Saturday, April 28, 2007

Part IV: Failing To Learn Business Fundamentals
Reason Number 9 Of Why So Many People Fail In Home Businesses

Part IV: Record Keeping, Break Even Analysis & Business Statements

This is the final installment in our series on "Failing to Learn Business Fundamentals". Everyone in business must keep records. In this post we are going to discuss the importance of :

(1) Good Record Keeping
(2) Doing A Break Even Analysis
(3) How To Calculate Your Break Even Point
(4) Cash Flow Statements |
(5) Financial Statements |
(6) Income Statements |
-----> Business Statements

Good business record keeping is very important to your business. These records will help you monitor progress, prepare your financial statements, keep track of deductible expenses, prepare your tax returns, and support items reported on tax returns. Business records can be divided into three categories: income, expenses, and capital expenditures.

Income Records - Your business may take in money from several sources. Maybe you sold your car to finance your business, or perhaps you received a business loan. You might receive income by selling goods and services to another business. Whatever the source of your income, it needs to be recorded.

Business records should indicate the type of payment received, the date it was received, and the source of the payment. While the information is fresh in your mind, write it down on the deposit slip in your checkbook. If your business sells services to another business, you should receive IRS Form 1099s from the payors, showing how much you were paid. Keep all of your income records in a central location.

Expense Records - Keep proof bills were paid, by holding on to copies of receipts, invoices, credit card slips, canceled checks, or rent receipts. These are standard documents that backup your business expenses. Each cost must appear reasonable and necessary for your business to deduct your business expenses from your taxes.

Asset Records - Whenever a business purchase gives you a long-term benefit-like a fax machine, a building, a car, or office furniture-these assets must be tracked separately from assets that will be used immediately, such as office supplies. These assets must be tracked separately because you generally can't deduct the entire cost of the asset in the year of purchase.

The IRS normally has three years to audit you and your business. So, you want to keep records for at least three years. However, if you seriously misreported your taxes, the IRS can go back six years. If you committed fraud, IRS can go back for an unlimited amount of time. Some state agencies have longer statute of limitations than the IRS, so to be safe, it's best to keep all tax-related documents for longer than three years.

Break Even Analysis

How can you tell if your business idea will be profitable? A break-even analysis shows you the amount of revenue you'll need to cover your expenses before you can make a profit. To perform a break-even analysis, you will need to know your expenses and sales revenues.

  • Fixed costs. Fixed costs (sometimes called "overhead") don't vary much from month to month. They include rent, insurance, utilities, and other set expenses.Example: Mary recently opened a dress studio. She designs formal dresses and suits for women. Mary's fixed costs are $6,000 a month.
  • Sales revenue. This is the total dollars from sales activity that you bring into your business each month or year. To perform a valid break-even analysis, you must base your forecast on the volume of business you really expect-not on how much you need to make a good profit.Example: Mary realistically believes she can sell 25 dresses each month. She charges $300 for each dress, so her monthly sales revenue is $7,500.
  • Average gross profit for each sale. Average gross profit is the money left from each sales dollar after paying the direct costs of a sale. Direct costs are what you pay to provide your product or service.
    Example: Mary pays an average of $100 for goods to make the dresses she sells for $300. Therefore Mary's average gross profit is $200 for each sale.
  • Average gross profit percentage. This percentage tells you how much of each dollar of sales income gross profit is. To calculate your average gross profit percentage, divide your average gross profit figure by the average selling price.Example: Mary makes an average gross profit of $200 on dresses that she sells for $300, so her gross profit percentage is 66.7 percent ($200 ÷ $300).

Calculating Your Break-Even Point

Simply divide your estimated fixed costs by your gross profit percentage to determine the amount of sales revenue you'll need to bring in just to break even.

Fixed Costs ÷ Gross Profit Percentage = Amount of Sales Revenue Needed to Break Even

Example: Mary's fixed costs are $6,000 per month and her expected profit margin is 66.7 percent. Therefore, her break-even point is close to $9,000 in sales revenue per month ($6,000 ÷ 0.667).

In other words, Mary must make $9,000 each month just to pay her fixed costs and her direct (product) costs. This number does not include any profit, or even a salary for Mary. Since Mary's break-even point is $9,000 a month and she has only estimated making $7,500 a month, she realizes that her business won't survive unless she makes some changes.

If You Can't Break Even. If your break-even point is higher than your expected revenues, you'll need to decide whether certain aspects of your plan can be changed to create an achievable break-even point. For instance, perhaps you can:

  • Find a less expensive source of supplies
  • Do without an employee
  • Save rent by working out of your home, or
  • Sell your product or service at a higher price.

Example: After Mary reviewed her break-even analysis, she decided to reduce her expenses by working from home rather than paying rent for a design studio. This will reduce Mary's fixed expenses from $6,000 a month to $1,500 a month. With these savings, her break-even point is now approximately $2,250 a month ($1,500 ÷ .667). Since Mary believes she can easily sell 25 dresses for $300 a piece each month, her total sales revenue will be $7,500 a month. Now Mary will make more than $5,000 in profit each month.

Cash Flow Statements

The cash-flow statement is your business's budget. It is one of the most critical information tools for your business, showing how much money you need to open your business and keep it running. It also shows when the money comes into the business and the expenses that need to be paid.

The result is the profit or loss at the end of the month or year. Just like your personal budget can show you that you need more income to cover your expenses, if the cash flow statement shows a loss, you will need more income to cover your expenses. Cash flow statements show four things:

  1. Income - Where cash is coming from (sales, investments, other).
  2. Expenses - Where cash is going (costs, interest, taxes).
  3. Schedule - When the activity took place (which month or quarter).
  4. Profit or Loss - How much is left over.

Financial Statements

Financial statements are important sources of financial information. Financial statements provide information about the financial health of your company. Business owners, investors, creditors, and the Internal Revenue Service use these statements. Some of the key figures include the income statement and the balance sheet.

Income Statements

The Income Statement is a formal financial statement that summarizes a company's operations (revenues and expenses) for a specific period of time, usually a month or year.

Small business owners use these statements to identify the areas of their business that are over or under budget. Items causing an unexpected expense can be pinpointed, such as phone, fax, mail, or supply expenses. Income statements can track dramatic increases in product returns or cost of goods sold as a percentage of sales. They also can be used to determine income tax liability.

For more information on these topics, go to Accion.Org. Next - "Falling for the Myth of Working Smart...Not Hard" - The number 10 reason why so many fail in home businesses.