Owning a small business can be rewarding; you control your own destiny, set your working hours, choose the employees you want to work with, and feel proud of building something of your own.
But owning a business carries many responsibilities. Business owners must keep track of many different facets of the enterprise, from sales and marketing to shipping and hiring vendors. There’s much to do and a lot to know.
One area that shouldn’t be overlooked is tax consequences. After all, a company lives or dies by its balance sheets, so it’s important for business owners to understand basic finances. Business owners don’t need to have an MBA in accounting, but they do need to have enough financial literacy to be able to read financial statements, ask the company’s accountants the right questions, and understand the financial and tax consequences to their business decisions.
How Financially Literate Are Small Business Owners?
A recent study of small business owners conducted by Intuit uncovered surprising results. The study found that 40% of small business owners consider themselves to be financially illiterate. At the same time, 81% of them are doing their business' finances themselves.
Let’s break these numbers down. If 40% are financially illiterate, and 81% are handling their own finances, this means that 32.4% of those handling their own finances are ill-equipped to do so. The number of small businesses operating in 2010 was 27.9 million. Therefore, a total of about 5.9 million businesses are operating without a strong financial rudder.
Why is Financial Literacy Important?
Understanding your business’s finances helps ensure you can withstand downturns. It will allow you to take advantage of opportunities that arise and increase the business’s chances of succeeding. On the other hand, if you are financially illiterate, your business will eventually run into problems, such as allowing expenses to increase to a point where profits are minimal. In some circumstances, business owners fail to include the correct amount of taxes on their profit and loss statement.
These are a few areas that can cause your company to run aground if you are unprepared:
Failure to understand federal and state tax requirements or to keep accurate records can lead to trouble with the Internal Revenue Service (IRS), your state, or both. Understanding these requirements and keeping proper records can minimize your risk of being audited or penalized by the IRS. Having clear and complete business records will increase your chances of success if you are audited by the government.
A clearly-defined pricing strategy that takes your company’s finances into account is important to ensure adequate cash flow and profitability. Giving deep discounts may not always be the best strategy because a lower price can deteriorate your brand and make it difficult to increase prices in the future.
Anticipating Cash Flow
At the start of a business’ lifecycle, suppliers want fast payment for inventory. If your products are sold on credit, it can be months between the time of making a sale and getting paid. Failure to plan for this scenario can jeopardize your company.
Which Areas of Finance Does a Business Owner Need to Understand?
There are three financial reports that everyone who owns a business should be able to understand:
1. Profit and Loss Statement
This financial statement details the amount of profit or loss over a specific time period, commonly a fiscal quarter or a year. The statement details the company’s revenues, expenses, gains, and losses. Net income is the difference between the revenues and gains and the expenses and losses. A positive balance equates to net income, while a negative balance is a net loss. A company can use this information to determine whether it can generate profit by increasing revenue and/or reducing costs. If the organization is losing money, the owner should investigate where to cut expenses. Tax preparers rely heavily on a profit and loss statement to prepare a tax return.
2. Balance Sheet
A balance sheet is a financial statement that reports the company’s assets and liabilities, as well as the shareholder’s equity at a particular point in time. This allows investors to understand the amount of assets owned and debt owed by the company, as well as the amount shareholders have invested. Business owners use the balance sheet to evaluate the financial health of the company. It’s used by banks to decide if a business has enough assets to qualify for a loan.
3. Cash Flow Statement
A cash flow statement is a quarterly financial report providing data concerning the amount of cash that enters the company from its operations and external investment sources, as well as the amount of cash that exits the company to pay for business activities and investments. Publicly traded companies must disclose their cash flow statements to the U.S. Securities and Exchange Commission (SEC) and the information must be made public.
While an understanding of these financial reports will go a long way in running a business, it’s also essential for a business owner to know their limits. If something seems too complicated or volatile for you to handle on your own, the best course of action is always to ask for help. In fact, knowing when to ask for help is just as important as knowing who to ask, so be sure to use the services of a trusted financial specialist and a tax attorney.
How Can I Become More Financially Literate?
There are many free financial literacy resources small business owners can take advantage of to up their game. Here are a few:
Small Business Development Center Program
Small Business Development Centers (SBDCs) offer technical assistance to small businesses and aspiring entrepreneurs. Administered by the U.S. Small Business Administration (SBA), and with more than 900 locations across the country, the SBCD program delivers financial literacy tools that can be accessed online. The SBDC also offers workshops, business counseling and business finance training.
FDIC Money Smart for Small Business
FDIC Money Smart is a complete financial education course created by the Federal Deposit Insurance Corporation (FDIC) to help low- and moderate-income individuals improve their financial skills. The program is comprised of 13 training modules that cover nearly all facets of small business finance. Topics include business planning, managing cash flow, insurance, credit reporting, tax planning, and business banking. Participants in the program can download the course material for free on the FDIC website.
SCORE is a nonprofit organization that counsels, trains, and and provides mentors for entrepreneurs and future small business owners. SCORE’s website features online tools and information that cover a wide array of topics on starting and running a small business. The Finance and Money section of the website contains articles and help on finance and financial planning. Local workshops and mentors are available.
360 Degrees of Financial Literacy
360 Degrees of Financial Literacy is a free resource provided by the American Institute of Certified Public Accountants (AICPA), with the goal of providing financial information to individuals. The website contains a section for small business owners that includes topics such as budgeting, business formation, and debt and business valuation. Financial tools and calculators are also available.
This free resource is provided by IBM and the International Finance Corporation (IFC), a subsidiary of the World Bank. The website is geared toward small and medium enterprises (SMEs). While the SME Toolkit focuses on minority, women and veteran entrepreneurs, most of the information provided is useful for any small business owner.
Improving Your Financial Knowledge
No matter how you look at it, if you own a small business, you have nothing to lose and everything to gain by increasing your financial literacy. At the very least, it will help you communicate more effectively with your accountant and could save your business from financial ruin.
John Milikowsky represents U.S. and foreign businesses and individuals in sophisticated business transactions involving U.S. tax matters. Mr. Milikowsky relentlessly defends each client in federal and state audits and criminal investigations to protect their civil rights and provide financial security. Mr. Milikowsky is recognized in the legal and business community for his experience and knowledge in the area of taxation and financial analysis. http://www.caltaxadviser.com