Taxes and Accounting

Here are my top tips for accounting:

1. Always keep your business finances separate from your personal finances. Don’t give the tax auditor a reason to audit both. Learn to pay yourself first and run your business on the remaining cash. By this I mean setup an automatic payment to your personal account twice a month (1st & 15th or 10th & 25th) like a regular pay cheque.

2. File all your tax compliance reports on time to avoid penalties, even if you can’t pay the amount owing. However if you begin the habit of putting money aside in a separate account to pay your taxes, you will never have this problem. Start today. Put 15% of all cash received by your business into a separate account. I recommend this account be at a different bank than your current business and personal accounts. I like to use one of the online banks for this like Ally, President’s Choice Financial or Tangerine.

3.Keep organized by:

• developing a method for handling all your paperwork;
• entering your bookkeeping data in batches;
• actively managing your cash flow; and
• reviewing your bank statement and financial reports monthly.

4.Audit proof your records.

• Keep all your receipts, no matter how small the amount and make sure they are legible. Receipts you must keep include debit receipts and credit card receipts.
• Deposit all your business cash flowing into the business … so you can prove what was income (taxable) and what was contributions or loan proceeds (not taxable).

5. Whenever possible, don’t go into debt to run your business. Run your business on your existing cash flow. Not enough cash flow to cover expenses? Figure out where to cut your expenses and consider not offering credit to your customers because you are not a bank. Let your customers pay by PayPal or a similar solution that accepts credit cards.  Keep a business journal to diarize your logic for your business ventures. It will help show you incurred the expenses with the expectation of profit. Consider implementing Mike Michalowicz’s Profit First system

Accounting for Debits and Credits in Double-Entry Bookkeeping

In double-entry bookkeeping, you enter all transactions in the books twice: once as a debit and once as a credit. This chart shows you how debits and credits affect your various business bookkeeping accounts.

Make a profit every year with the Profit First Formula

We see a lot of business owners at Wave who haven’t yet mastered their cash flow, and aren’t sure if they’ve actually made any money until the end of the year. Even worse, sometimes they haven’t made money, but by the time they realize that it’s too late to correct. That’s a stressful place to be, and it doesn’t need to be that way.

At Wave, it’s our mission to help our customers become more sophisticated and confident when it comes to managing the financial side of their businesses. A lot of small business owners struggle with this—hey, you probably didn’t start a business because you loved accounting—so we make a point of sharing tools that can help make it clearer and easier.

One of the tools we often recommend is the book Profit First by Mike Michalowicz. It’s a well-written book that teaches business owners how to “transform any business from a cash-eating monster to a money-making machine.” Profit First focuses on a cash flow management system that ensures you’ll take a profit and get paid, no matter how small that income might be.

Putting profit first

So what is profit? Check any business textbook, and you’ll find that your profit is whatever’s left over after you subtract your expenses from your revenue: Sales – Expenses = Profit. While it makes sense to cover your expenses first, there’s no guarantee that you’ll make a profit with this formula.

The Profit First Formula flips the equation, giving profit the focus it deserves: Sales – Profit = Expenses. You might wonder what difference this really makes—isn’t it just semantics? Kind of. But what Michalowicz is trying to highlight for you is more psychological than anything: you have to approach your business thinking profit first, not profit last.

The profit first method

The goal of the Profit First Formula is to develop a system for building your business in a sustainable way that creates long term success. First you account for your profit, taxes and your own pay, and then what’s left over is what the company has to spend on everything else.

We usually think of expenses (e.g., cost of material, rent, salaries, utilities) as unavoidable, when they can actually often be eliminated, avoided, or delayed. When you discipline yourself to set aside a percentage of revenue for profit and only spend what’s left to cover your expenses, you’re forcing yourself to spend more wisely.

Doing that can be uncomfortable. It might mean you have to delay some of your spending on growth in the short term, even when you want to keep pushing forward. But, it also means that when you do encounter a great opportunity to grow your revenue and profits, you’ll have the resources to invest in it without endangering your business. If you put every spare dollar back into your business, you might think you’re planting seeds for growth—but you’re actually putting yourself at risk for a future crisis.

How to put the Profit First Formula to work

Create smaller spending buckets

The first step you need to take is to get more granular with how you allocate your cash by creating smaller spending buckets. To make this easier, you’ll need to set up bank accounts based on the core functions of your business:

• Income/revenue account
• Profit account
• Operating expenses account
• Owner’s pay account
• Tax account

In addition, you might need a few other accounts depending on your business and the goals you want to achieve. Most businesses can get started with these five accounts and build out from there.

Determine your CAPS and TAPS

This is more technical part of the system. Your Current Allocation Percentages (CAPS) show where your Real Revenue is being spent right now—what your business is buying day-to-day in its current format. This is often the most interesting part of putting the Profit First Formula into action, since most business owners rarely pay close attention to that information.

The Target Allocation Percentages (TAPS) detail where we want your Real Revenue to go once the business in running at efficiency and profitability. You won’t hit these numbers overnight, or even this year in many cases, but you can’t work towards them until you know what they are. It’s important to note that depending on the size and nature of your business some of these numbers might deviate significantly from those outlined in the book.Below is a table outlining various revenue dependent scenarios. We can see that higher revenue often increases profitability and operating expenses while decreasing owner’s pay, for some businesses. These should be used as an example and may be different for your industry or business type.

Image: Profit First by Mike Michalowicz

Transfer your Cash

Establish a rhythm for transferring the funds that are accumulating in your income account to your other accounts. How often should that happen? It’s completely up to you. Almost every business owner starts out thinking they need to follow to the 10/25 rhythm outlined in the book, but this isn’t necessary. Some business owners do it every two weeks, while others do it weekly. But once you establish your rhythm you need to stick to it!

Make Payments

Use your profit first accounts to pay your bills. The key is to ensure that each account is only used for its designated purpose.

• Profit account: This account accumulates a very small amount ‘off the top’ that can be used for debt reduction, emergencies and for you to receive a bonus for all your hard work. The Profit First Formula is about generating profit, so this account comes first!
• Owner’s pay: This account is used to pay your after tax salary or wage. Fight the temptation to ‘re-invest’ this into your business because it’s your salary. You need to get paid!
• Tax Account: Use this account to meet all your tax and superannuation obligations.
• Operating Expenses: This is all the money your business has available for operating expenses. Get creative and spend it wisely because all the other accounts are spoken for.

Review

At the end of each quarter the system should be reviewed and adjusted. The Profit First mindset shift will challenge you to re-evaluate every element of your business model as well as your personal financial situation. As your situation changes, so too will your need for cash and your account transfers should reflect these changes.