Building Business Credit

This is a common theme I address with our small business owners.  I hope you find it helpful!

The Phoenix Business Journal included a pretty succinct article today about the importance of using credit even if you don't need it, to build your business credit score.

3 steps to building strong credit for your business

Sales Volume Impact Upon Total Variable Cost

Article written by EricBank

The minimum volume of sales necessary for your business to meet its profit targets can be decided using cost data. The sum of variable and fixed costs must be associated with every dollar of sales revenue. The company subtracts total costs from sales to compute operating profit. If you hold prices at current levels, higher variable costs are needed in order to increase sales volume.

 

Fixed and Variable Costs

The use of long-lived assets, such as machinery, land, factories, warehouses, vehicles and other items, are the direct sources of fixed costs. Other fixed costs, including selling and administrative expenses, are indirect. By definition, fixed costs such as leases, mortgages, depreciation and property taxes, do not change with production levels. In contrast, direct material costs (raw goods, packaging/shipping, direct labor) and electricity costs are variable, meaning they incrementally increase with operational output. The increase in unit variable costs may be straight-line for small increases in output, but can rise exponentially as production rises, due to items such as short-term rental of additional storage space, penalty electrical usage fees and payment of overtime wages.

Cost-Volume-Profit Analysis

Your company's survival requires profitable operations. To help figure the relationship between profits and production activity, you can perform a cost-volume-profit (CVP) analysis. The analysis helps you determine whether to change production levels, product mix and/or pricing. CVP requires you to calculate your contribution margin ratio:

[E1] Contribution Margin Ratio = (Sales - Total Variable Costs) / Sales

For example, if a company spends variable costs of $80,000 monthly to sell $200,000 of canned beans per month, then the contribution margin ratio equals 60 percent (($200,000 - $80,000) / $200,000). This means that the sale of each $1 dollar can of beans contributes 40 cents to variable costs and 60 cents to fixed costs.

 

Break-Even Point

The primary CVP equation expresses operating profit:

[E2] Operating Profit = Sales - Total Fixed Costs - Total Variable Costs

The break-even point (BEP) occurs at the point of minimum required production, creating zero operating profit.

[E3] At BEP: Sales = Total Variable Costs + Total Fixed Costs

By substituting E1 into E3, you get:

[E4] At BEP, Sales = Total Fixed Costs / Contribution Margin Ratio

For example, suppose the bean canning company has monthly fixed costs of $102,000. With a 60 percent contribution margin ratio, it must sell ($102,000 / 60 percent), or $170,000 of canned beans monthly to break even.

Required Profit

Now you have to calculate the sales volume necessary to provide your required profit:

[E5] Required Sales = (Required Profit + Total Fixed Cost) / Contribution Margin Ratio

For example, if the bean canning company requires $30,000 a month in operating profit, the required monthly sales volume is $220,000: (($102,000 + $30,000) / 60 percent). You will get a handle on your required sales volume by understanding your fixed and variable costs. You can also figure how many additional cans of beans to sell to attain your profit target by performing CVP on a unit basis.

How to Dispose of Accounts Receivable

Article written by EricBank

Many a small business has found itself in a cash crunch from time to time. This can be especially vexing for business-to-business (B2B) companies, which extend trade credit to other businesses and therefore depend on accounts receivable for payments -- a process that can take weeks or months. Retail businesses usually rely on credit card and cash purchases, which are normally not problematic as payment is immediate or prompt. But B2Bs might have A/R balances that represent a substantial part of working capital. In a crunch, a B2B has several options to quickly turn an A/R balance into cash.

Factoring

A bank or finance company that buys your A/R book is called a factor. The factor assumes title to the invoices in your A/R book when it buys it. In some contracts, you must guarantee that the factor receives full payment for all invoices -- this a contract with recourse. When the factor assumes all the risk of payment, it's called a non-recourse contract. Obviously, you receive less cash for a non-recourse contract. You usually receive a certain percentage of the A/R's book value and possibly a percentage of collections once they exceed the percentage you received. For instance, you might receive 80 percent of book value and 40 percent of all collections received after the factor has collected the 80 percent from your customers. You also might have to pay the factor a fee.

Auction

An online receivables exchange is a handy alternative to a standard factoring arrangement. The way it works is that you select some or all of your A/R invoices and list them on the exchange. Bidding then commences among financial institutions and banks, hopefully helping to boost the amount you'll receive for the invoices. The auction is pretty flexible, because you get to choose which invoices to unload and there aren't any long-term commitments. The risk is that the bid will be lower than the percentage you would have received from a straight-up factoring arrangement.

Pledging

 

Maybe you don't want to sell your A/R book, but still need some fast cash. Consider pledging the book as collateral for a loan from a bank or finance company. This is a recourse arrangement, but you retain title to the invoices. One good feature is that the process is invisible to your customers -- they continue to pay you, not some third party. In some cases, the lender might have you set up a lock box to receive the payments, but it will be in your name. Your balance sheet continues to list the pledged A/R balance as an asset, although you might have to add a footnote if you publish your financials.

Assignment

Assignment is a hybrid of pledging and factoring. The financial company or bank (the "assignee") pays you cash for the rights to your A/R collections. You use the A/R book as collateral for a promissory note that you sign with the assignee. It's still your job to collect your A/R invoices, but you forward the money to the assignee. The assignee has recourse in case any of the customers are deadbeats. The balance sheet requirements are similar to those for pledging, though you'll also have to show notes payable.

To count or not to count

Effects of Inventory Errors

Article written by EricBank

The difference between inventory selling price and acquisition cost is the basis for a merchandizing company's profits. The speed at which you restock inventory depends on your sales volume. To figure how quickly you are moving inventory, you can compute a measure called turnover. However, you have to avoid inventory inaccuracies lest you end up with misleading results.

Inventory Costs

As we've discussed in previous blogs, the cost of goods sold and gross profits are calculated thusly:

COGS = inventory purchases + beginning inventory - ending inventory

Gross profits = net sales - COGS = (sales - refunds -discounts) - COGS

To satisfy the IRS, you'll have to make a physical inventory count at reasonable intervals and apply adjustments to balance sheet inventory to realign it with the actual counts. You should look upon the requirement to take physical counts as a blessing, because you'll inevitably find discrepancies arising from shrinkage, damage, spoilage and other reasons.

Turnover Ratio

A successful merchandizer sells stock on hand and replenishes it with more inventory. Use the inventory turnover ratio to quantify this process:

Turnover ratio = COGS / average turnover

                      = COGS / ((beginning inventory + ending inventory) / 2)

Your goal is to increase your turnover ratio, because that indicates you are operating efficiently. A falling ratio is a red flag, since it means you have too much stock on hand. This is risky, because it increases storage costs and the chances that your older stock will become obsolete or spoiled. Ideally, you would never experience a stock-out and would only carry the amount of inventory you immediately need. Returning to reality, you have to settle for a respectable turnover ratio while keeping stock-outs and backorders to a minimum. Naturally, what constitutes a good turnover ratio depends on the industry you're in.

Effect of Errors

Let's examine sources of error in the turnover ratio's numerator, which is COGS, and in its denominator. COGS errors can occur for numerous reasons. For example, you are supposed to write down obsolete inventory, and failure to do so will understate your COGS, because it needs to absorb the loss in value of the obsolete stock. Your turnover ratio will be misleadingly low if you understate COGS. Denominator errors can crop up if you miscount or improperly record ending inventory. For example, you'll overstate turnover ratio and understate ending inventory if you fail to count everything you've stocked. Of course, errors in reporting your COGS or ending inventory will skew your tax bill, which is never a good thing.

Considerations

One excellent strategy to catch errors early on is through cycle counting. In case you're not familiar with the term, it refers to taking a partial count every day until you cycle through all your stock. Then you start all over again. Damaged and missing inventory will turn up during these spot checks. Keep in mind that, under generally accepted accounting principles, you have to restate your prior-period financial results arising from "material" errors, which are errors that result in incorrect actions. Sometimes, errors cancel over time. For example, overstating net income and ending inventory in one period will usually lead to understating these in the next period.

Let the Blame Game begin!

Today I'm seeing all over the news (yes, it's accounting news mostly) that the IRS Commissioner John Koskinen wrote a letter to Congress urging them to make a decision about the tax code for 2014, to prevent delays to the 2014 tax filing.

Does anyone else see a problem with this?

This has happened to us the last three years in a row and even when the "opening" date gets pushed back, the "closing" dates do not!  This only hurts the US population the Congress professes to care about most - the cash strapped!!

• The IRS can't get the parameters in place to get the e-file system ready to receive transmissions on time.
• The software provider can't get the software to the tax preparers.
• There is an increased risk of error.
• There is an increased risk of fraud.
• I could keep going, but I won't bore you with THOSE details.

But, what irritates me the most, is why should I have to wait until January of 2015, after Congress has it's holiday, to know what my income tax situation will be for 2014?  I know this time of year drives me crazy, but am I really crazy?

If you want more details, here is a more complete article about it:
http://www.accountingtoday.com/news/irs-watch/irs-chief-warns-congress-possible-delay-tax-season-unresolved-tax-extenders-72264-1.html?utm_campaign=daily%20b%20final-oct%208%202014&utm_medium=email&utm_source=newsletter&ET=webcpa%3Ae3164828%3A4397047a%3A&st=email

Is your Small Business in a tight cash situation?

How to Dispose of Accounts Receivable

Article written by EricBank

Many a small business has found itself in a cash crunch from time to time. This can be especially vexing for business-to-business (B2B) companies, which extend trade credit to other businesses and therefore depend on accounts receivable for payments -- a process that can take weeks or months. Retail businesses usually rely on credit card and cash purchases, which are normally not problematic as payment is immediate or prompt. But B2Bs might have A/R balances that represent a substantial part of working capital. In a crunch, a B2B has several options to quickly turn an A/R balance into cash.

Factoring

A bank or finance company that buys your A/R book is called a factor. The factor assumes title to the invoices in your A/R book when it buys it. In some contracts, you must guarantee that the factor receives full payment for all invoices -- this a contract with recourse. When the factor assumes all the risk of payment, it's called a non-recourse contract. Obviously, you receive less cash for a non-recourse contract. You usually receive a certain percentage of the A/R's book value and possibly a percentage of collections once they exceed the percentage you received. For instance, you might receive 80 percent of book value and 40 percent of all collections received after the factor has collected the 80 percent from your customers. You also might have to pay the factor a fee.

Auction

An online receivables exchange is a handy alternative to a standard factoring arrangement. The way it works is that you select some or all of your A/R invoices and list them on the exchange. Bidding then commences among financial institutions and banks, hopefully helping to boost the amount you'll receive for the invoices. The auction is pretty flexible, because you get to choose which invoices to unload and there aren't any long-term commitments. The risk is that the bid will be lower than the percentage you would have received from a straight-up factoring arrangement.

Pledging

 

Maybe you don't want to sell your A/R book, but still need some fast cash. Consider pledging the book as collateral for a loan from a bank or finance company. This is a recourse arrangement, but you retain title to the invoices. One good feature is that the process is invisible to your customers -- they continue to pay you, not some third party. In some cases, the lender might have you set up a lock box to receive the payments, but it will be in your name. Your balance sheet continues to list the pledged A/R balance as an asset, although you might have to add a footnote if you publish your financials.

Assignment

Assignment is a hybrid of pledging and factoring. The financial company or bank (the "assignee") pays you cash for the rights to your A/R collections. You use the A/R book as collateral for a promissory note that you sign with the assignee. It's still your job to collect your A/R invoices, but you forward the money to the assignee. The assignee has recourse in case any of the customers are deadbeats. The balance sheet requirements are similar to those for pledging, though you'll also have to show notes payable.

Do you have an Inventory Nightmare to share?

FIFO and Inventory Valuation for Income Tax

Article written by EricBank

The cost to purchase raw goods and inventory is a major factor affecting the net income of manufacturing and merchandising companies. Typically, inflation causes costs to rise over time, which pressures businesses to increase prices so that they can maintain their profit margins. These higher costs translate into increased deductions for purchased inventory, and this helps to reduce the squeeze on margins. Falling prices, or deflation, is another, albeit rarer, story.

Cost Flow Assumptions

You allocate costs to the goods you sell by making cost flow assumptions. Under IRS rules, you have two alternatives: first in, first out (FIFO) and last in, first out (LIFO). FIFO is like a single-file queue, in which to apply cost to your inventory in the order of purchase. LIFO is like a stack of pancakes: you grab the top one first -- that is, you apply current costs in reverse order to purchase. You have to notify the IRS when you adopt LIFO and when you switch from one method to the other. You also must tell the IRS if you change the way you specify the cost of individual items -- something only sellers of high-priced items such as yachts and cars would do.

Normal Times

If you choose LIFO when prices are rising, you'll be applying the highest costs to inventory purchases first. This is good for you tax bill, because it increases your cost of goods sold (COGS), reducing your balance sheet inventory value, your gross profit and your taxable income. This stems from the equation:

COGS = beginning inventory + inventory purchases - ending inventory

This demonstrates that the higher cost of purchases boosts COGS and cuts inventory value. If you're in the 35 percent bracket, then after taxes, you only shell out 65 cents on each dollar of COGS cost. The bottom line: maximize COGS via FIFO to reduce your tax obligation.

When Times Are Tough

When the economy slows down, prices can fall, which means older costs are greater than new ones. In this situation, FIFO will result in a higher COGS and lower taxes. The IRS frowns on hopscotching between LIFO and FIFO with changing economic conditions. Rather, it wants you to use consistent accounting methods. If you want to alter your cost flow assumption, submit Form 3115 and hope that the IRS approves it.

LIFO Reserve

Unless we are in a deep recession or depression, you're going to prefer LIFO to FIFO. Of course, veterans of the 2007-08 economic storm know how quickly things can turn bad, and during that period, LIFO didn't help business make profits or even keep the doors open. You can quantify the FIFO vs. LIFO tax effects through a metric called "LIFO reserve." This is simply the difference in ending inventory values taken as FIFO minus LIFO. Usually, higher values of ending inventory makes LIFO reserve a positive number. When prices fall, expect a negative LIFO reserve, suggesting that LIFO would give you a higher ending inventory value, lower COGS and a higher tax bill -- assuming you have net income and actually have to pay taxes.