The Changing Landscape of Sales Taxes (Segment I)

The Changing Landscape of Sales Taxes  (Segment I)

By Jacob M. Dietz, CPA

“A prudent man foreseeth the evil, and hideth himself; but the simple pass on, and are punished.” Proverbs 13:12

The landscape for collecting and remitting sales taxes is changing. If your business operates in more than one state, consider if you should be making any changes to hide yourself from unpleasant circumstances.

History

Decades ago, the Supreme Court ruled in the Quill case that merchants did not need to collect and remit sales tax in other states if they didn’t have a physical presence in that state. This exception allowed out-of-state merchants to sell items that would normally be subject to sales tax into another state without collecting and remitting sales tax.

The exception to collection and remission allowed merchants to avoid the hassle of determining if their product was subject to sales tax in a different jurisdiction. For example, just because something is subject to sales tax in Pennsylvania does not automatically mean it is subject to another state’s sales tax. On the other hand, a product that is exempt from PA sales tax is not automatically exempt under another state’s sales tax rules.

The exception to collection and remission also allowed merchants to avoid the time and expense of filing sales tax returns in other states. It takes time to file in other states. Also, it can make a significant difference in the price your customer pays. For example, suppose you are selling a $10,000 item to another state with a 5% sales tax rate. If you do not charge sales tax, then your price is $10,000. Suppose that you have a competitor with a physical presence in that state. They are selling the same item that you are selling, also for $10,000. Since they had a physical presence, however, they need to charge the 5% sales tax rate. If a customer buys from your competitor, they pay $10,500. If they buy from you, they pay $10,000. Merchants with no physical presence therefore had an advantage.

Some states have a use tax for this situation. The use tax would be payable by the customer, so they would still owe $500 of tax, which they should report and pay themselves. The merchant would not need to bother with it. Unfortunately, compliance with use tax is low.

The Great Change

We have been addressing the past, but there has been a great change. South Dakota wanted tax money, and they passed a law to collect sales tax from out-of-state vendors even if they did not have a physical presence in the state.

The South Dakota law, however, did not require every out-of-state merchant to collect and remit sales tax. It used the threshold of $100,000 sales and 200 separate transactions. Therefore, an out-of-state merchant that sold $10,000 of products into South Dakota in 10 separate transactions would not be required to collect and remit sales taxes under South Dakota’s law.

This law, even with the threshold, contradicted the Supreme Court’s rulings in the past, so this law came before the Supreme Court. The Supreme Court sided with South Dakota in a 5-4 ruling. In South Dakota v. Wayfair, Inc., the Court overturned its decades old precedent requiring physical presence for the collection and remission of sales taxes.

How Will This Case Affect Businesses?

If a business is selling into another state, even without a physical presence in that state, it is possible that the business will be subject to sales tax in that state. Note that it is possible, it is not guaranteed. It depends on the specifics of the situation.

This article is general in nature, and does not contain legal advice. Please contact your accountant to see what applies in your specific situation.

To be continued……

A Summary of the New Tax Laws For Section 199A (Segment I)

Preface: This blog is for entrepreneurs who are hereby advised to apply appropriate tax planning for their businesses activities to optimize the tax benefits and nuances of the new Section 199A tax laws, beginning with the 2018 tax year.

A Summary of the New Tax Laws For Section 199A

Tax Implications and Planning Features with the Qualified Business Income Deductions

Credit: Donald J. Sauder, CPA, CVA

Minted the Tax Cuts and Jobs Act, the newest business tax legislation relevant to the 2018 tax year, appears to have unique tax characteristics that are intentionally vague for taxpayers with regards to certain IRS code section interpretations. The summarized IRS tax code relevantly exemplified specifically to this blog are for the Section 199A or the Qualified Business Income Deduction.

To be confidentially advised towards IRS audit proof tax planning decisions for the 2018 tax year, it is imperative to understand how the new tax law of Section 199A are applicable to certain qualifying entrepreneurial activities and corresponding tax positions e.g. tax laws for service and non-service businesses, exact definitions of qualified business income (QBI) and individual tax filing threshold limits on Section 199A.

The new Section 199A tax code permits individual tax filers to deduct as much as 20% of qualifying 199A income for tax filing purposes beginning with the 2018 tax year. The qualifying Section 199A income includes qualified business income (QBI) from say partnerships, sole proprietorships, or S-Corporation. As with most new tax laws, Section 199A section has numerous tax planning nuances that we will outline in the following paragraphs.

A Section 199A Outline

So, what is Section 199A? It is a tax deduction akin to the prior Domestic Production Activity Deduction under Section 199. With the unique modifications to Section 199A (Section 199 called DPAD in prior years, was capped at 9% of qualifying income or 50% of W-2 wages), for the current tax year, business tax planning will encompass an entirely new level of tax variables with the introduction of this tax law modification.

The Section 199A deduction begins with the tax year 2018 and is currently legislated now, until 2025. Firstly, Section 199A is a standard 20% deduction of QBI from unadjusted income, with a threshold limit on individual taxpayer earnings, e.g. exceeding $315,000 MFJ or $157,500 otherwise. The Section 199A deduction limit phases out over $415,000 MFJ or $207,500 filing otherwise. Above these individual filing threshold’s, the Section 199A is limited to 1) the greater of the 50% of timely filed W-2 business wages, or 2) the combined sum of 25% of W-2 wages plus 2.5% of unadjusted qualifying business property.

The obviously unique characteristics of Section 199A from prior Section 199 DPAD also include capital gains, say from sales of stocks or bonds, being entirely deducted from QBI as non-qualifying income, and permitting a potential deduction for businesses that have zero W-2 income yet substantial unadjusted basis in property, i.e. in-service fixed assets.

Here’s how Section 199A works. If your taxable income is less than $315,000 MFJ or below $157,500 filing single, you receive a standard 20% Section 199A deduction from taxable income. Below the threshold level the Section 199A is a standard applicable 20% deduction for both service and non-service businesses, e.g. all entrepreneurs can supposedly participate in the tax benefits below that threshold.

Example: Bob and Brenda are married filing jointly. Brenda has QBI from a non-service business of $30,000. Their joint income is $375,000 for the tax year. Brenda receives a wage allocation of $40,000 from the business. The 50% of W-2 wages is $20,000. The $20,000 of wages are reduced from the $30,000 of QBI by the $60,000/$100,000 or 60% (excess of income from $315,000 threshold) equaling $12,000. So, the Section 199A is the $30,000 QBI subtracting the $6,000 threshold limit, equaling $2,400 of Section 199A tax benefits. Interesting math say?

End of Segment I — to be continued.

Too Good to Be True: Funding Private K-12 Education with Tax Dollars

Preface: “God never made a promise that was too good to be true” – D.L. Moody.  The Pennsylvania EITC is good and it is true, and gives Pennsylvania taxpaying constituents and parents of children in private K-12 grade school, something to smile about today.

Too Good to Be True: Funding Education with Tax Dollars?

Credit: Jacob Dietz, CPA

The Congress and the President handed the American people tax reform. Tax reform has various benefits that could make you smile, but it also has some reductions in certain tax benefits, such as the SALT (State And Local Tax, it has nothing to do with table salt) deduction cap.

SALT Cap

The SALT deduction has been capped at $10,000 starting with 2018, although the standard deduction has been increased for taxpayers that choose not to itemize. This new cap prevents a taxpayer from deducting more than $10,000 for their real estate taxes, state income tax, and local income tax as part of the taxpayer’s itemized deductions. Please note that this new rule does NOT limit the real estate taxes that can be deducted for real estate rentals or as part of a business. For some taxpayers, this cap will affect their bottom line.

For example, assume Melvin paid $8,000 in real estate taxes, $4,500 in PA income taxes, and $2,000 for local taxes. Under the old tax rules, Melvin’s SALT deduction would have been $14,500 if he itemized his deductions. Tax reform caps Melvin’s SALT is deduction at $10,000. Melvin therefore pays $4,500 of PA income taxes but he receives no increased deduction for it.

Is There a Solution?

Is there anything Melvin can do? Melvin could reduce his PA taxes if his business received the Pennsylvania Educational Improvement Tax Credit (PA EITC) by contributing to a qualified institution. The PA EITC is a tax credit against various PA taxes on eligible donations to qualifying organizations. If you want more details on the PA EITC, click here to read this blog.

Assume like Robert Louis Stevenson said, “Children are certainly too good to be true” and Melvin’s grandchildren attend a Christian school, and he endorses their education already, personally donating funds to the school. Melvin also owns and operates a single member limited liability company (SMLLC.) Instead of donating personally, Melvin could apply for the PA EITC for donations made to the school through his SMLLC. If approved, he could get a 90% Pennsylvania tax credit for his contributions with a 2-year commitment to contribute.

Let’s put some numbers to the scenario. Melvin’s SMLLC filed for and received approval for a 90% credit ($4,500) for a $5,000 contribution for two consecutive years. The company therefore pays $5,000, and the majority of that $5,000 makes it to his grandchildren’s school (a fee goes to administrative costs if he pays via a conduit scholarship fund say.) Pennsylvania gives his single-member LLC business a $4,500 (90% of $5,000) credit for the contribution, which he can pass down to use on his personal tax return.

Melvin avoids paying the $4,500 of PA taxes that would have been nondeductible under the new tax reform, and he contributed to education at the same time. Since he owes no state income tax, then the total remaining taxes of $10,000 ($8,000 real estate taxes and $2,000 local taxes) are not limited by the $10,000 cap. Melvin therefore used his money to build the Kingdom while still complying with the government’s rules.

Reason to Smile

If the tax reform SALT cap caused you to frown, and if you live in Pennsylvania, consider if the PA EITC is right for you. The PA EITC gives taxpayers and parents of children in school something to smile about.

Tax Planning on Residential Real Estate Transactions (Segment II)

Preface: Do you own a house whose value has increased since you bought it? If so, you might be curious about the tax consequences if you sell it. The taxes for selling a house vary depending on the scenario. This article explores some of the tax consequences when selling houses.

Tax Planning on Residential Real Estate Transactions (Segment II)

Credit: Jacob M. Dietz, CPA

Business of Buying and Selling

For this scenario, assume the profitability of buying and selling houses impressed John so much that he decided to quit his construction job to buy and sell houses full-time. He started buying houses, fixing them up himself, and then selling them at a profit. John managed to sell a house about every 2 months. In this scenario, John operates a business. The profits therefore would not be capital gains even if he managed to hold onto a property for more than a year. Furthermore, if John does not have an approved Form 4029 exempting him from self-employment tax, then John would owe self-employment tax on the earnings from his house-flipping business.

Since it is a business, John should carefully track expenses associated with it. Levi asked John to track which expenditures add basis to the property and which can be deducted immediately. Levi explained that certain fees paid when purchasing should be added to the basis, such as recording fees and transfer taxes. Construction costs to improve the house, such as adding a bathroom or a new retaining wall, should also be added to the basis. When John sells the property, the basis will then be subtracted from the sales price, reducing John’s income.   John and Levi should also consider if there are any filing requirements for his business, such as 1099s.

“One such advantage is the Section 199A Qualified Business Income Deduction. This taxpayer-friendly part of the tax system allows John to deduct up to 20% of net income from his house-flipping business, subject to certain restrictions”.

Although there is a higher tax rate if he is in the business of flipping houses instead of investing in properties for more than a year, there are also some advantages. One such advantage is the Section 199A Qualified Business Income Deduction. This taxpayer-friendly part of the tax system allows John to deduct up to 20% of net income from his house-flipping business, subject to certain restrictions.

Buy and Use as Principal Residence

Let’s change up the first scenario. Suppose John buys the brick rancher for 200,000, and he really likes the house. He likes it so much that he moves in after marrying Rose, and they live there for 3 years. When John and Rose sell the house 3 years and 1 month after purchase, they sell it at a spectacular $100,000 gain. Before selling, John called Levi to ask him what his federal tax bill would be. Levi explained how the federal tax system allows them to exclude that gain. If a taxpayer is married filing joint, he and his spouse can exclude up to $500,000 (it would only be $250,000 if John were single) of the gain on a house that was their principal residence for at least 2 out of the last 5 years.

This exclusion can only be taken once every 2 years. Levi also mentioned that there are various exceptions to the rules which could help taxpayers exclude at least part of the gain even if they do not meet the normal requirements but have special conditions. Special conditions include the death of a spouse, a health-related move, a work-related move, and others. John and Rose met all the requirements, and therefore they gained $100,000 without needing to pay a dime in federal taxes on the gain.

“Levi explained to them that they could exclude the gain from the sale of the lot as part of the transaction of selling their home, if they sold the lot within two years of selling the home, and if the total gain did not exceed $500,000”.

Let’s change up the principal residence scenario. Suppose that when John purchased the home, he also purchased a vacant lot on a separate deed next to it. John and Rose planted grass on the vacant lot, and treated it as part of their home’s yard. Levi explained to them that they could exclude the gain from the sale of the lot as part of the transaction of selling their home, if they sold the lot within two years of selling the home, and if the total gain did not exceed $500,000.

Final Thoughts

As you can read, taxes on house sales really varies. If you want to sell a house, talk with a tax expert before finalizing the sale. The tax expert may be able to help you find a benefit, such as waiting a little longer until a time deadline passes. Furthermore, if you will owe taxes, then the tax expert may be able to estimate roughly your tax liability so you can stow away some money to pay what is owed.

 

Tax Planning on Residential Real Estate Transactions (Segment I)

Preface: Do you own a house whose value has increased since you bought it? If so, you might be curious about the tax consequences if you sell it. The taxes for selling a house vary depending on the scenario. This article explores some of the tax consequences when selling houses.

Tax Planning on Residential Real Estate Transactions (Segment I)

Credit: Jacob M. Dietz, CPA

Buy and Sell Same Year

Assume John Georges had some money to invest, and he purchased a house at the advice of his father. He bought a $200,000 brick rancher in June 2018. John heard real estate prices were climbing rapidly in his area, so he decided to wait for a buyer instead of renting it out.

“John therefore sold it to them at a $25,000 gain. The income would be a short-term capital gain since John owned it for less than a year”.

In August 2018, John’s realtor that helped him buy the house called him and said another buyer desperately wanted to buy the house, and they were willing to pay John’s asking price. John therefore sold it to them at a $25,000 gain. The income would be a short-term capital gain since John owned it for less than a year. Short-term capital gains are taxed at ordinary tax rates. Note that only the gain (sale price less purchase price less other adjustments such as selling costs) is taxable, not the entire sales price.

Buy and Sell plus other Goods

This scenario is the same as the first scenario, except when John sold the brick rancher, he received an additional $25,000 for items left in the house by the previous seller. These items included furniture for all the rooms. The additional 25,000 increased his income to $50,000, taxed at ordinary rates.

Buy and Sell after more than a Year

In this scenario, the facts are the same as in scenario 1 except for the sale date. John owned the house without receiving any offers for nearly a year.

“Levi explained to John the difference between short-term and long-term capital gains. If John sells a house he owned for a year or less, it is a short-term capital gain”.

Shortly before a year ended, a realtor contacted John with an offer. John was pleased with the price, but he called his accountant, Levi, before deciding. Levi explained to John the difference between short-term and long-term capital gains. If John sells a house he owned for a year or less, it is a short-term capital gain. Levi explained that short-term capital gains are taxed at ordinary rates. On the other hand, houses owned over a year receive long-term capital gain treatment.

“Levi recommended that John go ahead and accept the offer, which would bring John a $25,000 profit, but Levi also advised that John wait to settle on the house until more than a year after the purchase date”.

The tax rate varies for long-term capital gains, but it is lower than ordinary income tax rates. Levi recommended that John go ahead and accept the offer, which would bring John a $25,000 profit, but Levi also advised that John wait to settle on the house until more than a year after the purchase date. By waiting a few weeks to close, John benefitted from the lower long-term capital gain rates.

Conclusion of Segment I.

Navigate Business with a Good to Great Balance Sheet (Segment II)

Preface: “We must go beyond textbooks, go out into the bypaths and untrodden depths of the wilderness and travel and explore and tell the world the glories of our journey.” — John Hope Franklin

“I vividly remember a conversation I had many years ago in 1974, which marked a turning point in my leadership journey. I was sitting at a Holiday Inn with my friend, Kurt Campmeyer, when he asked me if I had a personal growth plan. I didn’t. In fact, I didn’t even know you were supposed to have one.” — John C. Maxwell

Navigate Business with a Good to Great Balance Sheet (Segment II)

Credit: Jacob M. Dietz, CPA

If you want more accurate financial numbers, take the time to adjust your businesses balance sheet accurately. Trying to navigate a course for your business using inaccurate financial reports can be like trying to navigate with a 50-year-old atlas. You may miss your intended destination on the journey. Alternatively, you might reach your destination, but it may take you on a long route. Using accurate financials can help you reach your goals on your journey.

Liabilities

Liabilities are what the company owes, and they should be examined as well.

If your company has Accounts Payable, review an aging schedule. Does your accounting system indicate that you owe invoices that you really do not owe? If so, clean them up. Why would it show that you owe money that you don’t owe? One scenario could be that your company did owe that amount once, but that it was entered twice. Your company paid one entry, but the other entry still lingers in your books as a payable. If this scenario happened to your company, then the lingering entry should be fixed.

If you company purchases with credit cards, are the credit cards reconciled? Business expenses purchased on a credit card should be recorded in the accounting system. Verifying the ending balance could detect if some credit card purchases were not entered that should have been.

If your company has any debt, either to a bank, an individual, or anything else, verify if the ending balance is accurate. If you receive statements, the balance sheet can be compared to that. If it is a loan to a person, you may want to compare to an amortization schedule that you both agreed to in the beginning of the loan.

As with assets, consider if there are any liabilities not on the books that should be recorded. For example, did someone loan the company money but it’s not recorded in the accounting system? If your company uses the accrual system of accounting, consider if there are any accruals, such as for payroll, that should be entered or adjusted.

Equity

Equity shows the ownership interest in a company. Does the equity on the balance tie to the tax return, or the accounting records that were used to prepare the tax return? If it doesn’t, then you might overpay in taxes. How could this happen? Assume that your accounting records show an invoice of 5,000 on December 31 that is included in income. Your accountant receives your accounting records and prepares a tax return reporting the $5,000 from that invoice as income. Later, for some reason, the date of the invoice is changed to January 1.   If your accountant later looks at the profit and loss for the next year, the $5,000 will show up again. Thus, the $5,000 could get taxed twice. Moving the invoice from December to January will change equity, however, so reviewing total equity can help detect this change.

If the company has multiple partners, then consider breaking down equity by partner. If equity is broken down by partner, then generally it should tie to the K-1s in the tax filing. The accounting software likely will not allocate the equity for you properly, so it may need to be done manually. For example, the earnings from the previous year may get dumped into a single account by the accounting software. Your accountant should be able to help you allocate the equity among the partners.

Navigate with a Good Map

This article discusses clean books, but it takes more time to adjust books accurately than it does to read this article. The benefits of accurate accounting records, however, can be great.

If your balance sheet is as inaccurate as a 50-year old map, start adjusting it accurately right up to the FICA taxes. Systematically go through the balances and review if they are accurate and if beginning numbers tie to the prior year return. Although an accurate balance sheet doesn’t guarantee an accurate profit and loss statement or statement of cash flows, it puts you in a better position to prepare and accurate profit and loss statement and statement of cash flows. Travel with modern maps, and navigate your business with an accurate balance sheet.

Navigate Business with a Good to Great Balance Sheet (Segment I)

Preface: “One’s destination is never a place, but always a new way of seeing things.” — Henry Miller.

“Success is about dedication. You may not be where you want to be or do what you want to do when you’re on the journey. But you’ve got to be willing to have vision and foresight that leads you to an incredible end”. — Usher

Navigate Business with a Good to Great Balance Sheet (Segment I)

Credit: Jacob M. Dietz, CPA

Where is your business, and where is it going? Good to great financial reporting helps answer these questions, but too often the accounting records of a business cannot be trusted because of inaccuracies. If you want more accurate numbers, take the time to clean up your balance sheet. Trying to navigate a course for your business using inaccurate financial reports can be like trying to navigate with a 50-year-old atlas. You may miss your intended destination on the journey. Alternatively, you might reach your destination, but it may take you on a long route. Using accurate financials can help you reach your goals on your journey.

General Principals

If you crave an accurate profit and loss statement and statement of cash flows, start with an accurate balance sheet and end with an accurate balance sheet. If the balance sheet is wrong, then the profit and loss statement and the statement of cash flows may be wrong as well.

If the balance is wrong, how do you fix it? Begin with the beginning balances. Generally, treat the balances that were used to prepare the last tax return as correct. If the tax return contains significant problems, however, then consider starting with balances used for an earlier tax return. For this example, assume that there are no known problems with the last tax return. Let’s explore how to generate accurate balances.

Assets

The first part of the balance sheet lists what the company owns. Accountants call these items assets. Assets include bank accounts, inventory, accounts receivable, etc. Verify that the beginning balances for the year equal the ending balances used for the tax return. In a balance sheet, the asset ending balance for the previous year is the beginning balance for the current year. Sometimes accountants adjust the balance sheet when preparing the tax return but don’t adjust the company’s accounting records. If the beginning balances do not tie, adjust the balance sheet dated at the end of the previous year to tie the beginning balances to the ending balances used for the tax return.

What adjustments might be made by an accountant but not entered in a company’s accounting records? Accountants frequently adjust inventory at year end through cost of goods sold. If your accountant adjusted inventory for the tax return, but that adjustment was not made in your accounting records, then adjust your inventory to match the inventory that was used on the tax return. Accountants frequently adjust depreciation when preparing a tax return. Depreciation adjustments affect the balance sheet account Accumulated Depreciation. If Accumulated Depreciation in your accounting system doesn’t match the balance sheet used for the tax return, then adjust it to match.

If all the beginning balances match the ending balances used on the last tax return, examine the ending balances of the period being considered. A balance sheet is a snapshot of a company’s finances at a specific point in time. It is therefore important to know which date is being considered. For this example, assume that the balances are for December 31. Examine every line item in the asset section of the balance sheet, and consider if it is accurate.

Start with cash. If petty cash is listed on the balance sheet, is it accurate? If there is only $25 in the petty cash drawer, but the balance sheet says $1,500, then adjust petty cash to match the counted value. If an item is small, judgment can be used regarding how much verification to do. For example, if petty cash says $45, you might decide to skip counting petty cash since it is insignificant.

Verify the ending balances for bank accounts. Each account should have either a bank statement or a bank reconciliation that ties to the amount on the balance sheet. If a checking account has outstanding checks, review the outstanding check list to see if there are any old items there. For example, suppose there are 2 checks listed from 11 months ago. Why did those 2 checks not clear? Were they duplicated in the accounting system?

If there is inventory on the balance sheet, is it counted regularly? Many companies need to count inventory regularly or else the balance will be incorrect. If the balance differs from a physical inventory count, then adjust the balance to match the count.

When inventory is adjusted, the other side of the adjustment is cost of goods sold, which is on the profit and loss statement. If the beginning and ending inventory balance is not correct, then cost of goods sold may also be wrong, leading to an incorrect profit and loss statement. Therefore inventory, a balance sheet account, impacts cost of goods sold on the profit and loss statement.

If the company has accounts receivable (AR), examine an aging report for accuracy. Does the report list amounts that will never be collected? Consider if any AR should be written off as bad debt.

If there are other items in the asset section of the balance sheet, consider if they are accurate. Also, consider if there are items that are not in the asset section that should be. For example, did the company loan money to another company? If so, ensure that the loan receivable is recorded in the accounting system.

Segment I Summary: Where is your business, and where is it going? Good to great financial reporting helps answer these questions, but too often the accounting records of a business cannot be trusted because of reporting inaccuracies. The above steps as a good beginning step, with the guidance of your CPA, can begin to create an accurate map of your business financials.

Working Capital Tools for Successful Business Performance (Segment V)

Working Capital Tools for Successful Business Performance (Segment V)

Credit: Donald J. Sauder, CPA, CVA

 Looking Towards the Future

Working capital management is imperative to successful entrepreneurship because agreement on its relevance is a real deal when transitioning business ownership. Working capital requirements are often a key valuation feature in business exits.

Let’s look at some relevant marketplace data from Keystone Business Transitions for confirmation:

  • You are far from the only fish in the sea. Estimates indicate that there are approximately 7.5 million business owners in the United States, and 65% of survey respondents planned to leave their company within a decade or less. That could result in a glut of companies on the market, driving down valuations and giving new leverage to buyers.
  • If you are a Baby Boomer (born between 1946 and 1964) the generation following you is not nearly as big so expect far more sellers than buyers in the marketplace. This too, adds to the glut.
  • Even during boom times less than half of the owners who tried to sell their business actually were able to sell.
  • Unless your company is superior to its competitors because there’s something about it that a buyer can use to make more money than you do (or other businesses in your industry do) a rising tide is going to lift you only as much as it lifts that glut of competitors.

If three out of every five businesses plan to sell in the decade, the a superior business should have adequate working capital levels to gain an edge in the increasingly competitive transaction marketplace.

If your business lacks adequate working capital, at best, your business will only confabulate with regards to exit planning because it will not have the cash available to appropriately prepare qualified successors for ownership, e.g. adding and developing partnership/successor trainee(s),  or pay advisors to gear-up the business for  a successful sale, and further, substantiate that your business has an appropriate [any] value for a vertical or horizontal industry integration, i.e. even the tykes like the big fish; and those small fish, why bother right?

Entrepreneurship can be likened unto the Parable of the Talents in Matthew 25. Your business is an alike talent. There is risk, but if you’ve counted the cost, and faithfully apply your expertise, there are often rewards, i.e. your working capital levels will flourish. Similarly, your working capital levels will likely lead to entropy if you or your employees do not put diligent effort forth to continually develop the business.

It is advised to measure working capital levels, i.e. how many fish you have, and how many fish you need for the month, to keep the business continually flourishing financially. If your business faces continual pressures on working capital levels, your advised to get advice [early] on how you too can develop adequate working capital balances with improved business processes, communications, and strategies for successful business performance, e.g. acting [quickly] on working capital concerns improves your probabilities of being a long-term profitable servant.

Businesses succeed because of others, i.e. customers and clients. Some businesses cajole for development, and for others, “Honor lies in honest toil” to quote Homer. Yes, absent a customer(s) or client(s) to transact with in the marketplace community, their would be no business at all; people needs businesses, and businesses need people. Every big fish, began as a small fish, and the big fish are the result of a conducive environment i.e. working capital levels always sustained developments.

While the unprofitable servant likely didn’t realize he should pay an advisor, in addition, he took zero action towards profitability. If you’re investing in your future and your businesses future, you’re likely not an unprofitable servant.

Working capital and sparkling water have shared a value. Too few realize how precious it truly is. Effective management of working capital and the effective management of operating capital and the cash flow cycle is imperative for successful business performance, e.g. the fish will flourish and you will too.

Adequate working capital is your businesses sparkling well. If you’re one of three out of five entrepreneurs transitioning ownership in the next ten years, you’re now advised why you should start investing in the necessary financial tools to measure and manage working capital.

 

Working Capital Tools for Successful Business Performance (Segment IV)

Preface: Prevention of backsliding in already optimized working capital levels, and developing deeper and more conservative convictions on managing working capital to encourage the life of a more successful financial business environment, are truly inherent skills associated with decades-long successful entrepreneurship.

Working Capital Tools for Successful Business Performance (Segment IV)

Credit: Donald J. Sauder, CPA, CVA

Working capital management has two non-financial centric benefits. 1) To prevent backsliding in already optimized working capital levels, and 2) Developing deeper and more conservative convictions on managing working capital to encourage the life of a more successful financial business environment.

The discredit of the merits of working capital management is often par for business, until a shortage results in acute financial pains. In these scenarios, an awareness of the appropriate steps to take to manage and alleviate that financial pain, work to restore the financial vibrancy of the business. While those steps are not the subject of this article, at those time, few financial advisors measure working capital as a key financial metric. While that is not necessarily a mistake entirely, from an accounting standpoint, meticulous financial management and assessment of historic data, e.g. working capital measurement, will highlight changes, and bold concerns with organizational communication and cohesiveness, customer service, and marketplace conditions (i.e. customer inventory purchasing characteristics.) These are common quantifiable concerns that lead and precede extensive working capital atrophy.

Abrupt changes in working capital management such as extending payment terms on vendors from 15 to 30 says to improve the cash conversion cycle, can result in increased prices on purchases, and changes in vendor terms. Reducing inventory levels can lead to forfeited sales revenue, and customer atrophy. With appropriate data, chief financial officers can support these technical parameters to manage onboard assets, and unboard ancillary cash requirements.

It is of note to ensure that the data gathered is not a burdensome or intensive effort. The data collection is usually facilitated with IT systems that intuitively analyze and identify key parameters of both financial and non-financial data to provide informative data maps on customer activities. There is no business without sales. Data driven sales metrics lead to a greater appreciation of what drives customer revenues that are either recurring or discretionary.

Too often a lack of appropriate attention and guiding convictions towards the value of working capital management oversight, results in navigational challenges when financial turbulence occurs. Entrepreneurs cannot appreciate that in formative years they’ve run the entire business from an intuitive sense. Then when (the entrepreneur) begins to develop the business beyond what they comfortably can manage individually, they eventually face pressure because they do not have proven processes in place for monitoring delegated tasks, nor a process to track key performance data. As key persons revolve, the unattended monitoring of processes from a data standpoint, that can result in atrophy of working capital, eventually leading to financial turbulence.

Importantly, when a business is experiencing atrophy in working capital levels, if the business has not identified and quantified the root causes of backsliding performance, often the safest approach is to immediately scale back business activity as opportunity permits, to a more manageable level. Following re-stabilization, then develop processes of data management both financial and nonfinancial to effectively manage operations, and resulting working capital adjustments. Secondly, oftentimes businesses in turbulence need bolstered with working capital. Minimal risks on the additional credit is imperatively prudent.

Businesses that are solidly established from a working capital perspective, often have developed valuable convictions, and disciplined themselves to invest the time and have devoted proactive attention to prevent backsliding and atrophy of working capital levels, accomplished with timely measurement and reflections on historic, current and future data, and communication of likewise performance metrics. The big-ticket items on management include – inventory, customer deposits, and accounts receivables and payables.

Research at Harvard Business School by Lynda Applegate, Janet Kraus, and Timothy Butler takes a unique approach to understanding behaviors and skills associated with successful entrepreneurs. “The entrepreneurial leaders we know are constantly searching for tools that can help them become more self-aware so they can be more effective,” Kraus explains. “This tool is going to be uniquely useful in that it was specifically developed to help entrepreneurs gain a deeper understanding of the skills and behaviors that they need to be successful.”

Prevention of backsliding in already optimized working capital levels, and developing deeper convictions on managing working capital [conservatively] towards building a more successful business, are truly inherent skills associated with successful decades-long entrepreneurship.

Working Capital Tools for Successful Business Performance (Segment III)

Preface: Don’t tell me what you value, show me your budget, and I’ll tell you what you value.” –Joe Biden.

Working Capital Tools for Successful Business Performance (Segment III)

Credit: Donald J. Sauder, CPA, CVA

Working Capital Measurements    

Working capital is an easy calculation (current assets minus current liabilities equals working capital). Working capital measures the operational liquidity level of a business. Currents assets are primarily the cash and equivalents accounts, accounts receivable, vendor prepayments, and inventory. Current liabilities are primarily accounts payable, credit cards, line of credit, tax liabilities, accrued expenses, customer prepayments and deposits, and current portions of debt.

To accurately measure working capital, it is necessary to have accurate financials with appropriate accountant oversight to classify accurately current and noncurrent assets and liabilities. The current ratio applies the same financial numbers as working capital, yet instead of subtracting current liabilities from current assets, the current ratio divides current assets by current liabilities. Typically, a current ratio should be greater than two and likely 2.5, to be solidly established from an analytical measurement metric.

Working capital measurement and management are synonymous; an analytical approach to monitor a business’ capacity to continue operations with sufficient cash flows and to pay operating expenses and satisfy short-term debt obligations.

Sauder and Stoltzfus, and an entrepreneurs CPA firm, has developed a working capital grading tool to help clients measure optimal working capital levels, i.e. how much is enough when discussing working capital? Let’s call it the working capital grader.

Working capital seems easy enough to calculate. You look at your financial statements and subtract current liabilities from current assets. If you should have the financial accuracy to calculate the balance, the numbers independently, do not provide much analytical guidance. Tracking the balance from consecutive period to period will provide a data map, but you need to know, “Do you have enough yet?”

Numerous business owners have an intuitive feeling on working capital levels, but quantifiably grading working capital provides understandable and mathematical measurement where your business is at now, and where your business working capital could and should be.

Here’s how we grade working capital at our firm. You can do math or follow along (current assets minus current liabilities is the formula.) Now contrasting that mathematically to the profit and loss statement, measure your direct labor expenses,+ operational or general and administrative expenses on a quarterly basis, e.g. what do you pay in direct labor expense or general and administrative expense, on average, every three months?

A business with a direct labor expense of $1,000,000 per year, you would multiply the twelve- month fiscal year number by 0.25; that calculates to $250,000 per quarterly ($1,000,000 * 0.25). If your operating expenses or general and administrative expenses are $1,200,000 for the twelve-month fiscal year, then you would multiple that balance by 0.25 to arrive at a calculated $300,000 ($1,200,000 * 0.25). The greater of those two numbers is your optimized working capital or $300,000, e.g. your business is a solidly pillared if you have the greater of these two numbers in the working capital formula.

If you have working capital in-excess of the calculation your business can take on additional risk to safely develop the expansion of operational activity.

Now if working capital (current assets in the hypothetical business are $900,000 and current liabilities are $725,000) at $175,000, the $175,000 compared to the optimized $300,000 provides an accurate measurement and comparison; $175,000 is what is; $300,000 is the goal for optimization.

Here it is, the grading tool:

  1. 35% equals one month of working capital
  2. 70% equals two months of working capital
  3. 100% equals three months of working capital.

In the above calculated working capital scenario, the 175,000/$300,000 is a lackluster 58% grade. If your business working capital grade is below 5%, your business likely needs immediate help from “Now Man Central”. On the other hand, the $125,000 increase required from $175,000 to achieve $300,000 can be obtained with additional earnings and profits retained in the business, or long-term amortization of say a line of credit.

For a well-managed business, it is an achievable goal to work towards, and exceed a 100% working capital grade; For entrepreneurial businesses with optimized working capital at 100%, say  “Happy Birthday!”

Now comparing this to the current ratio; the current assets of $900,000 divided by $725,000 of current liabilities equals a current ratio of 1.24. A current ratio of greater than 2 would require more than $1,450,000 of current assets say in this hypothetical calculation with no changes in current liabilities.

Typically, as an entrepreneur builds equity with profitable earnings, liabilities decrease as they are paid, and equity increases. Therefore, the measurements and grades improve with time. Startup business ventures should appreciate that their largest risk is liquidity, i.e. measured as working capital.

Working capital tools advisedly should be continually applied and monitored for businesses in every industry.

Summary: “How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case”. –Robert G. Allen