When looking at small business failure rates, it is essential to realize that business owners control their destiny. For example, the foodservice industry has a 30% failure rate; this does not mean opening a restaurant is like betting on black at the roulette table. Instead, it indicates that a business owner must make better, more informed business decisions to avoid becoming another statistic. Typically, these business decisions are proactive and data-driven, focusing on controllable factors, such as tax compliance, budget allocation, and supply-chain management, while also attempting to mitigate variables outside of this realm of control, such as large-scale economic trends.

What is the Small Business Failure Rate?

The COVID-19 Pandemic has been devastating to small businesses, with 200,000 additional closures in 2020. In non-pandemic times, however, the failure rates remain consistent year to year; even in years of poor economic performance, the failure rate varies little. According to the U.S. Bureau of Labor Statistics, just over 20% of small businesses will fail within their first year of operation. By year two, just over 30% will have shuttered. After five years, only half will still be in business. And by the decade mark, two-thirds of small businesses will have ceased operations.

As the statistics show, a small business’s first year is its most treacherous — and as a business survives each year, its likelihood to survive the next increases. Interestingly, this pattern holds regardless of industry; barring extraordinary circumstances (like a global pandemic), there are no industry-specific survival bottlenecks.

While the survival pattern is consistent across industries, upon analyzing the Census Bureau’s Business Dynamics Statistics, it is clear that the actual survival rates can vary significantly between sectors.

Related Reading: Small Business Tax Preparation

Small Business Failure Rate by Industry

Let’s take a look at some industry failure rates:

Information Industry

Consisting of many different sub-industries, including information products, information services, information devices, and information distribution, the information industry features a constantly shifting business landscape that necessitates a highly proactive approach to managing business operations. While potentially lucrative, the information industry’s 5-year failure rate stands at a whopping 63%.

Construction:

Despite the constant demand for new builds, the high overhead, lack of cash flow security, and the ongoing battle for new contracts make the construction industry especially brutal for newcomers. While a plucky business owner can overcome the odds with the help of a sharp accounting team, the 5-year failure rate for fledgling construction businesses tops 64%.

Manufacturing:

A broad and highly varied industry, many variables come into play when operating a manufacturing business — some of which lie outside of your control. For manufacturing business owners, staying on top of global and local economic and supply-chain trends coupled with impeccable financial reporting is crucial for informing business decisions. Nevertheless, 51% of new manufacturing businesses shut their doors within five years of commencing operations.

Food Service:

Despite the ever-prevalent notion that food service is high-attrition and cutthroat, opening a food establishment is one of the less risky business ventures on this list. In addition, it is one of the most merit-friendly industries around — although possessing good business acumen is still essential for success. After five years, about 50% of new restaurants and bars can expect to remain in business.

Finance and Real Estate:

While most industries’ closure rates are somewhat unaffected by economic downturns, the same cannot be said for finance and real estate. Businesses in this sector provide ample opportunity for massive earnings and easy scalability, but at a cost — no business owner can control the markets. And when the markets dip, portfolios can go belly-up. The five-year outlook for new finance and real estate businesses is risky — just under 60% will fail.

Healthcare and Social Services:

While somewhat challenging to break into, the healthcare and social services industry couples decent stability with ample room for growth — the Bureau of Labor Statistics’s projected 21% growth rate leads all other industries. As far as failing — well, it’s a definite possibility. However, the healthcare and social services industry is incredibly immune to macroeconomic struggles. As is the case in any industry, survival is contingent on proactive, data-driven business decisions. Still, the five-year outlook is pretty good: only 40% of new healthcare and social services businesses are projected to fail before the half-decade mark.

Why Do Small Businesses Fail?

There are a plethora of reasons why a small business might fail. Some fall on the owner’s shoulders, while others can be attributed to strokes of bad luck. According to a study by CB insights analyzing failed companies, the primary causes of failure could be attributed to

• Lack of demand in the marketplace — 42%
• Cashflow issues — 29%
• Personnel-related issues — 23%
• Defeated by a competitor —19%
• Price point issues — 18%
• Product issues — 17%
• Lack of a business model — 17%
• Poor marketing — 14%
• Legal challenges — 8%
• Poor Business Credit — 8%
• Lack of advisors — 8%

Put simply, there is no single factor that can make a company fail — it is often a nexus of many different factors, both within and outside a business owner’s realm of control. And while there is no silver bullet in business, many of the aforementioned downfalls can be mitigated — or entirely circumvented — by employing a dedicated team of accounting and bookkeeping professionals. Dedicated small business accountants, such as the experts at FinancePal, utilize data-driven analysis to inform proactive, effective business decisions. 

Meanwhile, specialized small business bookkeepers can ensure that your business has high-quality financial data to use as a roadmap. Together, specialized accountants and bookkeepers can help your business avoid cash flow, price point, and business model-related issues while enhancing your company’s ability to compete in the marketplace.

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What Is Forensic Accounting?

Put simply, forensic accounting is a special type of accounting related to current or anticipated litigation and disputes. Accountants conduct forensic accounting under the knowledge that their findings will be used in court — hence, “forensic” — when the court wants to determine damages. For example, during litigation over a compensation dispute, the court may utilize a forensic accountant as an expert witness.

Forensic accounting has its uses beyond litigation; criminal courts may utilize forensic accountants in cases of fraud or embezzlement.

What Do Forensic Accountants Do?

Using a combination of accounting, auditing, and investigative skills to analyze and interpret complex financial variables, forensic accountants seek to trace funds, identify and recover assets, and establish damages from claims. Forensic accountants also may quantify non-transactional damages, such as those arising from non-disclosure agreement breaches or trademark infringements. During divorce litigation, a forensic accountant may scrutinize financial transactions to uncover hidden assets or violations of contract.

Forensic accountants must be comfortable with public speaking and preparing and presenting data; as previously mentioned, a forensic accountant may be called upon in court as an expert witness. The accountant must aggregate and analyze data before synthesizing it into an easily understandable visual aid when this happens. Then, during the court date, the accountant must present this data in a concise and easily digestible manner.

Related Reading: Catch-Up Bookkeeping Services

What Industries Use Forensic Accountants?

There are several industries that typically make use of forensic accountants, including: 

Insurance

The insurance industry is one of the most common employers of forensic accountants. When a client makes a claim, be it for an automobile accident, medical malpractice, negligence, or something else, the forensic accountant’s job is to quantify the resulting financial damages.

Police

Some police departments employ forensic accountants dedicated to criminal matters. These accountants investigate claims of criminal fraud and serve as expert witnesses in criminal court.

Governmental Agencies

The FBI employs forensic accountants to investigate federal financial crimes such as check fraud, credit card fraud, mortgage fraud, bank fraud, and more. The Securities and Exchange Commission (SEC) employs forensic accountants to investigate market manipulation and insider trading. In addition, the Treasury Department employs forensic accountants through the IRS to crack down on tax evaders.

Public Accounting Firms

Public accounting firms employ forensic accountants for use in litigation, typically divorce or non-business-related matters. During divorce proceedings, these accountants seek to find hidden assets or financial breaches of contract. In other contexts, public forensic accountants may seek to quantify damages in civil court.

Notable Forensic Accounting Cases

Bernie Madoff’s Ponzi Scheme

As the 2008 financial crisis raged, many Americans were reeling from the blow. However, Bernie Madoff was not; the rogue financier had been defrauding investors out of more than $10 billion over the past 17 years. Unbeknownst to Madoff at the time, however, forensic accountants were putting the finishing touches on an irrefutable mountain of evidence against him.

Using masterfully-fabricated claims, Madoff attracted thousands of investors to his scheme. Then, in a Ponzi-style fashion, Madoff used capital from new investors to pay off old investors seeking to cash out. As long as Madoff could find new investors, his scheme could continue. However, when the markets crashed, his scheme crashed with it. Forensic accountants had all the evidence they needed for a conviction. For decades, Madoff made off with an eye-watering sum of money — and he was handed an eye-watering sentence to go along with it. Courts ordered Madoff to serve 150 years in prison and forfeit over $170 billion in assets.

Al Capone’s Taxes

In the 1920s, the FBI spent years trying to take down notorious mobster Al Capone. Known for running illicit businesses such as speakeasies, distilleries, and gambling rings, he meticulously covered his tracks, making conviction nearly impossible in a court of law. Due to his diligence, he was able to freely operate his criminal empire. However, forensic accounting ended up being the mobster’s undoing; over two years, IRS accountants collected evidence that Capone wasn’t paying taxes on his illicit income and spending dirty money. After collecting enough irrefutable evidence, Capone was tried and imprisoned for tax evasion, shattering his racketeering network.

The Enron Scandal

Since the ’80s, energy company Enron had been committing fraud; the C-suite worked together with the accounting team to stash millions of dollars in debt from sight. However, this web of lies came undone in 2001 when Enron’s share price collapsed from $90 to just $1 in just a year. Sensing suspicious activities, the SEC decided to open an investigation. SEC forensic accountants pored over Enron’s financial statements, bringing the corporation’s “creative” accounting techniques to light — hiding debt in partnerships, intentional misinterpretations of financial records, and stock inflation, to name a few. After conducting a criminal investigation, the court convicted Enron CEO and COO Jeff Skilling on several felony fraud charges and sentenced him to 24 years in prison, although this was later reduced to 14 years. In addition, former Enron CEO Kenneth Lay was convicted of ten counts of securities fraud, although the judge vacated Lay’s convictions upon his death.

Related Reading: Bookkeeping vs. Accounting

How Forensic Accounting Can Save Your Small Business

While the notable cases mentioned above entail unthinkable sums of money, the reality is that most fraud cases happen on a smaller scale. Unfortunately, with median losses of  $125,000, it is still enough to cripple a small business. If you find yourself falling victim to payroll fraud, benefits fraud, or any other type of business fraud, hiring forensic accountants to track down and recoup fraud damages is essential.

To prevent fraud from happening in the first place, however, you must take a proactive approach to your accounting. Hiring experts to manage your small business bookkeeping services, such as the professionals at FinancePal, is crucial for having clear, concise, comprehensive, and correct financial statements that can protect your business — and your assets — from fraud.

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What is GAAP?

Ubiquitous in the worlds of business and finance, GAAP is an acronym for Generally Accepted Accounting Principles. GAAP refers to a common set of accounting standards, principles, and procedures issued by the Financial Accounting Standards Board (FASB). An external audit usually determines GAAP compliance.

GAAP is sometimes qualified as the U.S. Generally Accepted Accounting Principles in international dealings since it sees primary use within the United States. While businesses with under $5 million in yearly revenue are not required to follow GAAP, many do. However, those that do bring in $5 million or more per year must follow the GAAP guidelines to avoid possible fees, fines, and even criminal charges. 

Regardless of revenue, the Securities and Exchange Commission (SEC) mandates that all publicly-traded companies adhere to GAAP. While not required by law for non-publicly traded companies bringing in less than $5 million annually, GAAP compliance is still critical for cultivating a favorable perception from creditors and lenders. Most banks and financial institutions require GAAP-compliant financial statements when issuing business loans.

The 10 Principles of GAAP

GAAP is comprised of ten core tenets or principles. While GAAP may apply differently depending on whether a business uses cash vs. accrual accounting, the general principles remain the same. These principles are: 

1. The Principle of Regularity: The adherence to GAAP rules and regulations as a standard.
2. The Principle of Consistency: The application of the same standards throughout the reporting process to ensure financial comparability between periods.
3. The Principle of Sincerity: The provision of an accurate and impartial depiction of a company’s financial situation.
4. The Principle of Permanence of Methods: The commitment to using procedures used that are consistent, allowing comparison of the company’s financial information.
5. The Principle of Non-Compensation: The reporting of both positives and negatives with complete transparency and without the expectation of debt compensation.
6. The Principle of Prudence: The commitment to using fact-based financial data representation without speculation.
7. The Principle of Continuity: The commitment to operating a business while simultaneously valuing assets.
8. The Principle of Periodicity: The reporting of revenue during the appropriate accounting period.
9. The Principle of Materiality: The commitment to fully disclose all financial data and accounting information in financial reports.
10. The Principle of Uberrimae Fidei (utmost good faith): The commitment to honesty in all transactions.

What is IFRS?

IFRS, which stands for International Financial Reporting Standards, are principle-based reporting guidelines primarily utilized outside of the United States — in fact, more than 144 nations have committed to using IFRS. The IFRS are administered by the IASB or International Accounting Standards Board. 

With business dealings being notoriously opaque in the past, IFRS was explicitly designed to prioritize transparency for the sake of lenders and investors alike. The IFRS contains detailed instructions for record-keeping and financial reporting alongside guidelines for universal accounting practices.

What Does IFRA Require?

IFRS contains guidelines for creating five mandatory financial statements:

1. Statement of Financial Position: This document is equivalent to the balance sheet.
2. Statement of Cash Flows: This statement outlines financial transactions conducted during a specific period broken into three categories: operations, investing, and financing.
3. Statement of Comprehensive Income: Similar to a profit and loss statement, but this document also includes non-direct income.
4. Statement of Changes in Equity: Essential for investors, this statement details a business’s change in earnings during a specific period. Often, the statement of changes in equity is referred to as a statement of retained earnings.
5. Accounting Policy Report: While not a financial statement, this report details a business’s accounting approach to safeguard against strategically opaque accounting practices. 

Related Reading: Accounts Receivable

What is the Difference Between GAAP and IFRS?

As previously mentioned, the most notable difference between the two standards is their scope; while GAAP is primarily prevalent only in the United States, IFRS is used worldwide. This may change in the future — the SEC has been coaxing an American shift to the IFRS for some time now — but many American businesses do not see this transition as a priority. 

Another significant difference is that while GAAP seeks to enforce rules, IFRS is guided by principles. This becomes apparent in each standard’s language — while GAAP is rather particular, IFRS provides a more general overview of its tenets. As a result, IFRS does allow some room for interpretation. However, many experts consider IFRS to be more effective and representative of applicable business reporting, likely due to its inherent logic. 

Another primary difference is IFRS’s treatment of “intangible assets” — assets that, while not physical in nature, help a business’s bottom line. Common examples of intangible assets are concepts like brand recognition, brand goodwill, and intellectual property. Whereas GAAP does not provide guidelines for reporting intangible assets, IFRS very much does. 

Related Reading: eCommerce Accounting 

When running a small business, a highly competent financial team can provide essential business insights, find crucial tax savings, and allow business owners to spend less time stressing the financials and more time serving customers. Sign up to get a custom quote today for FinancePal’s professional financial services.

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When applying for a business loan, it is crucial to account for the 5 C’s of credit — character, capacity, capital, collateral, and conditions — to maximize your chances of favorable terms and loan approval. Commonly used as metrics by any lender, the 5 C’s paint an objective, holistic picture of your — and your business’s — creditworthiness. This article examines the five C’s of credit: what they are, how they are measured, their significance — and how you can master your C’s.

What are the 5 C’s of Credit?

The 5 C’s of Credit refer to character, capacity, capital, collateral, and conditions. Lenders utilize these five metrics to determine creditworthiness, adjust terms, and extend loan approval.

1. Character

Commonly referred to as Character, the first C of Credit is assessed based on credit history. The borrower’s credit history is considered using their credit reports generated by the three major credit bureaus — TransUnion, Experian, and Equifax. The purpose of scrutinizing these credit reports is to determine “creditworthiness” — basically, the quality of the borrower. To assess creditworthiness, lenders consider whether the borrower has taken out loans in the past — and if they have repaid them on time. Lenders will also look into information regarding collection accounts and bankruptcies.

The purpose of determining a borrower’s character, or credit history, is to provide lenders with information that can be used to gauge a borrower’s credit risk. Many lenders require potential borrowers to have a minimum credit score before approving them for a loan. These credit score requirements may differ between lenders and loan packages. As logic indicates, having a higher credit score increases the likelihood of loan approval. A borrower’s credit score doesn’t just determine the likelihood of approval; a better credit score can lead to more favorable loan rates and terms.

2. Capacity

Capacity measures the borrower’s projected ability to repay a loan by considering their income against recurring debts. When determining a borrower’s capacity, the primary metric to consider is the borrower’s debt-to-income (DTI) ratio. To calculate DTI, lenders divide the sum of the prospective borrower’s total monthly debt payments by their gross monthly income. A lower DTI improves the borrower’s chance of qualification. For most lenders, the DTI “sweet spot” would be — at most — 35%.

If your DTI is high enough, you may actually be prohibited from receiving certain loans. For example, with a DTI of 44% or higher, a borrower will generally not qualify for a new mortgage.

3. Capital

When considering a borrower, lenders take stock of any capital that the borrower earmarks for a potential investment; in principle, more capital decreases the chance of default. For example, a borrower with the capital to pay down a home will find it much easier to be approved for a mortgage. This correlation even extends to specialized accessible mortgages, such as Federal Housing Administration (FHA) or Veterans Affairs (VA) loans, which often require potential borrowers to use their capital to cover at least 3.5% of a home’s buying price.

Capital is also crucial for any borrower seeking to obtain optimal loan rates or terms. Let’s take another example using mortgages: with a down payment of at least 20%, many borrowers can avoid the lender requiring the purchase of additional mortgage insurance.

4. Collateral

Put simply, collateral is a tool to give the borrower further incentive to avoid defaulting on loans. In addition, Collateral acts as insurance for the lender; if the borrower defaults on the outstanding amount, the lender can repossess the collateral. Collateral is often used for auto loans and mortgages since the collateral object is typically the subject of the loan: in this case, cars or houses, respectively. Because of this, collateral-backed loans are often categorized as “secured.” Secured loans are widely considered to be less risky for lenders to issue due to the recourse they offer — and as a result, collateral-secured loans typically qualify for lower interest rates and better terms compared to unsecured financing.

5. Conditions

When considering giving a loan, lenders take into account the conditions of the loan — interest rate, principal amount, and more. How conditions’ favorability influences the lender’s propensity to approve the prospective borrower. For the sake of example, consider a potential borrower who applies for an auto loan. Because this loan has an express inherent purpose, a lender may be predisposed to approve the loans. On the other side of the spectrum sit what are known as signature loans. As opposed to auto and home loans, signature loans do not have an express inherent purpose. Because of this, lenders are warier to approve borrowers who apply for signature loans.

The interest rate, principal amount, and purpose of a loan are conditions that the borrower influences. However, lenders may also consider conditions that are outside of the borrower’s control. These conditions include, but are not limited to, the current performance of the economy and pending legislation.

Related Reading: Small Business Tax Preparation

Why are the 5 C’s important?

The five C’s of credit are crucial when applying for a business loan. Together, they paint a clear, objective picture of your creditworthiness to potential lenders, including underwriters, banks, or credit unions. The health of your five C’s can have a drastic impact on your loan application process, influencing rates, terms — and even approval. 

Related Reading: Double Taxation

How to Master the 5 C’s of Credit

Character

To master your business’s character, build a relationship with your bank or primary lender. By building a relationship that conveys your business in a positive light, your lender may be more inclined to offer favorable terms and approval.

Capacity

Have your accountants stay on top of your cash flow. Also, try paying down your debt before you apply for more loans.

Capital

Maintain an updated Statement of Owner’s Equity, which documents your investments into the company. Small businesses owners who tie more personal money into their business tend to be viewed more favorably by lenders. In addition, know how to value of your small business.

Collateral

Choosing the optimal business structure is crucial to prevent your personal assets from being seized as collateral. Talk with an attorney about forming a legal entity if you haven’t already.

Conditions

Stay on top of the ebbs and flows within the economy. If you become skilled at predicting the shifts, you can stay ahead of the curve and optimize the timing of your loans.

Our knowledgeable financial experts can help your business ensure you remain in good standing and preserve your fiscal health. Sign up to get a custom quote today for FinancePal’s professional financial services.

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It’s a saying almost as old as recorded history: never borrow more than you can payback. Since the days of ancient Mesopotamia, businesses have been borrowing money to bolster operations with the intent of resolving the debt with the ensuing cash flow. In modern times, companies can determine how their cash flow compares to their debt using a metric called debt service coverage ratio, or DSCR. This article examines the debt service coverage ratio, what it means, how to calculate it, and why it’s essential.

What is the Debt Service Coverage Ratio?

In personal, government, and corporate finance, the debt service coverage ratio is a metric that can be used to determine whether a debtor has enough capital to pay off a creditor. In the business world, the debt service coverage ratio measures how much of a company’s available cash flow can be used to cover its current debt obligations. The debt service coverage ratio is an essential tool for investors, who can use this metric to determine whether a business can settle its debts using cash flow.

What Does the Debt Service Coverage Ratio Mean?

Whether in the context of personal finance, government operations, or corporate finance, the debt service coverage ratio reflects the ability to pay off debt obligations using a specific amount of income.

Before approving a loan, lenders will typically assess a borrower’s debt service coverage ratio. The minimum debt service coverage ratio a lender will demand will vary based on the prevailing economic conditions. In a growing economy where credit is more readily available, lenders may, in turn, be more lenient with their minimums. It is important to note that a glut of less-qualified borrowers can affect macroeconomic stability. This happened in the run-up to the 2008 financial crisis.

If a debt service coverage ratio is less than 1, it indicates negative cash flow — and that the borrower will be unable to cover or pay current debts without falling back on outside help or taking on more debt. 

Let’s take an example: a small business has a debt service coverage ratio of 0.98, which means that, at current net operating income, the borrower will only be able to cover 98% of their debt obligation annually. In this scenario, this would mean that the business owner would need to invest personal funds every month to keep their business above water — or worse, take on more debt. Most lenders take a rather negative view on a negative cash flow; however, if the business has enough resources or backing, they may relent and provide additional support.

Suppose the debt service coverage ratio is too close to 1. In that case, it means that the business is in a precarious position — any decline in cash flow for any reason could cause the company to lose the ability to service its obligations. In some cases, lenders can require a borrower to maintain a minimum debt service coverage ratio for the duration of the loan. In fact, some loan agreements contain a provision that considers falling below the agreed-upon debt service coverage ratio a default.

If a company maintains a debt service coverage ratio greater than 1, it means that the business has enough cash flow to pay its current debt obligations. This is an ideal scenario for lenders and businesses alike.

Why is the Debt Service Coverage Ratio Important?

The debt service coverage ratio is a ubiquitous metric, often referenced by companies and banks when negotiating loan contracts. For example, a company seeking to obtain a line of credit might be obligated to keep its debt service coverage ratio above 1.2. If the DSCR falls below this mark, the lender may consider the loan to be in default. In addition to serving as a crucial risk-management metric for banks, debt service coverage ratios can also provide insights to analysts and investors regarding a business’s financial health.

What is considered a good debt service coverage ratio varies based on a company’s sector, competitors, and development stage. For instance, a smaller company in its nascence might face lower expectations in regards to debt service coverage ratio expectations compared to a mature, well-established business. However, a good rule of thumb is that a debt service coverage ratio above 1.25 is considered strong — and ratios that fall below 1.00 indicate that a business could be in trouble.

Related Reading: How to Prepare a Profit and Loss Statement

Debt Service Coverage Ratio Formula

There are two ways to calculate your debt service coverage ratio where:

•     Capex = Capital Expenditure
•     Interest = the interest accrued on debts
•     Principal = the initial loan amount
•   EBITDA = Earnings Before Interest, Tax, Depreciation, and Amortization. Often referred to as net operating, EBITDA is calculated by subtracting overhead and operating expenses — rent, cost of goods, freight, utilities, and wages — from revenue. The resulting figure portrays the amount of cash available to keep the business running after subtracting necessary expenses.

Method One (without Capex)

To find your DSCR using the first method, add your interest amount and your principal amount. Then, divide your EBITDA by the resulting sum. This formula will look like this:

Debt Service Coverage Ratio = EBITDA / (Principal + Interest)

Method Two (with Capex)

To find your DSCR using the second method, add your EBITDA and your Capex. Then, divide the sum by your interest amount plus your principal amount. This formula should look like this:

Debt Service Coverage Ratio = (EBITDA + Capex) / (Principal + Interest)

Because capital expenditure (Capex) is not expensed on the income statement (rather, it is considered as an (investment), some businesses may feel more inclined to use the first formula.

Debt Service Coverage Ratio Example

Let’s say a local food truck restaurant wants to purchase a brick-and-mortar location. The food truck owner seeks to obtain a mortgage loan from a local bank. The lender needs to determine the food truck’s debt service coverage ratio. The reason for this is to determine whether the food truck owner will be able to pay off their loan as the physical location generates income.

The food truck owner predicts net operating income to be around $800,000 per year, and the lender notes that debt service will be $300,000 per year. In this case, the debt service coverage ratio formula will look like this:

Debt Service coverage ratio = $850,000 / $300,000 = 2.83

This means the food truck owner can comfortably pay off the debt obligation.

Related Reading: Balance Sheet for Small Businesses

Interest Coverage Ratio vs. Debt Service Coverage Ratio

​​As opposed to the debt service coverage ratio, the interest coverage ratio (ICR) measures whether a company’s cash flow will cover the interest it must pay on all debt obligations during a specific period. Much like with a DSCR, the ICR is expressed as a ratio.

To calculate the interest coverage ratio, divide the EBITDA by the total interest payments due for that same period, like so:

Interest Coverage Ratio = EBITDA / Interest

The higher the ratio of EBITDA to interest payments, the more financially stable the company. This metric only considers interest payments — not payments made on principal debt balances — which lenders may require. 

The debt service coverage ratio is a more comprehensive metric. The DSCR measures a company’s ability to meet its minimum principal and its interest payments — including sinking fund payments — for a given period. Because the debt service coverage ratio takes principal payments and interest into account, the debt service coverage ratio provides a more holistic, comprehensive overview of a business’s financial health.

Related Reading: Taxable Income Formula

It is easy to think of small business accounting and bookkeeping as necessary evils to keep the IRS off your back. But a highly competent financial team can provide essential business insights, find crucial tax savings, and allow business owners to spend less time stressing the financials and more time serving customers. Sign up to get a custom quote today for FinancePal’s professional financial services.

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1. The Adjusted Net Asset Method

A strong balance sheet can facilitate Asset-based valuation. This is because asset-based valuation largely mirrors what is shown on a business’s balance sheet. To use this method, start by totaling the value of your business’s assets before subtracting its liabilities. This should give you the starting value.

To get a more realistic valuation, you may have to weigh the numbers differently. The adjusted net asset method requires knowledge of the business, your industry, and current markets to change the value of the assets and liabilities. For example, you may have accounts receivable that are assets on your books, but you know you won’t likely collect the total amount. If this is the case, you may want to adjust your assets down to reflect their likely real-world values.

 The adjusted net asset method is at its best when used to value a business that doesn’t have an abundance of earnings—or is even losing money. It is a commonly-used valuation method for holding companies that own parts of other companies or real estate investments. It is also helpful if you’re considering selling your business—this valuation method is quite useful when used to set a reasonable baseline price.

2. The Capitalization of Cash Flow Method

The capitalization of cash flow (CCF) method has the virtue of being simple; after all, it is the simpler of the two primary income-based methods that business owners use when valuing income-generating businesses.

To calculate the business’s value using the capitalization of cash flow method, divide the cash flow from a specific period by a certain capitalization rate. You will want to use one period’s worth of sustainable and recurring cash flow—you may need to make adjustments for recent one-off expenses or revenue outliers that you don’t wish to include in the results for the sake of clarity.

 The capitalization rate—also known as cap rate—refers to a business’s expected rate of return. This is the rate of return a potential buyer could expect to earn if they purchase the company. For small businesses, this figure often hovers around 20% to 25%.

The simplicity of the CCF method makes it less conducive to making business predictions or speculations. However, the CCF method can be a practical valuation method for those valuing a more mature business that is relatively unlikely to experience large or inconsistent swings in cash flow.

3. The Discounted Cash Flow Method

The discounted cash flow (DCF) method refers to yet another income-based method. The DCF method utilizes a business’s projected future cash flow alongside the time value of money to calculate the business’s current value. While the CCF is most optimized for enterprises that already boast steady cash flows, the DCF is optimized for companies with more unpredictable futures that may grow or shrink significantly in the coming years.

The time value of money refers to the notion that money is worth more today than it will be in the future. This may seem confusing at first, so let’s look at an example: if you have ten thousand today, you can invest the money, earn interest, and have more than ten thousand dollars in five years. The discounted cash flow model accounts for this, so it can also be helpful for comparing different investment opportunities.

While calculations can tend to be complicated, you can find online valuation calculators—but you will still need to know which numbers to plug in.

A company’s cash flow statement is an ideal jumping-off point, alongside projected cash flows—if they’ve already been created, of course. In addition, you must know the discount rate—otherwise known as the weighted average cost of capital (WACC)—which may require even more complicated calculations. The WACC is the rate the company needs to pay to finance its working capital alongside its long-term debts. Additionally, you must decide how many years’ worth of cash flows you want to include in your valuation.

4. The Market-Based Valuation Method

Market-based valuation relies less on specific business characteristics than current market conditions. When using the market-based valuation method, the company’s current value is determined by comparing the recent sale prices of similar businesses.

Finding comparable business sale prices may be challenging if you are valuing a smaller business. However, you will still want to look for at least a few similar sales if you plan on buying or selling a business. If you need help, you can hire an appraiser; they may also have exclusive access to large databases of business sale figures.

Even if the comparable sales aren’t located in the region your business is in, an appraiser may be able to identify similarly-sized firms within the same or similar industry before making adjustments to reflect your area. It is possible to utilize these results alongside other valuation methods to better value a business.

5. The Seller’s Discretionary Earnings Method

The previously mentioned valuation methods are great methods to use for businesses of all sizes. However, the seller’s discretionary earnings (SDE) method is utilized for small business valuation exclusively.

The SDE method might be optimal if you’re planning on selling or buying a small business. This is because it helps the buyer ascertain how much income they can expect to earn each year from the company. To calculate the SDE, you will first need to determine the operating costs of the business.

It is best to start with the business’s earnings before interest and taxes—referred to as the acronym EBIT—which you can find on its financial statements. Subsequently, add the owner’s compensation and benefits. Also, total non-essential, non-recurring, and non-related business expenses, including travel, one-off consultancy fees, and more.

Because the SDE is most often used at the time of a small business sale, it’s typical for debates about some of the numbers to ensue — especially regarding the expenses that get added back to determine the value.

Let’s take an example: the seller of a small business might want to classify a marketing project as a one-time expense and subsequently plug that portion back into the earnings in order to increase the valuation. However, the buyer might consider this to be an ongoing project that needs to be revisited and funded annually. For the sale to move forward, they must come to an accord.

Related: Profitable Small Business Ideas

Why should I value my small business?

There are a plethora of reasons to value your small business. Here’s just a few:

• You are trying to sell your business. If this is the case, acquiring a reasonable valuation will help you get the best possible price—with the least amount of uncertainty.
• You’re trying to attract outside investors. Investors want a clear picture of a business’s current value and projected value so they can determine whether they will likely receive an optimal return or not.
• You’re buying out the owners. Ascertaining a business’s value before buying out the owners is crucial for avoiding future headaches.
• You’re offering your employees equity. Knowing your company’s value is crucial before providing equity. You don’t want to over serve—and your employees may get upset if they feel their equity doesn’t adequately reflect your business’s value.
• You’re applying for a loan or line of credit. Your business’s value will serve as collateral, so it is integral to the loan application process.
• You want to understand your business’s growth better. Valuing a small business using the optimal method can be very insightful when gauging your company’s projected financial health.

Related: Bookkeeping Accounting for Small Businesses

How to Prepare for a Small Business Valuation

If you’re conducting an informal business valuation, you could do this entirely internally. However, suppose you value your company for a sale or another more serious matter. In that case, it is definitely worth hiring a professional appraiser or business valuation expert such as a bank, lender, or accountant. Whether informal or serious, always take these steps to prepare for a valuation:

1. Aggregate Your Financial Documents

Any valuation will be based on managing your small business finances. Even the market-based valuation method synthesizes your business’s financial information to find suitable comparable sales.

You can start by preparing the previous three to five years’ worth of business tax returns, balance sheets, income statements, and cash flow statements. Give each of these statements a thorough look in order to confirm their accuracy.

If you are undertaking a market-based valuation or a DCF, prepare finance-related documents, such as sales reports and industry forecasts.

2. Get Your Other Essential Documents in Order

It depends on the cause for the valuation, but you might want copies of your business licenses, permits, deeds, and certifications available. In addition, prepare documentation for any ongoing contracts with insurers, creditors, vendors, and clients, if applicable.

If you are looking for loans—or selling your business—you will need to share these. You should also prepare your business credit score and reports.

3. Organize Intangible Assets

Your balance sheet should list your tangible assets—cash, property, and equipment. Some intangible assets, such as patents or copyrights, may be listed alongside your tangible assets. However, you must consider your other intangible assets that may contribute to your company’s value, such as client data, SEO rankings, social media presence, and online reputation scores are all examples of intangible assets that may contribute value.

Related: Small Business Tax Preparation

How to Improve Your Small Business’s Valuation

More than anything, Your company’s valuation will reflect how much money it makes. That is why increasing your revenue and cutting your costs are crucial components to improving your business’s valuation. You can also hire a professional appraiser or evaluator to give you the best current valuation and help you identify your company’s strengths and weaknesses. The appraiser or evaluator might even offer insights for valuation improvement based on their experiences working for other businesses.

You can also demonstrate your company’s value to potential buyers in ways that go beyond the numbers. For example, if you can demonstrate that your operations, processes, and systems are in place and running smoothly for years to come, buyers may be more likely to reach an agreement on a higher valuation. Maybe you can demonstrate how happy and productive your employees are—lowered turnover can save the business money, after all, and functional employees can facilitate the transition to new ownership.

And when you do sell, it is essential to accept that you are at the mercy of the market. You may need to compromise on your valuation if the market doesn’t corroborate it. If you need a return on your investment orre you do not have time to be patient while selling, then you cannot be resolute with your valuation.

After all, your company is only worth what the market dictates. If your industry gets devalued for any reason, such as the coronavirus, you may place a higher value on your business than the market does. Business is all about leverage. Timing and the greater need for your business within the marketplace still matter, of course. Business is always about leverage. You don’t often get what you feel you deserve; it’s all about what you negotiate.

The Virtue of Regularly Valuing Your Small Business

Regularly valuing your company can be crucial for small business owners for many reasons. Even if you’re not planning on selling your business or applying for loans, consistently undertaking business valuations can shed insight into your company’s progress over a period of time—and may help you uncover growth opportunities. 

Key Takeaways:

The 5 Main Methods of Business Valuation:

• The Adjusted Net Asset Method: This method is ideal for valuing a business that doesn’t have an abundance of revenue or is losing money. It is commonly used for holding companies that own parts of other companies or real estate investments. It is also helpful if you’re considering selling your business or setting a reasonable baseline price.
•  The Capitalization of Cash Flow Method: This method divides the cash flow from a specific period by a capitalization rate. You will want to use one period’s worth of sustainable and recurring cash flow.
• The Discounted Cash Flow Method: This method utilizes a business’s projected future cash flow alongside the time value of money to calculate the business’s current value. While the CCF is most optimized for enterprises that already boast steady cash flows, the DCF is optimized for companies with more unpredictable futures that may grow or shrink significantly in the coming years.
• The Market-Based Valuation Method: This method relies less on specific business characteristics than current market conditions. When using the market-based valuation method, the company’s current value is determined by comparing the recent sale prices of similar businesses. If the comparable sales aren’t located in the region your business is situated in, an appraiser may be able to identify similarly-sized firms within the same or similar industry before making adjustments.
• The Seller’s Discretionary Earnings Method: This method is optimal if you plan to sell or buy a small business. It helps the buyer ascertain how much income they can expect to earn each year from the company.

Reasons to Value your Business:

• You are trying to sell your business.
• You’re trying to attract outside investors.
• You’re buying out the owners.
• You’re offering your employees equity.
• You’re applying for a loan or line of credit.
• You want to understand your business’s growth better.

Prepare for a Business Valuation:

• Aggregate Your Financial Documents: Prepare the previous three to five years’ worth of business tax returns, balance sheets, income statements, and cash flow statements. If you are undertaking a market-based valuation or a DCF, prepare finance-related documents.
• Get Your Other Essential Documents in Order: You might want copies of your business licenses, permits, deeds, and certifications available. In addition, prepare documentation for any ongoing contracts with insurers, creditors, vendors, and clients, if applicable.
• Organize Intangible Assets: You must consider your other intangible assets that may contribute to your company’s value, such as client data, SEO rankings, social media presence, and online reputation scores.

The post How to Value a Small Business: The 5 Main Methods appeared first on financepal.

In 2015, a California regulatory agency posed a similar question to Uber, and they weren’t satisfied with the answer.  They went on to conclude that Uber’s drivers were employees.  Subsequently, nearly 400,000 Uber drivers in CA and MA reached a $100 million settlement with the company in 2016 (later thrown out by a federal court as insufficient compensation). 

While Uber may serve as a poster child in this vexing area of employment law, no business, however large or small, is exempt from the requirements and the penalties for failure to comply. In this essential guide, we provide you with some practical tips to help you understand the differences.

Guide to Contents

• Setting the stage
• But why does it matter?
• How to get it right
• What happens if I’m wrong?
• Conclusion

Setting the stage

The debate over worker misclassification pervades the modern workforce and economy. In the United States, a multitude of employment arrangements exist.  For instance, some workers are part-time while others are full-time.  Some are salaried employees, while others work on an hourly basis.  One of the more complicated, and important, classifications is between employees and independent contractors.

These differences may seem like academic labels used merely to categorize the American workforce. However, in practice, they have far-reaching implications for employers (and employees too) on everything from worker rights to taxation, to compensation.

An important initial step in onboarding any employee is determining whether he or she is an employee or an independent contractor.  Employers that misclassify their workers—whether by accident, negligence or wilfully —face financial penalties and other legal ramifications.  Thus, as an employer, you must understand the difference between an employee and an independent contractor.

But why does it matter?

It’s really quite simple: Taxes. Sure, other reasons exist, but none more paramount than taxes. If an employer classifies a worker as an employee, it needs to withhold, deposit, report, and pay employment taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid. The IRS also has filing requirements for employees.

On the other hand, for “independent contractors”, the employer is subjected to a much lower compliance standard. Independent contractors arrange and pay their own income tax quarterly, they receive no benefits and aren’t eligible for unemployment insurance.

Not withholding taxes and benefits (or incorrectly withholding them) doesn’t just put an undue burden on employees and contractors. If you “misclassify” a worker and fail to correctly withhold or pay the required amounts, the IRS may flag your business and pursue you for the money, penalties and interest (which can be excessive).

For the employee, the impacts of misclassification are almost always the same: below-market wages, no benefits, and increased exposure to risks. And when misclassification is adopted as a business strategy by some companies, it disadvantages competitors who bear the costs of compliance with labour standards and responsibilities.

How to get it right

In certain situations, the line between employee and contractor can get incredibly pale.  But the difficulty is no excuse,  as the employer is responsible to make an accurate and consistent classification for each new hire.  Thankfully, the IRS has provided some guidance to help (at least at the federal level). Four key gating questions to ask are:

1. Does the company control what the worker does?
2. Does the company administer the financial and business aspects of the worker’s job (how the worker is paid, reimbursement of expenses)?
3. Does the company provide common benefits to the worker (ie. personal time-off, 401k plans, pensions, health or dental insurance)?
4. Does the company provide the equipment and/or tools needed to complete the worker’s job?

While each factor is considered, the IRS cautions that no single factor is dispositive. Control is of particular importance.  State and federal agencies, such as the IRS, normally rely on the “right of control” test to determine whether a worker is an employee or independent contractor.  If an employer controls when and how a worker performs the job, that militates in favour of employee status. On the other hand, if the company’s input is limited to accepting or rejecting the final results (much like you would with a painter at your house), then independent contractor classification seems correct.

While a survey of 50 state laws around classification is well beyond the scope of this article, it’s worth noting that the home state of the company and the worker will also have an interest in the classification, as it has implications for workers’ compensation and unemployment insurance laws. Most tend to rely heavily on control, but also focus on other factors. Most good small business lawyers will be able to help you with the classification, and with multiple employees on the books, you’ll likely need payroll and accounting help too.

What happens if I’m wrong?

The legal consequences of misclassification will include, at minimum, payment of back taxes.  The financial exposure increases if misclassification was intentional, and repeat-offenders will incur substantial financial penalties (in some cases even jail-time).  In addition to back taxes payable at the federal level, the business will also owe state unemployment taxes and unpaid workers’ compensation premiums and may owe unpaid overtime or minimum wages, medical expenses and unpaid vacation and sick pay.

Also, as noted, each state has an interest in the employee/contractor classification, so applicable penalties will likely be two-fold, once at the federal level and again at the state level.

Conclusion

Remember that state and federal tests as to proper classification will apply irrespective of the parties’ intent and contract language. Any business currently using independent contractors on a regular basis should review those relationships based upon the tests described in this article. If a company is not certain about the proper classification of its workers, a business attorney with employment expertise can assist with the analysis. The IRS, Department of Labor and state regulatory bodies are all paying attention even if you are not.

The post The Essential Guide to Navigating the Independent Contractor v. Employee Minefield appeared first on financepal.

• What Is Zero-Based Budgeting?
• Zero-Based Budgeting Example
• What Are the Advantages of Zero-Based Budgeting?
• What are the Disadvantages of Zero-Based Budgeting?
• How to Start Zero-Based Budgeting
• The Zero-Based Budget Renaissance
• Is Zero-Based Budgeting Right for Your Business?

What Is Zero-Based Budgeting?

Zero-based budgeting is a budgeting philosophy that entails allocating precisely 100% of income to covering expenses. The name comes from this philosophy’s core tenet—at the end of each budgeting period, the total revenue minus total expenses should equal zero.

Zero-based budgeting provides an alternative to traditional budgeting, which calls for incremental increases over previous budgets. Traditional budgets, or line item budgets, tend to fall short because it focuses mainly on new expenditures. Zero-based budgeting, however, shifts the paradigm so that you need to justify every single expense with each new budgeting period. The result of this added need for justification is a more informed, less bottom-heavy budget.

There are five fundamental characteristics distinctive to zero-based budgeting:

1. Within an organization, all levels participate in the decision-making process.
2. Items are broken down into “business units”.
3. Each unit is given a value (the cost it will incur) that it must justify in order to make the final budget.
4. Units are further assessed based on their alignment with corporate objectives.
5. The budget must be flexible and accommodating of instant adjustments, if necessary.

The reason for using business units instead of departments is because the zero-based budget philosophy emphasizes revenue-generating activities instead of operational departments.

Zero-Based Budgeting Example

For the sake of example, let’s take a look at a small car rental company. After each rental is returned, the car needs to have its interior cleaned. This company has been contracting this out to a private cleaning company for the past five years. 

After implementing the zero-based budget philosophy, the business owner looks at older, recurring spending to trim some fat and hit net zero. After poring over his financial statements, he finds that the contractor has been raising their rate by 3% each year—and at the current rate, it would be cheaper to hire a full-time, in-house cleaner.

This is where zero-based budgeting shines; old expenses such as startup costs tend to fly under the radar when crafting a traditional budget. Over-budgeting is very common, and if previous over-budgeting is not addressed, budget bloat can multiply with each incremental revision.

What Are the Advantages of Zero-Based Budgeting?

As previously mentioned, zero-based budgeting provides business owners with the necessary perspective to slash old, unnecessary expenses and reallocate these funds to more profitable items. In addition, zero-based budgeting is conducive to increased budget flexibility as less money stays tied down in the old budget bloat.

Zero-based budgeting is also a natural fit for growing companies. Many business owners find that as their company grows, expenses outpace revenue, and the gap widens as growth continues. A commitment to maintaining a zero-base budget will allow for controlled growth without saddling your business with debt.

What are the Disadvantages of Zero-Based Budgeting?

Zero-based budgeting isn’t without its share of disadvantages. For example, putting together a zero-based budget is time-intensive and arduous. Without the proper prudence, it can quickly become a recurring time-suck for your accountants.

Additionally, some may argue that a zero-based budget is a shortsighted tool. After all, it is conducive to reallocating funds to currently profitable items. If your business is constantly shifting around its spending to address momentary needs, it may result in inefficiency or even obscure your long-term vision. 

Zero-based budgeting also only works if the budget is crafted by those with the business’s best interests at heart. It is possible for somebody to fabricate justification of a pet project in order to over-allocate funds to that project.

Related: Catch-Up Bookkeeping

How to Start Zero-Based Budgeting

If you are thinking about implementing zero-based budgeting for your business, you must first weigh whether it is the right move for you at this point in time. Consult with your accountant or consider the following:

•     Do I have the time and resources to set a zero-based budget at regular intervals?
•     Do I trust the person setting the budget?
•     Are there opportunities to redistribute old spend to new items?

If you answer yes to all three, then setting a zero-based budget may be worth a shot. If you are still on the fence, consider building a traditional budget for the time being. If your expenses are larger than your projected revenue—or if you want to spend more on new items than your budget allows—consider going the zero-based route.

After deciding to set a zero-based budget, follow these three steps to prepare yourself for what comes next:

1. Ascertain your income so that you know exactly what you’re working with.
2. Look at past financial statements to forecast your expenses.
3. Categorize these expenses and sort them into a hierarchy by priority.

After you have finished, you can begin building your zero-based budget yourself or with the help of a specialized small business or startup accountant.

The Zero-Based Budget Renaissance

In today’s tech-focused era, the zero-based budget has experienced something of a rebirth. The proliferation of centralized data repositories for finance has allowed for greater transparency during budget negotiations. In addition, advancements in data analytics have led to more accurate budget estimates. These developments are highly conducive to crafting better zero-based budgets that save more money than ever.

Is Zero-Based Budgeting Right for Your Business?

The answer is maybe. Like most business decisions, the zero-based budget philosophy needs to be considered before it is implemented. When making any decision that may have a significant impact on your business’s financial future, it is always a good idea to consult a professional accountant. Sign up for a consultation with FinancePal today to talk through your options with one of our expert small business accountants!

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Banks and financial institutions prepare this document each month, allowing people and businesses to monitor and evaluate their finances. All small business owners can benefit from regularly reviewing and reconciling their bank statements.

A bank statement likewise allows you to see your income streams, expenses, spending activity, and profits related to the account. Financial experts recommend understanding the bank statement because it helps you make informed decisions and develop better financial habits. 

However, individuals and small business owners often face bank errors, account balance irregularities, and problems with deposits and withdrawals.

Why Reconcile Bank Statements?

Various reasons to reconcile your bank statement include:

• Data entry validation to evaluate and fix irregularities
• Confirmation of financial statement accuracy
• Tax reporting and assessment
• Cash flow monitoring and analysis
• Irregularities in outstanding check and electronic transfers
• Theft control and proper financial management

Keep reading to learn more about reconciling bank statements, using the links below to navigate to the sections that best answer your questions.

• • • What Is Bank Statement Reconciliation?
    • How Do You Reconcile a Bank Statement?
    • How Often Should You Reconcile Your Bank Account?
    • What is the Purpose of Bank Reconciliation?
    • The Bottom Line

   

What Is Bank Statement Reconciliation?

Reconciling your bank statement is an important process that focuses on finding the difference between your bank balance in the statement and the amount in your company’s cash account at the end of the month.

 Small business owners can take advantage of the process to ascertain their true cash balance by identifying discrepancies and irregularities in their bank accounts. For example, if the bank has cashed a check for a different amount, it is considered a bank mistake. Likewise, you have made deposits, but the bank did not record them, it is considered an online banking software error.

 Another reason bank account reconciliation is necessary is to legitimize automatic deposits and withdrawals that the accounting software hasn’t recorded. Payments taken without your knowledge are considered theft or fraud, meaning you need to reconcile your bank to know what happened.

How Do You Reconcile a Bank Statement?

Reconciling a bank statement helps you identify irregularities, possible bank errors, and fraudulent activities that happened in your individual or company’s bank account during the months. The entire process can keep you informed about authorized and unauthorized transactions, uncashed checks, income and expenses reviews, and more. 

Here are the steps for how to prepare a bank reconciliation statement:

Step 1: Compare the Bank Statement and Cash Account

The bank statement reconciliation process usually starts with comparing your individual or company’s statement and ledger cash account. The process requires you to check off all matching items to ensure all items in the ledger have cleared the bank account. After the item clears your company’s bank account, it means the completion of a specific transaction.

Step 2: Add Deposits in Transit

Adding deposits in transit to your ending balance is the second essential step after completing the comparisons process. The process involves focusing on the remaining items in your company’s general ledger and adding deposits in transit to your ending balance. Bear in mind that deposits in transit refer to the documented or recorded deposits in your register. However, you don’t see these deposits in your bank statement.

Step 3: Deduct Outstanding Checks

Once you have added deposits in transit to your ending balance, it is time to deduct outstanding checks from it. Remember, outstanding checks deduct from your register but do not appear on your bank statement.

Step 4: Analyze Bank Errors

Evaluate the ending balance and based on its status, and then add or subtract bank errors to your ending balance. For instance, these could be irregular or incorrect deposits and withdrawals. Make sure you double-check bank errors before adding or deducting them to the ending balance.

Step 5: Deduct Bank Service Charges 

This is a crucial step in the bank statement reconciliation process. You need to deduct bank service charges, such as wire transfer charges, check overage fees, account maintenance charges and returned check fees.

Step 6: Interest Earned and Check Register Errors

Many individuals and small business owners have interest-bearing accounts, allowing them to earn interest on their deposits. For example, depositing money into a savings account or interest-bearing checking account can help you earn interest on your money.

Therefore, when reconciling your bank statement, make sure you add interest earned to the ending balance. Remember, this is not necessary if you don’t have an interest-bearing account. Moreover, add or deduct errors in your check registers, such as a payment omission or a cash transaction.

Step 7: Prepare Journal Entries

The reconciliation process requires you to prepare journal entries. The purpose is to correct errors found in your general ledger and bank statement. Business owners can post items from the bank statement into the general ledger using the journal entries. It is crucial to re-run the ledger cash account after posting all journal entries. That way, you can update your ending balance for each posted item.

Step 8: Compare Adjusted Statements

Once you have updated journal entries for each posted in the ending balance, compare the adjusted general ledger cash balance and reconciled bank statement balance. Make sure the balances are equal. Otherwise, you will have to go through the steps again. The purpose is to adjust the balance for outstanding checks and deposits in transit.

How Often Should You Reconcile Your Bank Account?

Financial and accounting experts recommend reconciling your bank account every month, especially after the bank sends you the statement. However, you can also reconcile your bank account daily or weekly, depending on your business operations, the frequency of transactions, and irregularities in your general ledger and the bank statement.

Bank account reconciliation every month will help you keep track of your transactions. It also enables you to figure out unusual transactions, accounting errors, fraudulent activities and make efforts to fix them. Businesses that fail to perform bank reconciliations regularly are at higher risks of: 

• Bank errors
• Unauthorized withdrawals
• Fraudulent activities
• Cash flow leaks

 Therefore, it is crucial to check your bank statement and perform the reconciliation process daily, weekly, or monthly, depending on your needs. That way, you can avoid problems like cash flow leaks and streamline your business operations.

 Related Reading: Cash vs. Accrual Accounting

What Is the Purpose of Bank Reconciliation?

The primary purpose of preparing your bank reconciliation report is to identify irregularities between the bank and an entity’s accounting records. Research shows that a time difference is the leading cause of such discrepancies on the part of the bank or your company.

Discrepancies are also due to careless, fraudulent, or illegal activity on the part of your business. Reconciling your bank is an effective method to prevent embezzlements and frauds in your company’s funds.

Experts recommend proper handling of your bank reconciliation to identify errors in your company’s accounting records. Good management can also lead to a more streamlined process in revealing errors in your bank account.

Besides, reconciling your bank every month can help you monitor and evaluate your company’s cash flows. It ensures your bank or private financial institution provides you with proper credits and fees.

 A bank reconciliation process also helps you monitor and control internal functions. For example, these include identifying or tracking unauthorized bank withdrawals and figuring out excessive cash turnover.

The Bottom Line

It is common for many companies to come across discrepancies in their accounting records. The difference in your bank balance on the company’s account and your bank statement’s actual balance is often due to a timing difference.

 Certain transactions do not get updated in your bank even after being recorded by the entity, leading to inefficiencies. A bank reconciliation process is vital to ensure everything goes smooth and optimal.

 If your business needs help with reconciling bank statements at regular intervals, contact the professionals at FinancePal today! Outsourcing your accounting and bookkeeping to professionals is the most efficient and cost-effective way to save your business money come tax time. The small business accountants and bookkeepers at FinancePal have helped thousands of small businesses with their financials and taxes on a convenient subscription basis. We specialize in all areas of small business financials, including payroll, accounting for startups and new businesses, financial statement preparation, catch-up bookkeeping, and more! Schedule a consultation with an experienced small business professional today.

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This article weighs the unique advantages and challenges that small business owners face. If you are an entrepreneur considering starting your own business or expanding your current one, apply these advantages and challenges to your current situation to help inform your path moving forward.

• The Advantages of Small Business Ownership
• The Financial Advantages of Small Business Ownership
• Challenges of Small Business Ownership
• How Outsourced Accounting and Bookkeeping can Help Small Businesses

The Advantages of Small Business Ownership

You are your own boss.

One of the most exciting aspects of running your own business is the prospect of not having to answer to anybody but yourself. Many startups and small businesses were founded by former employees looking to break free from the corporate ladder. Your hours may be long, but you make them. The responsibility falls on your shoulders, but you can handle it your way. For many, the liberation and shouldering of personal responsibility inherent in running a small business is part of the allure.

You have more flexibility.

With more autonomy comes greater flexibility. Business decisions are yours to make; will you carve out and conquer a market niche? Or will you expand to cover a wide variety of goods and services? Small business ownership flexibility allows you to adapt to volatile market conditions to help maintain profitability and pounce on the endless opportunity.

You are in the driver’s seat.

Many employees become frustrated with the lack of control they gave over their company’s future. And the bigger and more involved corporate offices become, the less control the average employee has. Owning and running a small business puts destiny in your hands, giving you control that many employees can only dream about.

You are in a position of prestige.

It’s no secret — running a small business is a prestigious position to be in. Your customers look up to you as a valuable service provider. If you have employees on your payroll, they look up to you as a boss. And whether you run a partnership, sole proprietorship, LLC, or corporation, you quickly become a community fixture as your brand becomes ingrained in the area you are based in; small businesses are the lifeblood of American communities, after all. On top of community brand recognition, running a small business will give you influence; local government officials often take input from their small business owners when deciding future policy.

The Financial Advantages of Small Business Ownership

The previous section was dedicated to the “intangibles” — the oft-cited, feel-good benefits of running a small business. On top of these, there are several financial incentives to owning a business.

You build equity.

As your business grows, so does your equity. You can build up a hefty amount of equity over a lifetime that you can pass on to the next generation if you choose, setting up your family for financial security for years to come. You can also use equity to fund other business ventures.

You have a high ceiling.

When it comes to entrepreneurship, the sky really is the limit. If you specialize in an easily scalable niche such as personal training or digital goods, you can grow as opportunity allows. And if you use past equity to fund future endeavors, you can build quite the impressive portfolio.

You can claim numerous tax benefits.

Because small businesses are widely recognized as the backbone of American communities, there are numerous tax benefits to help small business owners maintain profitability. For instance, partnerships, LLCs, and sole proprietorships don’t have to file federal business taxes and can deduct qualifying business spending on their Forms 1040 or 1040-SR. Additionally, in times of crisis such as the recent COVID-19 pandemic, Congress typically prioritizes small businesses when designing aid packages.

Related Reading: Accounting for Startups

Challenges of Small Business Ownership

While the upshot to running a small business is enormous, it is not necessarily easy. Successful entrepreneurs need to possess a tenacious drive and business sense to maintain substantial growth. Here are some challenges unique to running a business:

Good things take time.

While overnight success stories accrue widespread coverage, many entrepreneurs recognize that these are not typical results for business owners. Carving out a niche and becoming a community fixture can take years of steady growth. In entrepreneurship, patience and perseverance are virtues of the highest order.

More responsibility means more risk.

Because business owners shoulder the responsibility, they also burden the risk. Poor business decisions can wreck a businessman’s carefully-built equity. And if your business can’t pay its liabilities, insolvency is imminent.

Financials are your responsibility.

Many business owners started their business because they were experts in providing a good or service, not balancing a book. However, being on top of your financials is part and parcel of running a business. Proper small business accounting and bookkeeping don’t just help maintain legal compliance — it can help find opportunities for additional profit within the crevices of the tax code. 

How Outsourced Accounting and Bookkeeping can Help Small Businesses

More and more business owners see the benefit of outsourcing their financials to small business bookkeeping and accounting professionals. The long hours business owners used to waste poring over seemingly arcane financial documents and crafting statements are better spent on actually running the business. The rise of outsourced small business financial services has shifted that burden away from business owners, allowing them to devote more time to building their businesses.

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