If you're struggling to prioritize your financial decisions, you're not alone. Whether it's investing in technology or remodeling your office, it's essential to distinguish between priorities and preferences before purchasing big-ticket items.
By Gwen Moran
Judah Lerer wasn’t a practicing CPA, but he did have a solid number-crunching background as an accountant. When he was contacted by the founders of Office Zone to advise them on their launch, he attempted to talk the partners out of choosing prime retail space for their offices. After all, since the Spring Valley, N.Y., company shipped office supplies through its Web site, there wasn’t a reason to pay a premium for glitzy offices.
“They didn’t listen and got this beautiful location, with great visibility, which was totally meaningless for what they were doing at the time,” says Lerer, who eventually became the company’s CFO and later acquired the company. “They ended up spending five times the amount of rent that they should have been spending.” Lerer has since bought out the founders and has moved the company into more affordable space, saving approximately $50,000 per year on rent.
Making wise financial decisions can mean the difference between steady, long-term growth and quick, flash-in-the-pan failure. The biggest mistake that small business owners make is failing to understand their financial priorities, says Julie Aydlott, owner of San Diego Business Accounting Solutions, and author of The Quick Guide to Small Business Budgeting.
“Everything is associated with money, and the person who knows what they have at all times wins,” Aydlott says.
That means first having a solid grasp of what money—and debt—you have. Before you move into a new office, invest in the latest technology or hire additional staff, you need to take an inventory of the following factors: debt ratio, cash flow, necessity and return-on-investment.
Divide your current assets by your current liabilities to determine your company’s current debt ratio—a good indicator of how financially solid your business is. The stronger the assets versus liabilities, the better positioned the company is for growth and new investments. For startups that don’t have assets or liabilities, it’s important to create a budget and cash flow projection to see what it’s going to take for your business to sustain itself. They also help to determine how much money is required for investments that are essential to sustaining your business.
It may seem cost-effective to administer payroll in-house, but it can be costly if you falter in terms of penalties, interest and time. Forty percent of small businesses that do their own payroll are fined an average of $845 per year for inaccurate returns, according to the Internal Revenue Service.
“If you knew tomorrow that it would cost you $25,000 per year in personal living expenses and business startup costs to survive, you would be one step ahead of most new small businesses who just wing it,” Aydlott says. If you’re at a break-even point and need to shave expenses, it’s probably not the best time to make a big, new investment, she says.
The Small Business Administration offers a free lesson on debt ratios, in addition to a downloadable worksheet.
In addition to understanding your debt and expenses, you need to take a close look at cash flow. Cash flow is the overall amount of money that your business is taking in. It’s different from profitability, which is calculated by subtracting the cost of producing the goods or services sold from the overall amount of money that the business takes in.
A business can be profitable and lack cash flow, so entrepreneurs need to be sure that income is steady enough to cover the new expense of a big investment, says Ruth King, author of The Ugly Truth about Small Business and founder of businesstvchannel.com, a small business Internet television channel, based in Norcross, Ga.
“Cash flow is the lifeblood of a business. Without it, a business cannot survive,” King says. “I find that many times, small business owners confuse profitability with cash flow. Taking out a loan for new equipment, for example, could really hurt them if they’re not comfortable they can cover that loan each month. You may be profitable, but if your income is uneven, you could find yourself in trouble some months.”
If you find that you are in good financial shape, with regular income and a low debt ratio, you need to take a hard look at whether you really need to make the new investment, Aydlott says. Evaluate your “needs” versus your “wants” to ensure that you don’t get caught up in the excitement of making a big purchase. First, consider whether there are less expensive, reasonable options to help your business thrive, or if it would be better to delay the purchase until your business can better manage the expense.
Aydlott says you also need to figure out whether the expense has the opportunity to earn money for your business, through increased productivity and revenue or by decreasing expenses. If so, how much is the savings or increase in revenue versus the cost of the resources needed to achieve it?
Business owners should treat themselves like their bankers do. Before approving a big expenditure, ask yourself: Am I a big risk? Is this purchase going to increase revenue or the bottom line? Am I able to manage payments? How long will it take me to pay back this expenditure? How much of the capital do I need to put down or will I need to finance it? If the latter, what is the interest rate and how much will it add to the cost? On top of what I already bill, how much more income would my business need to earn to pay for this purchase?
If you are comfortable with the answers to all of those questions and have looked carefully at your company’s debt ratio and cash flow, as well as the necessity and potential return on investment, then you will have solid indicators about whether the investment is a good idea or could lead to nightmarish consequences.