Lessons I Have Learned

Debt is a Tool - But Should Come With a Warning Label

Debt, if used correctly, can be a vital tool for a business. Businesses use debt in a variety of ways such as financing start-up expenditures, purchasing equipment, and providing capital until a business can “bank itself”. Even though debt can be a tool, loan documents should come with the warning label “BORROWER BEWARE”. First, the debt must be paid back. Second, not allocating funds to the debt reduction pocket will keep you in debt since taking on more debt will be necessary to sustain the business and pay off old debt. Finally, debt, like quicksand, can pull you under if it is excessive.

There are two types of business debt: lines of credit and term debt. Business start-up loans and loans for equipment purchases are usually term debt. Lines of credit are used to provide working capital. Lines of credit should have a double warning label. In his book Simple Numbers, Straight Talk, Big Profits”, Greg Crabtree says,

“For entrepreneurs, credit lines are the equivalent of crack cocaine—it’s that addictive.  Why? Because when you draw money on a line of credit, you have postponed a hard business decision that should have been made a lot sooner. Sometimes people would rather exhaust their resources than make the hard decisions.”

A true line of credit is one that goes to zero for at least thirty consecutive days in a twelve-month period. Unfortunately, too many businesses use lines of credit to make up for the lack of essential core capital, putting them on a debt treadmill. Their balance sheet shows the maxed-out line of credit year after year, and the business owner, like a drug addict goes from bank to bank looking for more money.

Debt incurred to purchase equipment should be done so prudently. Equipment that increases capacity, enhances efficiency, or reduces repairs and maintenance expense should result in more profit for the business. Ideally, the increase in profit will provide the funds to pay down the debt. This will keep the business from taking money out of other pockets to make the debt payments.

Purchasing equipment at year-end to reduce taxes is the go-to tax planning strategy for many accountants. A business owner goes to the accountant at year end and has $100,000 of taxable income with a projected tax liability of $30,000. The business owner has saved the funds to cover the tax liability but despises paying any tax. The accountant explains the accelerated depreciation rules and tells the client he can reduce the taxable income to zero by spending $100,000 on equipment. The business owner says I would rather pay the equipment dealer than pay Uncle Sam and puts the $30,000 he saved for taxes down on the equipment, taking out a loan of $70,000 for the remainder of the purchase price.

The accountant fails to point out that depreciation deduction pushes the business owner into a 12 percent tax bracket, which reduces the actual tax benefit of the depreciation.  To make matters worse, the $70,000 of debt will have to be paid back form future profits that will likely be taxed at a higher rate. This is a clear example of letting the tax tail wag the dog.

I have never heard a client say, “I wish I hadn’t paid off that debt.” It should be the goal of business owner to get out of debt. This can be done by properly allocating funds to the necessary pockets for taxes, core capital and debt reduction and having the discipline to only pull the funds out for their intended purpose.

The Importance of Core Capital

In the personal finance world, individuals are taught to build up a “rainy-day” fund. Most financial advisers suggest having between 3-6 months expenses saved in case of a job loss or another emergency. Businesses are no different. Every business should establish a reserve fund, which I refer to as the core capital of the business.  It serves as an emergency fund, but it is also more than that. It is the fuel that keeps the engine of the business running. Core capital is not the same as working capital.  The accounting definition for working capital is current assets (typically cash, accounts receivable and inventory) minus current liabilities (accounts payable and other liabilities that will be paid within twelve months).  Essentially, core capital is the amount of cash needed to pay for several months’ operating expenses, debt payments and the cost of anticipated equipment purchases.

The amount of core capital that a business requires will vary depending on the industry in which the business operates. An accounting firm, for example, is not a capital-intensive business so the amount of core capital it requires would be much lower than a manufacturing company. Manufacturing companies have inventory to purchase, high repairs and maintenance costs and expensive equipment to replace. These costs can add up quickly and if the company does not have adequate core capital to pay for such items, it will be difficult to continue operating profitably. For capital intensive businesses larger equipment purchases that increase capacity or efficiency may be financed and would not need to be figured into the target core capital calculation. I will discuss the use of debt in the next blog in this series.

My most valuable lessons have been learned the hard way. As a young CPA, I failed to maintain the appropriate level of core capital in my business. The firm earned most of its revenue from February through May and operated at a loss for the last five months of the year. Instead of reserving cash to cover the losses, I paid out staff bonuses at the end of tax season.  I am sure that my bank considered me a good customer since I had to use a line of credit to finance the operations of the business from October to January. I then had to use tax season profits to pay the loan back. This was a cycle I was stuck in.  The simple solution would have been to calculate and retain the amount of cash needed to cover future months’ losses, and delay bonuses until reaching the firm’s target core capital.

What if a business is paying down debt? Should the debt be paid off first before filling the core capital pocket?  In my opinion the core capital pocket should be filled as debt is being paid down.  If not, a business will find itself on the debt treadmill, relying on the bank or creditors to provide funds for operating that should have been financed by cash retained in the business.

A business that has met its target core capital is better prepared for a “rainy-day”. The current pandemic is such a day. Due to the downturn in revenue, many businesses have depleted their core capital and will be back to square one and will need to build its cash reserves back up. Their core capital has provided shelter in this storm.  On the other hand, businesses with little cash reserves before the rainy day came are struggling to survive.

In his book Simple Numbers, Straight Talk, Big Profits!, Greg Crabtree writes, “Businesses that have cash and no debt attract magical things.  The opportunities that fall into their laps are just amazing.”  I can attest that this is true. My successful clients keep the necessary core capital in their businesses and experience the magic and find shelter when the rainy days come.

-Butch Rogers, CPA

Taxes Can Be Managed

Taxes, if managed effectively, will not cause a business to go broke.  Unfortunately, during the year, taxes often fall into the “out of sight out of mind” category and business owners fail to allocate the necessary funds to the tax pocket.  Most people will admit its painful to allocate money to the tax pocket.  It is especially hard for business owners who write the checks for the tax bill, as opposed to employees who have taxes taken out of their paycheck. Not providing for the tax liability during the year will lead to a big surprise at tax time.  

Over the years, it has become clear to me that one of my primary responsibilities as an advisor is to help my clients eliminate unwelcomed surprises at tax time. The way I help my clients eliminate these surprises is by planning and ensuring that their tax pocket is adequately filled.  Some of the funds allocated to the tax pocket will be taken out on a quarterly basis.  If a business is more profitable in the current year than the previous year, the taxes paid quarterly will typically be based upon the prior year’s tax liability.  This can leave the funds in the tax pocket short if cash has not been allocated to cover the projected tax liability.  Year-round tax planning is the key to keeping the tax pocket adequately funded.

At a minimum, tax planning should include calculating the anticipated tax liability on the business’s projected profit at least quarterly.  It also includes incorporating tax strategies that potentially will save the business taxes.  I need to point out that most common tax saving strategies require an outlay of funds such as equipment purchases or funding retirement plans.  I do not encourage spending on equipment unless the equipment purchase will result in more efficiency or reduce repairs and maintenance expenses. In other words, is the machine needed?  Or, is it just being purchased to produce a deduction?  My go to line with clients is, “You are spending a dollar to save forty cents.”  I also advise against maxing out retirement plan contributions to reduce a tax liability if the core capital of the business is not adequately funded.  I will discuss the concept of core capital in my next blog.

If a business takes a downturn during the year, the amount of estimated tax payments may be able to be reduced and no additional funds will need to be allocated to the tax pocket.  Not quite on par with being surprised by a large tax bill but being significantly overpaid is also frustrating for business owners.  The frustration level is particularly high if the over payment of the estimated taxes has put them into a cash bind due to a downturn of the business.  Again, a simple tax projection will reveal if estimated taxes can be reduced and allocation to the tax pocket can stop.

As I stated at the beginning, if properly planned for, paying taxes will not cause a business to go broke. My most successful clients properly fund their tax pockets and they do not allow the tax tail to wag the dog.

Cash is King

I started in public accounting in 1982.  I am now at the point where I can say things like, “back in the day” and “I’ve been at this a long time”. I like this stage of my career, where I can occupy the seat of the wise old sage. However, I must admit that it is hard for me to keep up with the rapid changes in technology and I cannot work as fast as I used to.  Over the years, experience has been my primary teacher.  We never graduate from the classroom of experience, nor should we want to.  We become better people when we learn from experience. These experiences include not only our own but also those of others. I have learned from both, particularly in the context of my career.  In this series of blogs, I will share some of the lessons that I have learned owning my own business and serving my clients.

It should come as no surprise that the first lesson I have learned is – Cash Is King.  I learned this lesson as I was growing up. Money, my Dad would say, “…burned a hole in my pocket”. I was a spender and would always be short of money and I relied on borrowing from my frugal younger brother.  I always paid him back when I got paid, which put me in a hole on pay day. Fortunately, I finally realized how much less stressful it is when all the money is not spoken for on pay day. Unfortunately, I have witnessed over and over how many people never learn this lesson and live under the stress of always being short of cash.

Successful business owners understand that when King Cash is on the throne, there will be freedom and peace in the kingdom. Freedom from the burden of unpaid bills.  Freedom from the worry of an economic downturn. Freedom to take advantage of opportunities that invariably come along. Freedom cannot exist when business owners live under the stress of being cash poor.

Admittedly, some businesses are not profitable.  With expenses consistently exceeding revenue, a day of reckoning will eventually force the business to cease operations. In 2011, I started a business providing continuing education to CPAs. I closed the business at the end of 2012. The business was never going to be profitable, so I took my lumps and shut down the business. It is foolish to keep an unprofitable business going when the business will never make it.

Learning how to manage King Cash is skill that all business owners need to learn. I like to advise my clients that cash must be segregated into pockets and those pockets cannot have holes. Typically, the pockets are operating cash, cash reserved for paying taxes, paying debt, and making equipment purchases. My successful clients do not rob their business of cash and they set reasonable pay for themselves. This is the pay they receive for what they do. The pay they receive for what they own (the business) is determined after cash has been allocated to working capital, taxes, debt reduction and equipment replacement that will not be financed. They get paid last in order the keep King Cash on the throne, which, as I have witnessed, has never failed them. Over a short series of blogs, I will discuss how to manage cash within each of these pockets, and why having each pocket adequately filled is so important. 

-Butch Rogers, CPA

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