A business owner recently asked for help in understanding where his money was going. He didn’t actually ask the question directly. He hinted at his frustration saying, “My tax return says I made a profit, but my checkbook says it lies.” I’d never heard it put quite that way, but I knew what he meant.
Ronnie has lots of company. Business owners put sales on the books, pay their business bills, don’t have a lot of cash left, and are stunned when they learn they made a decent profit and owe more income tax than expected. Therefore the question, “Where did my money go?”
After paying business expenses, there are only two places money can go – first, investment in the business, and second, a return to the owner/investor. Let’s explore those places.
Let’s dispense with the second possibility first – return to the owner. Ronnie is a sole-proprietor and doesn’t receive a paycheck. Instead, he receives draws from the business. Partners in partnerships and members in limited liability corporations typically are paid the same way. Ronnie properly records every check paid to him. He knew how much money he received from the business. Shareholders may receive a combination of salary and dividends. In any case, most owners know how much the business paid them. The possible exception occurs when draws are taken in the form of merchandise. Unless the owners are meticulous in identifying this form of draw, they may have an inaccurate picture of how much the business pays them.
Ronnie didn’t realize how much he was investing and reinvesting in his business. Because his sales were growing rapidly, his investment in accounts receivable also was growing. He bills his clients monthly and collects most accounts within the following month.
Ronnie ran up against a cardinal rule of business: Money almost always goes out before it comes in. Stated another way, expenses must be paid on time (usually monthly) while revenue (sales and receipts) come in more slowly.
Like most entrepreneurs, Ronnie has loans and makes monthly payments. He thinks of the payments as an expense. However, only the interest is an expense. The principal portion of his payment is an investment in his business – the repayment of a loan that allowed him to buy equipment before he had spare cash to pay for it.
Other forms of investment and reinvestment don’t show up on tax returns as expenses. Inventory is an example of an expenditure that is not deducted until sold.
Ronnie learned there are many different ways to invest and reinvest. He doesn’t like conflicts between his checkbook and his tax return, but he now understands where his money is going.
Methods exist for reducing the gap between money going out and money coming in. These methods are called “cash-flow management.” We will discuss cash-flow management techniques in future columns.
For now, remember there are only two places your money can go after paying expenses: 1) investments in your business, and 2) paying yourself.
Bowser@BusinessValueInsights.com. Dan Bowser is president of Value Insights, Inc. of Durango, Chandler, Ariz., and Summerville, Pa.