Wow, that made you feel really good, until the whiplash of looking at your checkbook balance sets in. It certainly doesn’t look like you made $88,000 in profit, does it?
So, Where’s Your Money?
Before you go looking for it, it’s important to understand a few basics surrounding debt. Especially when in the form of loan payments, debt can be a silent killer, kind of like carbon monoxide. You actually feel good, not realizing it’s sucking the life out of you.
Every loan payment is made up of two parts. The first part is principal, which is applied toward the cost of the vehicle or piece of equipment you purchased, for example. The other part of the loan payment is called interest — the cost of borrowing the money from the bank or lending institution. This is Finance 101, I know. The real question is, “How does this hurt my profitability and taxes?”
The problem is that the IRS handles principal and interest differently from an accounting standpoint. The interest is treated as an expense in terms of your profit and loss (P/L) statement, and the principal portion of the loan sort of wanders off toward Neverland. Sure, it will appear in the assets and liabilities on your balance sheet, but it doesn’t show up in your P/L statement, which, for tax purposes, determines your profitability.
Case in Point
Let’s say your company grossed $1,000,000 in annual sales. At the end of the year, the net profit shown on the P/L statement is $73,500.
However, you also have four monthly loan payments: vehicle 1 ($690, of which $123 is interest); vehicle 2 ($562, of which $99 is interest); vehicle 3 ($751, of which $137 is interest); and pond equipment ($619, of which $107 is interest).
When you add up the interest and multiply by 12 months, your total comes to $5,592 in annual interest payments. Uncle Sam considers interest an allowable business expense, so it shows up that way on your P/L statement. However, the P/L statement does not show that you paid $25,872 in principal.
That’s right. You wrote the check, and the money came out of your account, but you are not allowed to count the principal as an expense. According to your P/L statement, your loan payments were only $5,592 for the year. Ouch!
So, when your CPA says that your company made a $73,500 net profit, your real profit from a cash-flow standpoint must consider all the principal payments. This leaves you with $47,628. In all likelihood, this dollar figure is probably closer to what you had actually calculated in the company checkbook or accounting system.
When you look at general debt (non-loan) repayment, it gets even worse. This includes making payments on a line of credit, a personal loan or credit card. These payments generally contain a much higher share of the principal, so most of this money flowing out is pretty much ignored in terms of counting it as an expense.
So, What Do You Do?
The solution is really pretty simple. Stay out of debt! But in order to do that, your company needs to properly price your products and services to cover equipment depreciation and replacement in order to return a reasonable profit.
Depreciation is an accounting term that allows the company to write off a portion of the original purchase price of equipment, normally over a five-year period. This does not address equipment replacement costs down the road. For example, let’s assume an existing truck will last the company three more years. When you trade it in, the new vehicle will cost you about $30,000. To avoid accumulating more debt, you should consider this $30,000 you’re going to need in three years and set aside $10,000 per year so that you can pay cash for it.
This sounds like the responsible thing to do, but as usual, there is a catch. Uncle Sam is going to tax you on this money you’re putting away, because it is considered profit.
So, you have to make sure you are earning a reasonable profit. Be sure to price your products and services with a proper net profit, from a cash flow perspective, not based on your P/L statement. In principle, a well-run company should generate at least a 12% net profit to cover future company growth and increased inventory. It also grows your accounts receivable and generates additional cash to purchase new equipment and vehicles instead of taking out loans. This is the cornerstone of keeping your company out of debt.
Tom Grandy has more than 35 years of experience in industry and small business. He has worked as the general manager of a service company and is the founder of Grandy & Associates, a firm that holds seminars, two day workshops and one-on-one consulting for business training. Go to www.GrandyAssociates.com or call 800/432-7963.