Accounting: Yesterdays weather report.
Although we are no longer in the public accounting business, we were for 20 years. We see it today as an antiquated business that in many cases does more harm than good.
Most business owners hire out accounting. In most cases, this means oftentimes, their accounting systems are useless and antiquated.
The richest and most successful men in history were their own accountants.
Men like Andrew Carnegie and John D, Rockefeller took a basic accounting.
Most what businesses think of accounting is not accounting at all.
Accountants prepare financial statements. Can you read a financial statement?
Accounting is the final step in what used to be called bookkeeping. 50 years ago, companies hired armies of bookkeepers to keep tabs on where their money was going. But bookkeeping has been replaced by technology and is in most cases, not cost effective.
Let me give you an example.
We were once asked to value a bar-restaurant that operated in a rural area. Bars are complicated businesses, as you might imagine.
They had six sources of income. Beer and liquor, lottery tickets, food, the music box, catering and rent. The owner owned operated as an old-style pub and rented rooms through Airbnb.
In New York, beer sold in bars is segregated from beer sold with food for sales tax purposes.
What we were asked to do is determine profit margin per menu item, overall margin, and the value of the business.
The bar took in cash and credit cards, but also received income from the state (lottery), Airbnb and the music machine. The owner, an incredibly anal former fast-food manager had five different bank accounts!
In fact, it was her anal-ness that made the place work. The business was so complicated and had so many moving pieces we finally threw up our hands and walked away!
Another of our clients is a distributorship.
They do about $10 million a year in sales at a 7% net margin. Yet, they generate their margin calculation internally. Why? Because on a thin margin and high sales they cannot afford to wait until a month after the end of the quarter to find out what they are profit margin is.
In the bar above the only measure of profit margin they had was their bank balance. This should NEVER be used in a profit calculation, as from an accounting standpoint, it is useless information.
All you must do to run up your cash balance is to stop paying your bills! In fact, we had a client that did just that. A large lumber company. Aside from the fact that his suppliers wanted to kill him, he eventually straightened things out, but it was a nightmare!
In any business, profit margin is all that matters.
It does not matter how much you love what you do, or even how much your customers love it, if it is not profitable, you are out of business. And if your financial statement does not help you calculate margin on a weekly basis, it is worth as much as yesterdays’ weather report.
Very few small or even medium sized businesses think of margin, even though men like Rockefeller, Carnegie and JP Morgan were obsessed with it. Henry Ford was not so much obsessed with margin as he was assembly line efficiency.
Most successful small businesses work on high margins. That is not something they planned. If they did not have those margins they would have failed. Thin margins make even small mistakes game changers. High margins insulate them from useless accounting.
It is not that accounting in useless; it is just useless TO BUSINESS OWNERS.
If you do not know your company’s margins while you are generating them, then what good is the data?
What good is yesterday’s weather report?
The only way accounting data can be made real time is to do the following.
1) Use an online payments processor that takes checks, makes refunds, and bills for future payments automatically. Deposit cash in the same account.
2) Make sure all your charge points or branches are linked to it.
In other words, eliminate the need for bookkeeping FOR ALL OF YOUR INCOME AND EXPENSE POINTS. You probably already do this in other aspects of your business.
In my to do list, which is on an excel spreadsheet, the first columns are “task,” “Time,” and “Leverage.” Leverage means getting someone else to do it. That saves MY time. (Which is the $1,000 an hour piece) When I can put nobody in the leverage column, that means the job can be either automated, or done by a vendor.
When you put nobody in the column for bookkeeping, you have hit pay dirt.
3) Adopt an online banking system integrated with software such as QuickBooks Pro.
4) Set up your views so they are understandable by you.
Any accountant with an ounce of gray matter can do this for you in their sleep. If they give you blowback it is because it reduces their billable hours. If that is the case, time to shop for a new CPA or hire a controller.
Note: Many large CPA firms use staff to process accounting data they get from you. That means even though you have a reputable company as your CPA firm, the people creating your financials may be recent college grads.
Can business owners understand the Accounting Statements they get?
No. I have gotten so many calls from CEO’s of firms asking me if their financials done by major CPA firms were correct, I stopped taking their calls. (And many were close friends.)
The fact is, like Henry Ford, if you can automate, you do not need ½ of what they bill you for.
Now that you have eliminated the bookkeeping function, we can talk about accounting.
Accounting is so simple, if I had a few weeks and a pocket calculator, I could teach it to a chimpanzee.
For the purposes of our discussion, profit margin works like this.
1) What you earn minus what you spend is your profit.
2) What you have minus how fast it wears out is your equity.
Number 1 is not as simple as it seems. Accounting is the matching of income and expenses. Income is not counted when you collect but when you invoice. If you run a restaurant, that is the same day.
The purpose is to determine what it costs you to sell a product. That knowledge tells you whether you should sell more, what kinds of sales you can run and what products you should prioritize.
Let us say you are contracting to a company that pays on a 30 day pay cycle. That means 30 days after they take delivery, they send you a check. (30 days is a SHORT amount of time for most corporations.)
If you are using your bank statement to determine profit margin, you are screwed. You want to match what it costs to sell a product with what you charge.
Not only that, but margin analysis tells you how much working capital you need. If you get paid in 45 days, that means your spending money before you receive payment. Margin analysis tells you how much you must keep in the bank.
If you add a product or service, that increases your working capital needs.
This is not hard; you just must think it through. It is the essence of running a business. If you cannot do this, profit is based on luck, and believe me, this is not a place you want to be!
We used to have a client, Louis who was a landscaper. (He mows the lawn at my house. He earns $80,000 a year. He has sales of $100,000 and costs of $20,000. Easy, right.
Let us imagine he buys $50,000 worth of landscaping tools. So, he has sales of $100,000, costs of $20,000, new equipment of $50,000 so that year’s profit is $30,000.
In fact, that is what will show up on his tax return.
But that new equipment has what is referred to as a useful life. Let us say that equipment will last 10 years. From a profit margin standpoint, his PROFIT for that year would be $100,000 in sales, minus $20,000 (his normal expenses) minus $5,000 which is the amount of wear and tear on his $50,000 in new equipment for that year.
This means his margin in $100,000 – $20,000 – $5,000 or $75,000.
This $5,000 number is what the IRS refers to as depreciation. It is the wearing out of your stuff and is a very real thing.
Now, this is a simplified profit margin, which leads us to the cardinal rule.
ALWAYS use simplified margin calculations. By automating your bookkeeping, it is easy.
I am not saying you should not have an accountant. What I am saying is that he is an employee. A good one is worth paying a premium for. A bad one is worth nothing.
Remember, accounting will not make you a successful businessperson. Marketing will do that. But without accounting you will beat your head against the wall trying to price products and will be practicing voodoo when you take out loans.
Accounting gets further complicated when you start to inventory products for future sale. This is where you either lean on your accountant to keep your system up to date or hire a controller.
The above-mentioned wholesaler had a fulltime employee that did nothing but run the accounting system.
When you first start out though, it is enough to have the information in your head.
Let me give you an example of why this can be critical.
Years ago, we helped facilitate a sale of a small ($500,000 in sales.) manufacturing operation to another company. The operation generated $150,000 a year in net pretax profit.
When we did the financial estimates, we combined the operations to show the buyer why they should pay $1 million for the company.
They already had a facility and a manger. That saved $25,000 a year in rent. Much of the labor cost was employees standing around waiting for machines to stop running and the products to cool down.
In other words, on its own the company could generate $150,000 but enveloped into another operation could generate $200,000. They liked the pitch and bought the company. We walked away. Success.
Not exactly. Within a year, the buyer hired another manager, which they did not need. They moved that operation to another location and changed the process. Within two years, the margin was down to $60,000 and they called us back in.
They were smart guys, but their decisions were not the kind of hard cold decisions you make when you are profit margin obsessed.
It is a business. You are trying to make money.
They ended up subletting the new space, moving the process back to the old plant, firing their manager and hiring a guy that could do the job.
Oftentimes the most successful businessmen and women are misers. Why? Because they do not spend money, so they can withstand screw ups. If you cannot handle constant screw ups become a toll collector for the State. Do not start a business.
But there is another BIG reason why accounting knowledge is critical to a small business. Taxes.
This part is a bit heady, but do not skip it. Getting this wrong will total F up your life.
When you have a job, you pay taxes per paycheck. These are deducted for you by your employer.
Businesses pay taxes quarterly. They must send a check to the IRS.
Imagine you are Louis, our lawn cutter. His taxes are (say) $7,000 per quarter. (Federal) But this number is based on what Louis earned IN THE PRIOR YEAR.
You are required to send in what you owed last year or what you currently owe, whichever is lower.
So, let us say Louis business increases 50%. He gets to the end of the year. His account does his taxes, and he owes income taxes on (say) $120,000. But he is only sent the IRS his tax based on the $80,000 he made last year.
So, come March, he must pay $7,000 (his fourth quarter payment, plus an additional $15,000 on the excess profit. So instead of $7,000 he must pay $22,000! And his NEW quarterly payment is now $7,000 plus 1/4th of the 15,000 or 11,250 per quarter!
Goodbye checking account.
Now, let us say his business goes back to where it was.
His quarterly payment is now $11,250, but his net income has fallen to $80,000 per year. That means he is going to send in $45,000 when how only owes $28,000.
To understand this, you must understand how accounting firms operate for small business. They do annual reports and tax returns. That means they calculate profit margins ONCE A YEAR, three months after the year is over.
In the bar (above) their accountant was a clown. (And worse, a relative.) She was perpetually on extension, which meant their annual financial report came in June!
To be sure if you overpay you get your money back, but you must shell it out and wait, sometimes for a year, to get your it back. This is the essence of why online accounting is critical.
Cash flow management.
It is one of the biggest reasons businesses either fail or struggle.
Let me give you an example. Let us go back to Louis’ $50,000 in new equipment.
Imagine that Louis buys equipment with easy payment terms. No down payment and 5 years to pay. For the example, imagine the sale takes place on January 1st.
In the first year, Louis pays 1/5th of the loan, or $10,000. He then gives all this info to his accountant who does his tax return.
Even though Louis paid only $10,000 of the bill and still owes $40,000 the IRS allows him to deduct the whole $50,000. They do not care how you pay off your loans, just how you write them off.
In the first year, Louis gets a big tax deduction. The second year, he must make an additional $10,000 payment but his tax deduction is gone! He is already used it up.
Keep in mind, taxes are bracketed. Not only are his future payments no longer deductible, but the money also he now must earn he has to pay taxes in higher brackets that he used to take the tax deduction!
This can lead to a situation where businesses will have taxable income and no cash flow!
This can ruin you.
And believe it or not, for small business, this is almost always the case.
The solution is an online system that creates a continuously running profit margin calculation. In fact, it has never been easier to do it. This is what the online accounting software companies are designed to do. They are cheap, efficient and have hundreds of hours of free online tutorials.
Remember. Yesterday’s weather report has no value.
In the appendix you will find a topic called “Phantom income.” These are income sources with no corresponding cash flow. We redo and update this list when new information comes in. Feel free to browse it online.
I am not suggesting that you become an accountant.
You just must know what they do so you can use them.
In the Marines, all infantry officers are required to learn how to fire all the weapons they use, from pistols, to rifles, to missile launchers and Howitzers. In combat, officers do not fire them, but to lead, they are expected to know what the men they give orders to are doing. This is what you should know if you are going to start a business.
