The biggest lesson I have learned from this experience is that we have a different mindset when it comes to our personal finances. When managing cash for a business we tend to make fairly educated decisions. For example, we analyze why we need the new equipment and how it will create efficiencies. Or we have a list of reasons why the new item is necessary for the business or how it will be beneficial in the long-term. This does not appear to be the case with our personal monies.

As individuals we tend to participate in emotional purchasing. We buy what we want vs. what we need. We make impulse purchases (and stores know this, which is why they have so much “stuff” near the cash registers). Or we can be guilty of buying something when it is on sale so we can brag about what a great deal we got.

One of the guest lecturers had a tool that showed the difference in the amount of money someone would have if they invested 5 percent of their income over a 20 year period. He then compared this to how much money they would have if they increased the investment to 10 percent. This difference was staggering. If we could all cut out 5 percent of our spending and put that money into a savings account we would all be much more prepared for retirement.

Personal financial planning does take time. I have learned a lot about my own personal goals and limitations during this process. It was interesting to see what my net worth is as I haven’t completed a balance sheet using my personal information before. Where you really see your spending habits is in the creation of an income statement. Once you see where you are spending money, it is easier to make changes.

So set aside some time to write your short-term, intermediate and long-term financial goals. Then create a balance sheet to determine what you own and what you owe. From there complete a summary of your income and expenses. Find an area or two where you can reduce your spending and allocate that money into a savings account. You are on your way to financial freedom.

Did you plan for year-end bonuses? Or was it a last minute decision? What about purchases for automobiles, machinery, equipment, furniture, etc.? If you want to expand your business you will need to buy new equipment. If you want to maintain your business you will need to replace old or outdated equipment. The best way to prepare for the purchase of these large items is to prepare a capital budget.

Summarize the items you think you will need and in what month you plan on purchasing them. Compare the cost of these items to your cash budget. Will you have enough cash in the bank? If not, consider building a relationship with a banker if you do not already have one.

Next, determine the net cost or benefit of your purchase. There are a couple of ways to do this, but the easiest and most commonly used method is Net Present Value (NPV). You will need to know:

1) the cost of the item or project,
2) the life of the item or project,
3) annual cost savings or maintenance expenses,
4) the savage value, if any, and
5) the required rate of return.

Using the data listed above, you’ll drop the data into a table that includes some of the following pieces of information:

• Initial Investment (this is the amount you are paying for the new equipment or project. Show as a negative number)
• Annual cost savings (this is how much the new equipment is expected to save you over its useful life. Show as a positive number)
• Annual costs, if any (this is if the new equipment will have maintenance or other costs to operate in addition to what you pay now. Show as a negative number)
• Salvage Value (If the equipment will have value at the end of its useful life, show as a positive number)
• Net Present Value (this is the result of the figures above summed together)

For an example calculation of NPV visit NPV Example. The best way to decide when to buy, refurbish or scrap equipment/machinery is with a capital budget. Estimate the amount you will need to spend and when you plan on buying the item. Then conduct a NPV analysis to make sure the purchase is a good decision for our business.

A budget is a great planning tool, but it is generally a static document – meaning it usually doesn’t change after it has been created. When you compare the January budget to the January actual results the differences may be significant. To reduce the wide gaps between budgeted figures and actual results you can create a flexible budget. There are many different types of flexible budgets, but the academic version of flexible budget is a budget that uses the “static” budget estimates using a per unit rate to estimate a “revised” budget for actual production or sales.

For example, assume that you had budgeted to sell 1,000 units (or hours) in January but you only sold (or billed) 900. Comparing a static budget to actual results will show you variances in quantity. However, creating a flexible budget at 900 units will allow you to compare a budget at 900 to the actual results at 900. When comparing the same number of units you can then see inefficiencies instead of just quantity differences. This information can be helpful in determining why you had higher than expected labor or materials costs.

As you sit down to prepare your 2011 budget, reflect on what worked and what didn’t work in 2010. What are some areas that you can cut costs and others that should be allocated additional dollars? Has the marketplace changed, for better or worse, since you prepared your last budget? What changes, if any, do you anticipate for sales, labor costs, and other operating expenses? Remember that you can always change the data later if you need too. A budget is a tool helpful too, create one that it is relevant to your business.

The formula for the break-even point is simple, but can be more complicated if you have multiple products. First you need to determine your selling price per unit as well as the variable costs per unit. The difference between the selling price and the variable costs is call Contribution Margin per unit. Next determine your fixed costs. The formula is:

Fixed Costs / Contribution Margin per unit = Break-Even Point in units

For example, your fixed costs are $90,000. You sell your product for $150 per unit (or you charge $150 per hour for your services). The variable costs associated with your product are $90 per unit (or per hour). The contribution margin per unit (or per hour) would be $60. Using the break-even formula the break-even point in units would be 1,500. ($90,000/$60=1,500 units)

Assume you want to know what your revenue will be at the break-even point. We can convert the contribution margin into a percentage. Take the contribution margin per unit and divide by the selling price. The result is a percentage. Then you use the following formula:

Fixed Costs / Contribution Margin ratio = Break-Even Point in dollars

Using the same example as above, we know our contribution margin per unit is $60. So the contribution margin ratio is 40% (solved by taking: $60/$150). When we put these figures into the formula we get $225,000 as the amount of revenue we need to generate to break-even. ($90,000 fixed costs/40% contribution margin ratio)

When you have multiple products or services you can still calculate the break-even point using a couple of different methods. The easiest is to determine the proportion of each product to the whole. Then multiply the number of units needed to break-even by the prorated allocation. It’s not a perfect methodology, but it can give you insight as to how many of each units you need to sell to break-even.

As you start to plan for the new year, I will be posting about various accounting terms and other accounting tools. First let’s discuss types of cost behavior. There are two main categories of cost behavior; variable costs and fixed cost. Each of these two categories have subcategories of costs.

The definition of a variable cost is an item (i.e., expense) that varies in direct proportion to the level of activity. For example, a consultant may have to pay an independent contractor $15 per hour to complete a project. The independent contractor is only paid for the hours they work on the project.

With variable costs sometimes the amount can change when their are large blocks of activity, this is called a step-variable cost. For example, let’s say that you are ordering 1,000 brochures. If you order and additional 250 brochures the cost may decrease by $.15 for the additional brochures only. Note the original 1,000 brochures are offered at the original price.

When an cost is considered fixed it means that it does not fluctuate with changes in activity. The amount we pay each month for a car loan will be the same regardless of how many miles we drive. Fixed costs can be considered committed or discretionary. A committed fixed cost is one that cannot be changed over a period of time. An example is the rent on a 5 year lease. The rent payments will be the same each month and we do not expect to be able to break the lease without penalty. A discretionary fixed cost is one that we can choose not to incur, such as the cost for an advertising campaign.

As you analyze your performance over the past year and plan for the next one, consider how your costs are classified. Which ones are variable costs and which are fixed, either committed or discretionary? Once you know your variable costs you can estimate the amount for the new year based on activity levels. For the discretionary fixed costs, determine if those items helped you generate revenue in the past year. If not, can you get rid of them and improve your bottom line?

• The timing of collections from customers. First determine what percent customers pay in the first month? In the second month? What portion is usually deemed uncollectible. For example, say 70 percent of your customers pay within 30 days, 20 percent pay within 30-60 days, 5 percent pay within 60-90 days, and the remaining customers never pay. Use this information to estimate your expected cash collections from customers by month.
• The timing of payments to suppliers and vendors. Do you pay your invoices in 30, 45 or 60 days?
• A summary of your monthly cash expenses for items such as: salaries, supplies, rent, utilities, telephone, bookkeeper fees, etc.
• The one-time or infrequent cash payments for insurance, licenses, tax preparation, etc.

With this information in hand you are ready to input the data into a cash budget template. Create a template that makes sense to you, and be sure to include sections to summarize all of the cash collections and cash payments (wages, inventory, rent, utilities, advertising expense, etc.) In order to prepare an accurate cash budget you will need the information from your master budgets, such as sales, production/inventory, and selling and administrative budgets.

A cash budget should be used to manage your daily cash flows, but more importantly, it can be a tool to help with planning for the future. Before you decide to buy a new piece of equipment, prepare a cash budget to determine if you have enough cash flow to purchase the item. Before you move into a bigger facility, review your cash budget to estimate the amount of cash flow left after the increase in rent payments have been taken into consideration.

As with any budget or accounting tool, the information provided by the cash budget is only as good as the data put into it. Use the information from the cash budget to time the payment of your expenses to maximize cash on-hand.

A few notes about creating a sales budget:

1. Be as realistic as possible. While it is always good to create big goals, you want to be able to use this information for making decisions in future months.
2. A sales budget is not necessarily the same as a cash budget. Many times sales occur before cash is collected.
3. Use units, where possible. When you create your template have the units and selling price(s) in separate Excel cells that can be easily changed so that you can play with units and/or price to see how your sales budget would change with different variables.
4. Units are also important because you will use this information when creating the production/operation budget.

Create a spreadsheet with a list your products/services in the very far left column. You will want to list the months at the top of the spreadsheet too. You can create an “assumptions” page or use the current page to track the units to be sold per month. Multiply the units times the sales price for each month. If your business has predictable seasonality this should be reflected in the month units.

A sample sales budget is presented below:

Once you have completed your sales budget you should compare your estimates to prior periods. How do the current projections compare to the prior year or to the same month of previous years? Are your sales projections too high, too low or just right? Adjust the units as necessary to create a realistic sales budget.

After you finalize your sales budget you can create a schedule of expected cash flow due to sales, assuming you allow your customers to pay on credit or if you submit claims to insurance. Estimate the percentage of sales collected in the month of sale, the percentage collected the following month and any percentages collected in future months. You’ll use this information to calculate your cash budget after your production and administrative budgets are completed.

A friend of mine recently told me he has become a cash buyer. If he doesn’t have the cash, he doesn’t buy. In my personal life I follow this logic, to some extent. Our home is financed as is one of our cars, but everything else is paid for in full at the time of purchase. My husband and I are both simple people so this work for us. However, this might not work for you in your personal life, but can it work for your business?

What would happen in your business if you only made purchases when you had the cash to do so? Note, we are talking about big purchases, not your daily operational costs associated with inventory or supplies to provide your products or services. Would your manufacturing process suffer because you don’t have the most modern equipment? Can you get by with the computer equipment you current have?

We have all heard the saying that you have to spend money to make money. And while this saying does make sense, especially for advertising and outsourcing, we should strategically plan for how we use our cash. Incurring debt to buy a new laptop creates additional burdens on the business owner for how they manage the cash available for daily operations or emergencies.

I challenge you to only make purchases when you have the cash on hand for one month. Can you do it? If so, does the “cash only” negatively or positively impact your gross sales? If your sales are not negatively impacted, could you use this strategy for one more month? What changes do you notice in your bank account? To your stress levels?

Share your story here.

There are several advantages and disadvantages to debt financing and maintaining an appropriate debt-to-equity ratio is essential for securing future financing as well as for long term financial health. Financial experts cite numerous advantages to Debt Financing. One of the main advantages is that debt financing provides funding without diluting the ownership of the company. Additionally, with debt financing, lenders do not have a claim on any future profits of the company; the lender is limited to receiving an amount equal to the loan principal plus interest.  Most business owners find that raising capital from debt financing is much easier than equity financing as business owners do not have to comply with state and federal securities regulations. Debt financing also provides tax benefits in that the interest paid to service the debt is tax deductible.

Companies often find that there are disadvantages to debt financing. One of the obvious disadvantages is that funds financed through debt must eventually be paid back. In debt financing the principal and interest payments become fixed costs that must be accounted for when a company is determining its break-even point. Although debt payments occur on a fixed schedule, the payments require careful budgeting of cash flow which can be difficult for new businesses or business with highly varying business cycles. Debt financing also negatively affects the company’s debt-to-equity ratio causing lenders to view the company has a higher risk. With debt financing there is generally a requirement to offer company or personal assets as collateral to secure the loan. Small business owners often have to personally guarantee the loan, in full or in part. A personal guarantee means that if the company cannot pay back the debt the owner pledging the personal guarantee will repay the loan with his personal funds.

The decision to borrow funds from a bank or find an equity investor can be a tricky one. With debt you are only obligated to pay back the principle plus and interest component. With an equity investor you give up a portion of ownership in your company and your payment of dividends/distributions are variable over the life of their investment. An analysis to determine which option is best for your company should be completed before making a lending decision.

It makes sense to buy rather than lease an asset when:

1. You have the ability to use your cash reserves to pay for the asset. Or you have the ability to finance the asset through a bank or seller without hurting your debt covenants. You do not want to create too much debt for the business so take a look at the debt already outstanding before buying a new asset.

2. The asset will have a long estimated useful life and there is little risk of obsolescence.

3. You can take advantage of double-declining depreciation* in the early years of the assets useful life. This accelerates the benefit of tax deductions in the first few years of the asset life. *Double Declining Depreciation is a method commonly used for income tax purposes. Many businesses use Straight-Line for book purposes and Double-Declining for tax purposes.

4. You can afford the cash down payment or have the ability to obtain financing because the overall cash cost of the asset is less when you purchase vs. lease.

When you purchase an asset a few things happen from an accounting standpoint. The item is recorded on the Balance Sheet as an asset. The asset will be subject to depreciation so you’ll need to track the Depreciation Expense (which is reported on the Income Statement) as well as the Accumulated Depreciation (which is recorded on the Balance Sheet). In addition, as mentioned in point #1, you’ll have to record any related debt for the asset purchase as a liability.

The decision to lease vs. buy is not always an easy one. Compare the lists on the Lease blog post to this one and decide which option makes the most sense based on your current cash position.