Each business is unique in how they decide to organize their Revenue Streams. The question to ask is: What are your customers buying from you? If they are either buying an X or a Y or a Z, then you create your revenue categories to match whatever are the X,Y, and Z in your case. This lets you line up your tracking with your selling, and you can see where and how you’re making your money overall. Understanding your Revenue in terms of your Revenue Streams is critical to your businesses success.
Managing Expenses
Your expenses are everything that you spend money on to operate and to invest in your business throughout a given time period (month, year, whatever). A small business owner often drowns in expenses. You have core expenses, small expenses, and capital expenses. Your core expenses are your big ticket items that are critical for the operations of your business – payroll, rent/mortgage, utilities, marketing, equipment leases, or wherever it is. Your small expenses are recurring and one-off items like supplies, contract fees, isolated purchases, and more. Lastly, your capital expenses are when you make a significant purchase that can be planned for and will then be used for benefit over a long period of time. This could be machinery, a building, office furniture, computers, trucks, or whatever you need to buy in order to operate and grow.
Another reason you need accurate and useful accounting, is that there are so many things you spend money on as a small business owner that it’s hard to keep track of it all. You have to know that you’ll have the cash come time to pay bills (Cashflow), that you are making money at the end of the day (Income Statement), and that the whole endeavor is making you better off financially over time (Balance Sheet).
For your accounting tools to deliver you these necessary reports, they must have all of the data, and that data must be accurate. Everything must be tracked and entered into your accounting tool – spreadsheet, software, or whatever.
There are many options out in the market for small business accounting software. Online accounting software syncs with your bank accounts and your credit card accounts making things pretty easy for the small business owner. It means that every transaction (whether the money is going in or out) in both your bank accounts and on your credit cards gets pulled automatically into your accounting software. You then just have to go down the list of transactions and put each item into a category. The software does the rest. As long as every transaction is in there and is categorized, then your Income Statement will be completely accurate. You’ll be able to see where you’re making your money, how much money you’re making, how much money you’re spending, what you’re taking home, and how much you’re going to likely owe on your taxes. All you have to do is to put each transaction you made into your software and categorize it correctly. That, of course, is the hard part.
Unfortunately, it is a difficult and frustrating task to get your system set up to have your transactions being inputted and categorized accurately. It’s tough to get all of your accounts linked and syncing appropriately, and it takes discipline to do the manual activity of categorizing transactions. You will also need to do regular audits between the information sources that are syncing. You have to compare your bank account to your accounting software and see if everything is exactly the same. You have to do that for any account that is in your overall system – point of sale, hours tracking, bank accounts, credit cards, etc. And you have to cover every day of the year. So, at the end of the year, you are certain that there is no transaction out there in one of your accounts that is missing from your accounting software.
But, as daunting as this may seem, it is doable and manageable. This is definitely an area where I suggest a small business pays a professional to help them get set up appropriately. I then recommend the small business owner do most of this accounting work personally. It really puts you close to the money and forces you to be aware and see pitfalls coming before they happen.
If you choose to pay people to do your inputting and auditing for you, then it is even more important that you commit to studying your business accounting reports regularly because you will be more removed from the money. You can’t get too far removed from the money, or your business will go sideways.
One common tool used by small business owners for expense management is a Purchasing Card, or a p-card as people call it. This is a single credit card that you use for purchasing whenever possible and then pay it off in full at the end of each month. This puts all of the business purchasing in one place. It can sync right to your business software. Plus, when you have to make that payment every month, it forces you to be aware of how much money you are spending, and hopefully it inspires you to look at the list of expenses and ask yourself if you’re making the right spending decisions. You also get the benefits offered by the credit card – be it airline miles or cash back or whatever.
Having that card in your pocket also helps you take advantage of any business spending that you do in your day-to-day life. For example, if you’re with your family hanging out in a book store before you go get ice cream next door, and you see a book about small business management and you think it will benefit you in running your business, then buy the book with the business credit card. The spending will go automatically into your business accounting, and when you pay that card off in full next month, the money comes from your business checking account to do so. This means the business pays for the book, and you’ve lessoned your tax liability.
It’s what people call a “write off.”
People often misunderstand what it means for a business to write something off. For a small business owner, a write-off is just a business expense. If you make $100 but you’ve spent $60 to do it, then you don’t pay taxes on $100. Instead, you “write off” the $60 in spending, and you only pay taxes on the $40 that you kept.
To write off something doesn’t make it free. People say, “just write it off” or “oh, he’ll just write it off” to mean that it’s cheaper or free to buy it for the person who is writing it off. This is not true at all. You still have to have the money to buy it in the first place (at full price like everybody else). It’s just that it shows as a business expense, which means you made less profit because of buying it, and that will lessen your tax burden (because you are taxed on the profit you make).
But remember, your business goal is not to pay less taxes. It’s to make more money.
Variables Costs
Variable Costs are a special type of expenses that are usually taken out of the Revenue first on the Income Statement. Then, the rest of your Expenses are subtracted. This extra step introduces two more lines to your Income Statement: Variable Costs and Income.
So, your Income Statement now looks like this:
Revenue
– Variables Costs
_______________
Income
– Expenses
_______________
Profit
Variable Costs are expenses that are attached to your Revenue Streams. They generally go up as the Revenue goes up (often in direct correlation). Another name for Variable Cost is the Cost of Goods Sold (COGS).
Let’s say you sell a widget for $100. That’s your Revenue. But it cost you $50 to buy the widget. That’s your Cost of Goods Sold (or your Variable Cost). Every widget you buy is going to cost you $50. But you can turn around and sell each of them for $100. So you try to sell as many as possible. The Variable Cost is variable because it goes up as your Revenue goes up and it goes down when your Revenue goes down.
Also, when you sell a widget for $100 and you had to pay the wholesaler $50, then you made $50 Profit, right? Well… you still have to cover your Expenses before you get to your profit. So, we call the $100 you made Revenue, the $50 you give to the wholesaler Variable Cost, and the $50 you keep Income. And every widget you sell puts $50 into the Income bucket. Then, it’s from that Income bucket that you must pay all of your Expenses – rent, payroll, utilities, and so on. And whatever is left after all those Expenses are paid, that is your Profit.
Variable Costs are important to understand because they are specific to your Revenue Streams. Widget A sells for $100 and costs $50. Widget B sells for $10 and costs $2. These are two very different situations with different price points, margins, and volume needs. You’ll need to clearly understand the success of each of your Revenue Streams, so you can make the right decisions for investing your time and money.
Profit
You’ll hear people say things like, “You can lose money in the first few years of your business, and that’s good for tax purposes” or you’ll hear people say that they want to post a loss this year because of this and that. But keep in mind, these tips and tricks are only relevant for you when you are stuck looking at how to shore-up a bad situation. In general, you want to make as much profit as you can. Yes, that will increase your taxes, but it will increase your overall gain in the end. When it comes to taxes, just organize everything correctly and pay-in appropriately as you go, the rest will take care of itself.
Business owners often confuse Profit with Revenue. They often focus on the topline instead of the bottom line. They try to sell their way out of their problems. Or, even worse, they focus on Expenses and think that they can cut their way to Profit. You can cut wasteful spending, which is good, and you can even squeeze for a little short term gain. But ultimately, choking the business does not lead to profit in the long term. So, you have to increase Revenue, while maintaining or improving Variable Costs, while managing your Expenses. You must understand and operate the whole equation, and you can’t do this if you can’t see it clearly. You must measure it to then improve it. Therefore, you must have a basic business accounting system in place, and you must engage with it regularly. Such practice will guide you to making the right decisions for your own success.
Paying Yourself
Small business owners often skimp (or even skip) on paying themselves. This isn’t sustainable. Eventually, you won’t be able to fund the business with the sweat off your brow because you won’t be able to fund yourself with the cash in your personal savings account. You have to pay yourself.
As far as the IRS is concerned, any Profit that the company makes is actually your money (as owner). And you will be taxed on the Profit at the bottom of the Income Statement, regardless of whether you were able to take it home, so to speak. It’s your money. You just need to know when you can pull out how much money. You need to know when and how to pay yourself and how to represent those payments in these business accounting documents in a way that helps you better understand your business success as a whole.
If your business is incorporated, then your pay will be represented as an Expense along with everyone else in your payroll. But if you are a sole-proprietorship (or even a partnership LLC), the easiest way to categorize your personal income is to show it as a Draw from the Profit at the bottom of the Income Statement.
So, your Income Statement looks like this:
Revenue
– Variables Costs (COGS)
_______________
Income
– Expenses
_______________
Profit
– Draw
______________
Capital
You have your Profit (that you will be taxed on), and you have what you took home of that money, your Draw. You can take home more than what is in the Profit, but as we know, the money has to come from somewhere, and that’s always ultimately from you. On the other hand, if you take home (or Draw) less than the total Profit, then what’s left in the company is Capital. Any cash you leave in the company is an asset that will show on your Balance Sheet as cash, thus increasing your business’s overall net worth.
As a sole-proprietor or small partnership, you will be taxed on your Profit. That means the tax calculation that determines how much you owe will be made on your Profit line, not on the Draw line. So, whether you take the Profit home or leave it in the business, you are paying taxes on it regardless. Unfortunately though, when it comes time to write the IRS a check, the Capital you have in your business doesn’t help you come up with the cash owed. You are writing the check from the money you have taken out.
So, you’re Personal Income Statement looks like this:
Draws
– Taxes
______________
Net Personal Profit
The Net Personal Profit is what you have after you pay your taxes. Yes, you may have Capital in your business, but your Net Personal Profit is the total cash you ended up with as cash payment for your work. It’s what you actually got paid for doing the whole production of owning and running a small business as a life choice. So… did you make more money owning a small business than you would have if you just went and got a job? Which one ultimately pays more? Which will pay off more in 5 years? 10 years?
If it is the job that creates more income and wealth in the long term, an entrepreneur would take the job, then make plans to leverage the job into even more money, and then into the creation of some other kind of business, or some other kind of job, and so on. A small business owner will stick with the small business, even if the job would have paid more. This is not a flaw. It’s a life choice. Remember, the small business owner works to make the business successful so that the business can be the lifestyle of choice for that small business owner and be the provider of income over time. So, it’s not just about how much money you make. It’s about your overall return.
Building Wealth
You are a person with a life and presumably a family. The true financial bottom line is how all of your efforts and all of your personal income is ultimately building your personal wealth. Yes, more personal income can fund more personal spending, which may look like houses and cars and vacations and such. But it is an inescapable fact that you will have to stop working one day. Will you be able to pay your way from there? Will you have the wealth to support yourself?
The rates of bankruptcies for business owners in their 60s is at an all time high. This means that when people should be transitioning out of their small business and into their retirement life, they are saddled with so much debt, that not only are they left with nothing, but they don’t have the ability to settle all of their outstanding debts. They have less than zero. They may have a nice house and a nice truck and a big company and lots of employees and lots of machinery, but when added all together it pales to the money they owe. At that point, the only two things that can save them from having to forfeit their home and personal items and go into a destitute state is either a bailout or a bankruptcy. A bailout could be a buyer who is willing to take on your debt, and bankruptcy is when you are able to get legal protections around your personal items as you just fold the business to nothing.
You use your Balance Sheet to manage the overall value of your business, to keep you from getting your business into that upside down situation. But you need to, most importantly, measure and affect your personal overall wealth – your Net Worth. Your Net Worth is everything you own minus everything you owe. If you have a house, and a couple of cars, and a piece of property, and a boat, and a 401k, and some stocks, and a life insurance plan, and you may have about $500,000 in assets or more. But if you owe money on all of those items, and you have a line of credit, and you have a lot of credit card debt, and so on, then you may have $600,000 in debt. This means your total wealth equals negative $100,000. How long do you think you can run from that? Eventually, you will need to retire. Where will you be then? Remember, the money has to come from somewhere.
So, you must make sure that while you enjoy the daily challenge of running your business, and while you track your finances accurately, you must be intentional in how you are turning that business into personal income and then that income into personal wealth. You must have more wealth in 5 years than you do today. Your Net Worth must go up over time. Eventually, you will not have the ability to make income from your hard work. When that day comes, will you be able to support yourself with your own wealth? This is the key to financial success.
Overall Success
Success is not about money. I don’t know how to say that more clearly. Don’t just pay lip service to this. Fully and completely understand that life is not about money. Money, though, is power, and power can be used for good or for ill. If used well, money can give you more control over many aspects of your life. It can give you the power to create comfort and security, and to invest in yourself and your family’s enjoyment and well being. If used poorly, it can create cages and burdens and rifts in your life. So, use it well. Use it as a means of providing for yourself throughout your life, and thus not being a burden on others in your later years. Use it to stay safe, stay healthy, and stay happy. Money is power, so use it for good – love, security, enjoyment, support, bettering your community and the world, and for time well spent.
You only live once as far as we know, so create a working situation in your life where you add value, enjoy your time at work, and are compensated for your efforts. Invest your money in your own life, in your family’s happiness, and in a better world to live in. That’s the bottom line.
More:
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