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.

When you lease an asset the transaction is fairly simple from an accounting standpoint. Since you don’t own the asset you are leasing there is no impact on the Balance Sheet, meaning you do not record the asset nor a corresponding liability for the debt (i.e., lease payments). You simply make monthly payments to the Lessor. Keep in mind, this is true for operating leases, not capital leases. With an operating lease you have no intent to own the asset at the end of the lease agreement along with a few other accounting tests to verify the lease is in fact an operating lease.

It makes sense to lease an asset when (i.e., operating lease):

1. Your cash flow is fairly low. Since you don’t have the ability (or willingness) to make a large payment to purchase the asset outright, a lease allows you to have access to the asset you need via monthly lease payments.

2. The asset is one where the risk of obsolescence is high, meaning that the technology will be outdated quickly. For example, many businesses lease rather than purchase computers/laptops for their employees because technology changes so quickly. Rather than being stuck with outdated technology they replace their computers every 2-3 years through lease agreements.

3. The debt on your balance sheet is a little too high or you have exceeded debt covenants by your lenders. If the asset you want to purchase is expensive, you might pay for it using some cash and financing the rest either through a bank or the seller. If you buy the asset, then you will need to record the corresponding debt on the balance sheet. If you lease the asset, you do not record any debt on the Balance Sheet.

Leasing an asset can be a good business decision, especially if you like the idea of no down payments and replacing the asset at the end of the lease term. Generally the overall cash cost of a leased asset is higher than that of a purchased one. There is no correct answer, it depends on what is the best option for your business.

A company called Auto Equity Loans offers loans on motor vehicles (cars, trucks, vans, motorcycles and farm equipment) that are owned outright. The loan amount is a percentage of the fair market value of the vehicle. The loan interest rate is not cheap, yet it can be a lifesaver at a time when you need cash now and do not have any other options available.

Auto Equity Loans is accredited by the Better Business Bureau. The offer loans for both personal and business needs. If you are in need of immediate funds and do not have anywhere else to turn this could be an option for you. Be sure to review all of the terms and understand the rate you are paying so that you are not caught off guard when the loan comes due.

To learn more about Auto Equity Loans visit their website. Please note that I have not used their services before. I am just informing small business owners about some additional options for quick cash or “seed” money to start their business. Be sure to check out any company before you sign any documents or agree to any financial terms.

I just finished helping two business owners prepare projections for their business ventures. The problem with an estimated projection of the future is that it is rarely 100 percent accurate. Generally you will not earn as much in revenues as you anticipate and your expenses will be higher. The expenses will be higher in part because items were left out, either intentionally or unintentionally.

Creating a pro forma is not a waste of time because it forces the business owner to really think about what the business can achieve. Can you really sell 100,000 widgets with only 1 sales person, i.e., yourself? When you put numbers on paper you have take an honest look at what needs to happen from a financial perspective to create and sell your products or services.

The real challenges for business owners is not the time it requires to create a pro forma/projection, but creating one that is realistically achievable. Does it really do you any good to underestimate your expenses or overstate your revenues? Do you think the bank or investor won’t doubt your numbers? They will, even if your numbers are totally realistic.

The problem with pro forma financial statements isn’t that they are unrealistic or unachievable, it is that often times the data used to create them isn’t accurate or there are too many unknowns. Yearly projections are a good business practice. These exercises can help you and your business be more profitable as long as the information used to create them is considered high-quality and items are not left off in order to make the numbers “look” good.

Contingency Planning is usually a tiered process. Usually, when you put a Contingency Plan in action you start with the easiest or least dramatic change. For example, your cash flow is low and you are having problems paying the bills. Your first plan may be to secure or utilize a line of credit with your bank. If a line of credit is unavailable or maxed then you need to cut costs. You can approach your landlord and ask for terms to be renegotiated so that you can afford to stay in your current location. You can evaluate your current expenses to determine where you can easily and quickly save money, i.e., reduce marketing or advertising expenses, reduce meals and entertainment, etc. Or as a last resort, you might ask your staff to take a pay cut or layoff some of your employees, which is my least favorite option. These changes may help to increase cash flow long enough to get you through the tough times.

If you offer credit terms to your customers, you could consider factoring your Accounts Receivable (AR). This is a quick way for you to get cash from your AR, but factoring does reduce the overall amount of funds you receive so consider this option carefully. If you are still in need of cash but do not have any more available credit with your bank another option is to sell an interest in your business. The amount of cash you receive will depend upon the type of business you own and your willingness to give up a portion of ownership in your business.

As a last resort you may decide that you would prefer to sell the entire business rather than adding another owner. If a willing buyer cannot be found, you might be able to find someone who is willing to take over the business “as is” including all debts; this is called a transfer of ownership. Ending the business by walking away is not a very good option. There are usually assets that can be sold and/or Accounts Receivables that can be collected. While not easy, you can try to sell the business assets or portions of the business so that you can generate enough cash to pay your outstanding debts.

Whether your business is new or established, Contingency Planning is very important. It does not hurt your business to have a plan in place in case problems occur. On the contrary, this type of planning could very well help you survive tough economic times or an unforeseen disaster.

The formula for the Payback Method is: payback period = initial investment divided by annual savings/revenue. For example, you need to buy a new machine that will improve your efficiencies, thereby reducing your expenses by $20,000 per year for the next 6 years. The machine costs $100,000 in today’s dollars. Formula: 100,000/20,000 = 5. Therefore, using the Payback Method, you would see a “payback” on your investment by the end of the 5th year. Note: the payback method does not tell you if your purchase will provide positive profits over the long-term, but rather the length of time it will take for you to “recoup” your initial investment, ignoring the time value of money concepts.

This purchase might make sense at first look, assuming the machine will provide cost savings for more than 5 years. The Payback Method can be used to perform a first level evaluation of a potential purchase. Using the Payback Method you might determine that one purchase isn’t feasible because the payback period is just too long. However, run a quick NPV calculation to make sure the project truly isn’t profitable for your business.

As I showed in the NPV Example blog post, when you convert the $20,000 per year cost savings into their Net Present Values the true net cash flow for the investment will be a ($11,723). This is because a dollar tomorrow is less than a dollar today and the value lessens the further out in the future you go.

While the Payback Method might be easy to use, it does not take into consideration the time value of money. Relying solely on the Payback Method might result in poor purchasing decisions. A quick NPV calculation may save you the disappointment from future low returns on the cash you spend today.

In order to perform the calculation you will need to know:
1. The discount rate (usually a target return on investment rate or the current market rate),
2. The number of years the project/equipment is to last, (note: MS Excel doesn’t require this item)
3. The cost of the initial investment, i.e., cost of equipment or new project,
4. The estimated the cash flow for each year of the project or cost savings from the more efficient equipment (or increased revenue).

Let’s assume a discount rate of 10%, 10 years, initial cost of $100,000 and annual cost savings for 6 years of $20,000. Note: Input the initial costs as a negative number, i.e., -100,000 in your formula. Using MS Excel, find the Finance formula function for NPV. It will ask for the rate, input this as a percent, such as .10. Then it shows a field for Value1, input this as a negative number, as discussed above, -100000 (this is your cash outlay). Then input the value 20000 in the Value2 through Value7 slots (for the $20,000 of annual savings for six years). Using the NPV formula this equipment returns a value of ($11,773), so this equipment is actually costing more money than it is saving. For this purchase to provide a positive value the annual savings of $20,000 would need to occur for 8, not 6 years or the interest rate would need to be about 5% instead of 10%. This MS Excel calculation took less then 2 minutes to complete!

Of course these figures are based on estimates, so you need to be as realistic as possible. Since you use estimates in order to calculate the Net Present Value keep in mind that the results are not guaranteed. However, this is true for any similar evaluation of future outcomes. It is also helpful to perform two calculations; one as a best case scenario and one as worst case scenario. Combine the results from these two estimates and evaluate if the purchase would still show a net positive result.

Many business owners rush out and make purchasing decisions without doing any analysis on whether or not that asset will add value to their business. While many purchases cannot be avoided, such as repairs or replacement of old equipment, it is still worth the time to assess the cost and/or benefit of the purchasing decision.

It can be challenging to determine whether or not you should make an investment. You make every effort to invest in equipment or a project that is going to earn you more money than it costs. Therefore, it is important to use some sort of calculation to figure out how much the project is likely to earn so that you can determine whether it is worth the initial investment. There are a number of different methods to do this, but one of the better options is the Net Present Value (NPV) method.

In the Net Present Value method, you determine how much your return on a project will be using today’s dollars, so you can figure out whether the initial purchase price or investment makes sense. If the NPV is more than what the initial investment costs would be, it would be a profitable investment. If, however, the NPV is lower than the initial costs it would most likely lose you money so you should pass on the investment. This can also help you to choose between two different options that you are considering as you should choose the one with the higher NPV.

The Net Present Value calculation isn’t all that difficult to do if you have a calculator with special functions. You can find the formula online. However, you will also find Excel spreadsheets work well, or online calculators such as the one at Investopedia.

In my next blog post I’ll provide an example of how to use NPV in your business.