Benchmarking: Part 2

In our latest blog post, we looked at why benchmarking is important for your business. Some of those reasons include:

  • It keeps you up to speed with real-time data (that is, as long as the data is timely, relevant, and accurate).
  • It never goes out of style and can be used continually, rather than a one-and-done solution.
  • It truly helps you understand the well-being of your business situation.

So now that we have a refresher of why benchmarking is great for your business, let’s dive in deeper. After you decide which data source you’ll use (make sure it’s accurate, timely and relevant), the challenge is now deciding which benchmarks to analyze and use as a tool for the success of your business.

We’ve said it before, but we will mention it again. Different industries, and different companies within an industry, might have different success measures. For example, a contractor might have large subcontractor expenditures. Are these expenses normal considering the contractor’s sales volume?

Instead of taking a look at industry-specific metrics, we’re going to focus on some metrics that are universally important and can provide a quick look into a company’s health.

  • Liquidity Ratios. Yes plural – because there are two that need to be analyzed together. They are:
    • Current Ratio which is shown as current assets divided by current liabilities. This metric shows general liquidity, but it does have some limitations. If inventory is included in calculating the current ratio, it might provide a distorted understanding of your cash flow.
    • Quick Ratio is expressed as cash accounts receivable divided by current liabilities. This ratio might not be perfect for showing liquidity, but it can be a useful and popular comparison to pair with the current ratio.
  • Net Profit Margin. Expressed as net-profit before taxes in a given period divided by sales. Another way to view this? How many cents of profit you extract from each dollar you earn in revenue. This might be a basic metric, but it’s extremely important!
  • Turnover Ratios. There are three ratios that you should consider:
    • Inventory Days which is shown as inventory divided by cost of goods sold, multiplied by 365 days. Inventory days tells the story of how long it takes to sell off inventory. However, it’s important to remember this ratio is very industry-specific. Imagine how long wine is stored in a winery compared to the length of time milk sits in a grocery store cooler. Usually, lower numbers are better.
    • Accounts Payable Ratio is expressed as accounts payable divided by cost of goods sold, multiplied by 365 days. The accounts payable ratio shows the number of days you take to pay the vendors. Higher numbers are better – it means you hold on to cash longer.
    • Accounts Receivable Ratio is shown as accounts receivable divided by sales, multiplied by 365 days. This is a rough measure of the number of days your company takes to turn accounts receivable to cash. You want lower numbers, as it is better to have cash in the bank than extra receivables on the books.

By paying attention to some of these important metrics, you can build a picture of where your business Is, where it should be going and what it will take to get there.

Behind the Metrics: Inventory

This set of blogs will take you behind some of the metrics you should be measuring in your business. We’ll talk about what they are, what they really mean and more.

We know what you’re thinking … of course it’s important to track inventory. And you’re right, it absolutely is. But it’s more than just the physical finished product in your warehouse you need to track. Inventory has several layers and they’re all important to your business.inventory

Let’s start at the beginning.

Inventory, at its most basic, is your goods on hand. We don’t just mean finished goods either.

Typically there are three components under your inventory account:

  • Raw materials (read, the things you’re using to create your product)
  • Work in progress (the product that’s almost there, but not quite)
  • Finished goods (we’re not going to explain this one)

These are all consider part of your business’ assets.

Seems pretty straight forward.

Well, not quite. Inventory might be a pretty straightforward concept, but tracking it isn’t. In fact, it can get pretty complex. Let’s take a look at the basics…

Raw materials are the basic components that go into producing your product. When raw materials are purchased you debit Raw Materials Inventory and credit Accounts Payable (or another payment type).

Once your product goes to production, you need to start adding in costs such as labor, supplies, occupancy and equipment. These costs can be broken into two (2) categories: direct and indirect.

Direct costs are costs that are easily identifiable to one (1) unit. For example, let’s say it takes a line worker two hours to assemble a unit [and line workers track their time to a specific unit]. The line worker makes $30 per hour. Therefore, you would add $60 to the cost of the unit.

Indirect costs are costs related to the production process however are not easily identifiable to one (1) unit. For example, as a part of the assembly process, the line worker must glue a component to the unit. You wouldn’t necessarily want to measure the glue each time; so you allocate a cost for the glue. You know that one (1) gallon of glue costs $20 and you expect to be able to complete 10 units for every gallon; so you allocate $2 to each unit for the cost of glue.

The direct and indirect costs are added to the raw materials throughout the production process. Here’s what the accounting could look like (actual accounting may differ based on specific circumstances … but this should give you the idea).

 

Account Debit Credit
Work in Progress $XXX
Raw Materials $XXX
Labor Allocation* $XXX
Supplies Allocation* $XXX

*Assuming when you pay the line worker and purchased the supplies, you recorded it to a wages and supplies expense, respectively under costs of goods sold.

Once the production of the unit is complete, you would debit Finished Goods Inventory and credit Work in Progress.

So what can your inventory tell you?

Other than the value of the asset you are holding, inventory can have a direct correlation to how they’re doing (we are talking profitability and cash flow).

What do we mean? Well if you’re holding on to too much inventory and not selling it, you’re basically a costly storage facility. Plus, if you use anything that could spoil, you’ve lost money. Not to mention, your inventory costs money to produce which is recouped when you sell the units; that can lead a cash shortfall if not managed properly. If you have too little inventory, on the other hand, you run the risk of not being able to complete sales in a timely fashion. Which might led to your customers going elsewhere to get the product.

So what do you do? Use an inventory management system. Oh, and a little thing like benchmarking against your peers will also help.

What else do I need to know?

Here are a few common metrics to be looking at within inventory.

Inventory Turnover

In simplest form, this is how often your inventory is sold and then replaced over a period of time. For instance, you can use this metric to see how many times you sell through your inventory in one year. One of the best things to do is then compare this to industry averages to gauge where you stand.

Here’s how you calculate it:

Cost of Sales

Average Inventory

Low turnover could indicate an excessive amount of inventory, as well as low sales. A high ratio, on the other hand, could indicate strong sales. Or it could indicate a large discount.

In essence, inventory turnover is about speed. But inventory turnover is also tied directly to profit. Why? Well, it doesn’t matter how fast you sell inventory if you’re not making a profit each time.

Days Sales of Inventory

Taking your inventory turnover one more step, this is a measurement of how many days it takes you turn your inventory into sales.

Here’s how you calculate it:

365

Inventory Turnover

The inventory to sales ratio is also the first part in a larger ratio, known as the cash conversion cycle. This cycle tracks how long it takes you as a business to convert your resources into cash flow.

Inventory Days of Supply

Days of supply takes your current sales levels and then tracks how many days your current inventory will last. As you can guess, this is an important metric because if you’re low, you’ll risk running out of inventory and not being able to fulfill sales.

The moral of the story …

Inventory management is important and has a direct effect on your business. So ensure you’re not only tracking your inventory, but also looking at it in relation to the sales cycle.

 

 

 

Tracking Taxes

We all know we need to track our business transactions. However, there might be some tax considerations you weren’t thinking of…

Apportionment.

What? Apportionment is a fancy tax term describing the method you use to allocate your income (or loss) to a specific tax jurisdiction. Determining which states your income should be apportioned to goes back to the concept of nexus. O, man another fancy tax term…

We’ve already talked about the concept of nexus as it relates to sales and use tax on our blog. If you remember, nexus (a.k.a sufficient physical presence) creates the responsibility to pay tax in a state you are doing business. If you want to know more, click here.

Once you determine you have nexus in a state (and we are talking for income tax purposes), there are some considerations when it comes to tracking your assets, income and expenses. Here are a few of the common areas that need to be tracked by state:

  • Fixed Assets
  • Inventory
  • Payroll
  • Rent
  • Revenue

If any of those terms don’t sound familiar, our glossary might help.

Tracking these areas from the beginning is much more fun (only because we think accounting is fun) than going back through a year’s worth of financial data to figure it out.

Personal Mileage

Bottom-line, Uncle Sam only wants you taking a deduction for business miles (makes sense right?). Here are two points we think are important for you to consider:

  1. Track your mileage (personal, business + commuting (from home to the office and back)
  2. Personal mileage could be considered a taxable benefit (and should be reported as taxable wages)

Meals, Travel + Entertainment

Here’s the deal on meals, travel and entertainment…these are some of the most scrutinized expenses when it comes to Uncle Sam (that’s because the line is often blurred between personal and business in this area). When it comes to tracking these types of expenses, make sure you are keeping the supporting documentation (ex. receipt or invoice) to substantiate the business purpose of the expense.

Business Documents

We’re talking about your articles of incorporation, bylaws, member and operating agreements, etc. These documents are not only important when starting your business but also important throughout your business lifecycle; keep them where you can find them. In addition, keep copies of any correspondence with Uncle Sam (a.k.a IRS). And if you want to be really nice to your tax professional, share these documents and correspondence with them (keeping them in the loop can save you).

These are just some of the considerations from a tax perspective. Make sure you are staying connected to your business partners (i.e. your tax professional) throughout the year. Need one? We have plenty; let us know how we can help.

 

 

Benchmarking 102: Prioritizing Benchmarks

In a previous blog, we learned WHY benchmarking is so important. Here’s a brief refresh:

  • It helps you understand your situation.
  • It can be used continually. Benchmarking is not a use it once and pitch it solution.
  • It provides you with real-time data. That is, as long your data is accurate, timely and relevant.

So now that we’re all up to speed, let’s revisit benchmarking again. After securing the accurate, timely and relevant data source you’ll use, the challenge becomes choosing which benchmarks to analyze and use as a proxy for business success.

Different industries, even different companies within an industry, could have different measures of success. For example, a contractor may have large subcontractor expenditures. Are these expenses normal considering the contractor’s sales volume?

Rather than define all these industry-specific key performance indicators (KPIs), we’re going to focus on a few financial metrics that are the most universally important to business and, when analyzed together, provide a quick and high-level review of a company’s health. Get excited.

  • Net Profit Margin. Generally expressed as a net-profit before taxes in a given financial period divided by sales. Another way to look at it is how many cents of profit you extract from each dollar it earns in revenue. This may be a rudimentary financial metric, but it is also the most important!
  • Liquidity Ratios. Did you note the plural usage? Good because there are two that need to be analyzed jointly.
    • Current Ratio is expressed as current assets divided by current liabilities. This metric shows your general liquidity, however it has some limitations. By including inventory in the calculation, it may provide a distorted understanding of your very short cash flow.
    • Quick Ratio is typically expressed as cash accounts receivable divided by current liabilities. Again, this ratio may not be perfect for gauging liquidity, but it is a useful and popular comparison to pair with the Current Ratio.
  • Turnover Ratios. Plural again … because there are three this time to consider:
    • Accounts Receivable (AR) is expressed as accounts receivable divided by sales, multiplied by 365 days. It roughly measures the number of days your company takes to turn accounts receivable into cash. Lower numbers are more desirable since it is better to have cash in the bank than extra receivable on the books.
    • Accounts Payable (AP) is expressed as accounts payable divided by cost of goods sold, multiplied by 365 days. The accounts payable ratio indicates the number of days you take to pay its vendors. Here, higher numbers are better as it means you are able to hold onto cash longer.
    • Inventory Days is expressed as inventory divided by cost of goods sold, multiplied by 365 days. Inventory days measures the number of days it takes to sell off inventory. As a note, this ratio is very specific to the industry. Imagine how long wine is stored at a winery compared to how long eggs are on grocery stores shelves. Generally, lower numbers are better.

By using some of these financial metrics repeatedly, you can being to build a picture of where your business should be going, where it’s excelling and where you can change and improve.

Cash is King

Cash is KINGWhen you’re just starting out, it’s important to remember one thing (well, a lot of things, but this one is really important). CASH is king. Why? In the early stages of a business, traditional financing may be hard to come by, so cash in hand is necessary to run your business.

You guys are really on the cash bandwagon.

Sure are. When you have limited financing as a startup, cash is a necessary commodity. You need it to pay vendors, make payroll, fund product or service development and buy equipment. You know, the kind of important stuff it takes to make sure your business is actually running.

Plus, cash can really benefit you in way of discounts. Some vendors may offer purchase discounts in return for prompt payments.

Okay, okay. Cash is important. So what do we need to watch for?

You can’t just use all your cash in hand to pay all your expenses. While you need to pay your bills and keep the lights on, you also need to be able to survive slow periods (all businesses have them) and be prepared for when cash is not coming in.

But you also need to prepare for when times are good. When growth is strong and increasing revenue generates higher inventory and receivables, you have to be prepared to meet demand. Increased working capital needs can consume cash, especially in periods of high growth.

What else should I pay attention to?

What industry are you in? Industry sectors can have an impact on when you collect cash and when you spend it. Some industries have the benefit of collecting cash early in the sales cycle. Think schools here. They collect tuition before classes even start. Other industries require spending cash early in the sales cycle. We’re looking at you manufacturing and wholesale. So examine your entire sales cycle when mapping out your finances and know that no two businesses are exactly alike.

Plus, while it might not seem like it when you’re just starting out, but you may want to acquire other businesses down the road. You’ll need cash to do this.

So cash is a good thing. Can I do anything to get a handle on it early?

Monthly projections can help you understand your cash cycle. Look ahead to periods of high cash outflow and plan. Take into account periodic events like taxes, bonuses, capital expenditures, prepaid expenditures and one-time events and account for them. Cash will not only help you in the early stages of your business, it can also be a catalyst to map out your overall financial journey (which we think is pretty fun, and a really good thing to do).

 

 

Cash v. Accrual Accounting: Why It Matters

One of the more important things to consider when starting a new business is the decision to use the cash or accrual accounting method. This decision is not just another item to check off your to do list, but one that has repercussions on how you do your taxes and on the future of your business. The key item to consider is which method will most clearly reflect the financial outcomes of your business.

It is also important to note that once a method of accounting is established, it must continue to be used, or the taxpayer must file an accounting method change to request consent to change their method of accounting. This can get tricky, and end up costing you time and money to accomplish, so make sure you think through which method works best before you start recording transactions. Plus, by knowing what to expect, it will make it a little easier on you at tax time (which we can all agree, is a pretty nice thing).

So I get they’re different. But how are they different?

Cash basis accounting is probably the most common for small business owners, often because of its simplicity. Income is reported when cash, or the constructive receipt of cash, is IN HAND. Same principal applies for expenses. You don’t report, or deduct, your expenses until they’re actually paid.

Accrual basis accounting is a little more complex. Income is reported when it is EARNED. This means it may often be recorded before payment is actually in hand. Expenses follow the same vein, and are reported when they occur and are fixed as to the amount.

Okay, but which is better?

It depends on your business type and what you do. The accrual basis of accounting helps you better understand the current condition of your business finances, while the cash basis of accounting focuses on your current cash on hand. The accrual method may allow you to see a better picture of your financial position and company profits because it reports everything earned during a period as well as expenses incurred. You need to also keep in mind, while the cash basis offers simplicity in application, there are some limitations on the use of the cash method of accounting. Further, accrual accounting is generally used by a business that has inventories as part of their business operation.

What about tax reporting?

The type of accounting method you choose affects your tax deductions. It’s a subtle difference, but an important one. Say you, a calendar year taxpayer, received an expense invoice in November 2015 and pay it on January 15, 2016. Under the cash method, you won’t be able to deduct that expense until you report taxes for 2016. However, under the accrual method, you can claim the deduction in 2015 if all events have happened to fix the amount due.

Now, let’s talk about income reporting. You, again a calendar year taxpayer, invoice a customer in November 2015 for services performed and they pay you January 15, 2016. If you’re using the accrual method, you’ll pay tax in 2015 on services for which you haven’t actually received payment, since the right to receive, and the amount of payment to be received, was known and fixed in 2015. However, under the cash method, you would pay tax on the service completed once the cash was in hand in 2016.

The moral of the story?

It’s important to understand your business and your finances. By understanding your books and where you’re headed, you’ll be able to choose the accounting method that works best for you.

Still not sure what we’re talking about?

Here’s the truth: taxes are complex and complicated. You don’t have to know it all. We can help.

Cash v. accrual