General Knowledge

/General Knowledge

Fix or Replace?

By | 2018-05-07T17:00:51+00:00 May 7th, 2018|

 

We have often been faced with the decision to buy a new product or fix the one we have. But how do you know which option will leave more cash in our pockets.

Throwing money at a bad product could get quite expensive. At the same time, just because a product is broken does not mean replacing it will be the better cost savings. To make a good decision you will need to know what costs are relevant to your decision and the opportunity cost of your decision.

When making a decision between multiple alternatives, the only factors you should consider are the factors that make a difference between the alternatives. Cost that will be the same regardless of what option you take are not relevant. For example, the cash you used to buy the vehicle or any recent upgrades are irrelevant to the decision. These are sunk cost and no matter what you do, you cannot change this cost. Taking sunk cost into consideration will cause you to make the more expensive future decision.

Find below a workbook to help you make the fix or replace decision.

Free Resources

 


Needed Information for your analysis

  • The life time of the new product or asset: How long do you expect to keep the new asset
  • The average cost of maintaining the old asset: This will include annual maintenance like oil changes, replacing parts, etc.
  • The cost of maintaining the new asset: Newer assets tend to have lesser cost of maintenance. There could also be increased energy savings, improved gas mileage, etc.
    • Any savings should be added and any expenses should be subtracted.
    • For example, if you will save $500 a month on electric bills but spend $50 on supplies, your net monthly maintenance cost is a positive $450.
    • If no savings are expected, then your maintenance cost should be a negative -$50.
    • This number is hard to nail down but do your due diligence to get as close to a good number as possible. In this day and age, it is easy to find information from other consumers who use the same product. So, do your due diligence rather than assuming your new purchase will save you money. If you end up spending the same as you did in maintaining your old product, then keeping the old will probably make more sense.
    • The difference between your cost of maintaining the new and the old is your annual cost savings.
  • Enter the cost to repair the product – this is the cost to fix it now to get it to a working condition. Future estimated cost of maintaining the product should be added with the annual maintenance cost.
  • Enter any cash you will receive from selling the asset
  • Enter the purchase price of the new asset
  • Enter the opportunity cost of the cash you use to purchase the new asset. For example, you could have an investment deal that will earn you 10% on the same cash. This should be considered as it is relevant to the decision.

After you enter your data, you get the following analysis:

The final decision to fix or replace is an individual one. There could be other factors that are personal to the decision maker which will make one choose otherwise.

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Pricing in a very competitive market

By | 2016-04-29T03:09:48+00:00 April 29th, 2016|

Pricing is an important topic faced by all entrepreneurs. There are many factors that affect the price of a product or service. The purpose of pricing is to enable the entrepreneur to gain market share while achieving a target rate of return. Pricing must be high enough to cover the cost of doing business while earning a reasonable profit. In some cases, due to high level of competition, a business owner is unable to set the price of its products or services. This happens with mostly commodity services or products where customers see little difference between competitors’ products. If this is your case, then you need to get serious about watching your cost.

As a small business owner in a competitive market, you are a price taker. To stay profitable, you need to control cost by setting a target cost of making your products or services. The formula for target cost is as follows:

Market price – desired profit = target cost.

If the business owner cannot reach this target cost, then it will not reach its desired profit. Once a target cost is reached, the business owner will need to work with its team to make sure that the cost of production stays within the target cost.

It is difficult to operate in a competitive market. It is even more difficult if cost is not controlled. A small business owner facing fierce competition must set a target cost and must be careful to stay within the target limit.

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Not all cash is the same!

By | 2016-04-28T04:14:00+00:00 April 28th, 2016|

Cash is the lifeblood of a business. A business owner gets cash from every day activities (operations), financing or investing. Cash flow from operations should be the most significant source of cash in a business. However, a business striving for growth would often get financing to fund this growth. Let us take a look at the three main sources of cash below:

Cash flow from operations

Cash flow from operations comes from the sale of goods and services in your business. Cash flow from operations is all the money that flows in and out for daily operations. This is the most important source of cash in the cash flow statement. The cash flow from operations should be sufficient to fund the business normal operations with enough left over for further investments or distributions to owners.

Investments in your business

Cash flow from investments includes cash flows from changes in investments and long term assets. Buying long term assets in your business is an investment in your business. Assets have to be created and maintained to grow. Some assets are held for the income producing value and some are held to appreciate. Not all assets are investments. Investments is money put forth to bring back more. In business, you want good investment assets. A good investment is one whose net present value exceeds the required rate of return. Before investing in an asset, you should analyze the return to estimate whether or not you have a good investment.

Cash flow from financing

Investments are often financed through external sources such as lenders or equity investors. A lender lends you money and you pay the money back over a period of time with interest. Unlike personal loans, I am not against business loans, as long as you can borrow money at a lower rate and then invest it for a higher return. Financing activities can also be used to finance the purchase of inventory. Payments for loans usually come from cash from operations. This is because financing activities are usually used to finance investments that result in more cash flow from operations. Cash from operations should be more than sufficient to pay back loans plus the interest.

In summary, cash is the lifeblood of a business. Understanding the sources and timing of cash is vital. This is why preparing cash flow projections is very essential because you want to know where you have short fall in cash. If a short fall is determined then you need to figure out how to fill the gap. You can choose to sell an asset which will be cash inflow from investment or get a loan or use personal funds which will be cash inflow from financing.

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Wealth versus income

By | 2016-04-22T18:55:56+00:00 April 22nd, 2016|

The word wealth is often confused with income. Wealth could be of various forms, there is spiritual wealth, material wealth, time wealth, etc. Wealth simply means an abundance of something you find valuable. Some people would rather have more time to pursue personal interest, others like material wealth, while others do not place a lot of value on material things but rather value spirituality. All of these values are not mutually exclusive and it’s up to the individual to decide what matters to them.

On the other hand income, is an amount of money brought in from your pursuits. Income could come from a job, a business or investments you have made in the past.

This article focuses on the difference between financial wealth and income. It is possible to have income without wealth. And it is also possible to build wealth with your income. However, as entrepreneurs, we sometimes forget that our business can be a great source of wealth and not just income. Growing your business from an income producing machine into an asset takes some thought. You could have a business that brings in a lot of income but is worth little at time of retirement. This means you cannot sell the business and you retire with very little if you have no other source of wealth.

Creating wealth in your business involves building assets. Assets can be tangible or intangible. Intangible assets like creating systems in your business could increase the multiple at which your business sells. Your systems should include the three legged stool every business should have namely, marketing, financing and operating. All systems running together help your business run smoothly and creates an asset which can be sold for a higher return at a later date.

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Financial Leverage

By | 2016-04-21T05:46:17+00:00 April 21st, 2016|

Financial leverage is using borrowed funds to increase revenue producing assets. This is done with the hopes that the increased income will be more than the cost of borrowing. Using debt financing allows a business owner to benefit from financial leverage. If a business borrows money at 4% and reinvests it with a return of 10%, revenue benefit from the 6% spread.

Moreover, interest expense is tax deductible further reducing the cost of borrowing. If a business owner, borrowed money from an investor, dividends paid to the investor is not tax deductible. Also, when you sell equity, you give away a part of your company which is something you don’t have to do with debt borrowing.

Let us take a look at an example:

ABC Co. has the option to bring in new investors or get a bank loan. The principal amount needed is 100,000 dollars. The bank will loan this money at 4%. ABC co. has a tax rate of 25%. The equity investors also require 4% annual dividends. Let us take a look at the effect of debt financing over equity financing:

 

Equity Financing

Debt Financing

Revenue

50,000

50,000

Expenses

(30,000)

(30,000)

EBIT

20,000

20,000

Interest

0

(4,000)

EBT

20,000

16,000

Tax @ 25%

5,000

4,000

Net Income

15,000

12,000

Dividend

4,000

 

Increase in retained earnings

11,000

12,000

 

Debt financing results in less taxes and also an increase in retained earnings. Regardless of using debt or equity financing, ABC will need to pay 4,000 dollars as either dividend or interest. However with equity financing there is no tax benefit of paying out the 4,000 dollars while with debt financing there is a tax savings of 1,000 dollars.

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Is your income sustainable?

By | 2016-04-20T02:28:56+00:00 April 20th, 2016|

Sustainable income can be defined as the level of income that is most likely achievable by the business not just today but also future years. It excludes all temporary hikes in income due to non-repeatable events. A better way to evaluate your business is how much of your income is sustainable. Sustainable income is different from the actual income on the profit and loss statement. It is the income minus all the noise. Separating your sustainable income from non-sustainable income allows you to plan better by seeing the fruits of your repeatable processes. Ultimately, the repeatable processes are what really builds value
in your business.

Creating repeatable processes makes your business less dependent on you which means you can scale your business more quickly. This means you can enjoy more life outside your business and make your business more attractive to a potential buyer.

While this all sounds good, business owners sometimes find themselves so entrenched in their business that creating sustainable income takes back seat. Sometimes all you need is a little tweak to turn non sustainable income to sustainable income. This takes careful thought and planning. Doing the same thing you have always done expecting a different result is the definition of insanity.

In summary, take the effort to separate your sustainable income from non-sustainable income in your financial statements. Keeping track of sustainable income is crucial. If you lack sustainable income, it is time to rethink your business!

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Some ways to evaluate investments

By | 2016-04-19T04:48:31+00:00 April 19th, 2016|

 

Cash payback period

The cash payback period is the time period it takes to recover the cost of the capital investment from the cash flow generated by the investment. The cash payback is the cost of the investment divided by the net annual cash flow.

Net present value

The net present value discounts net cash flow to its present value. This method compares the present value of the cash inflow to the required investment. The net present value is the difference between the capital requirement and present value of cash flows.

Internal rate of return

Unlike the net present value, the internal rate of return finds the interest yield. The internal rate of return is the amount where NPV equals zero. Excel offers a great tool to help compute this number.

Annual rate of return

The annual rate of return is the expected annual cash flow divided by the average investment. The annual rate of return is compared with the required rate of return to see if the investment is acceptable. The required rate of return is based on the businesses cost of capital. The cost of capital is based on the weighted average of borrowed money and capital investments provided by equity owners.

These are just a few metrics with which a business owner can use to measure potential investments. Investing in new project could be quite risky but with taking the time out to analyze the investment, the chances of making bad investments are reduced.

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The best way to save on taxes

By | 2016-02-20T15:47:38+00:00 February 20th, 2016|

010515_1656_Howcantaxpl1.jpgOwning your business is one of the best way to save on taxes. When you are a W-2 earner, you pay taxes on every dollar earned. As a business owner, you only pay taxes on your net profits. Your net profit is the difference between what you bring in and what you spend in building your business. This means you owe taxes on what is left and not all you made.

For a business expense to be deductible, it has to meet these 3 conditions:

  • The expense must be ordinary and necessary for your business or profession
  • The expense must be directly related to your business – this means not a personal expense
  • The expense must be for a reasonable amount – beware of lavish meals and entertainment expenses

How to deduct your business expenses

How you deduct your business expenses depends on what type of business entity you operate. Whether you are a sole proprietor, C Corporation, S Corporation or partnership, you are allowed deductions before arriving at net income.

Sole proprietor

If you are a sole proprietor, your business expenses are deducted on Schedule C. The net profit is transferred to your form 1040. Your business income is also subject to 15.3% Social Security and Medicare taxes. Paying social security and Medicare taxes is not all bad as this is money that comes back to you when you are 65 and older. You also have to pay federal taxes and depending on your state, pay state taxes too.

However, if you have a loss on your business (that is expenses exceed income), you do not have any income to pay taxes on.

C Corporation

If you own a corporation, you file your taxes on form 1120. Your expenses are also deducted on form 1120. Your corporate tax return is taxed separately from your personal tax return.

S Corporation

An S corporation files a separate tax return on form 1120S but unlike a C corporation the income flows through to your personal tax return. However, unlike the sole proprietorship you do not have to pay self-employment taxes on the income that flows through to your personal tax return. An S Corporation deducts expenses on form 1120S.

A partnership

If you are going to into business with a partner and you do not want the hassle of incorporation, then you can form a partnership. Forming a partnership is as easy as forming a sole proprietorship. You will need to file a separate tax return on form 1065. Your expenses are also deducted on form 1065. Your share of partnership net income flows through to your personal tax return. Partners are not employees and do not get W-2s. Rather than a W-2, they should get a schedule K-1.

LLC

As a LLC you can choose to be taxed a corporation, s corporation, sole proprietor or partnership. See above on how to treat your deductions depending on what entity you choose.

Regardless of what form you choose to operate your business, starting your business is one of the best ways to save on taxes because you do not pay taxes on every dollar earned.

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Why does my business profits not equal my cash?

By | 2016-02-10T03:41:14+00:00 February 10th, 2016|Tags: , |

As a business owner, you have probably wondered why your income sometimes says you make more money than you have in the bank. There are many reasons why business profits don’t equal cash and I will be discussing a few of them.

Operations

This is cash received from or used in the business main operations. A well run business main source of cash will be from operations. In running your business, not all sales result in cash collection upfront and not all expenses are paid with cash up front. Also, non-cash expenses like depreciation decrease your income but do not affect your cash flow.

Financing

Businesses often use debt or money from other investors to purchase business assets. Companies can finance operations by issuing stock, borrowing money, etc. These activities are not cash flow from the business operations but receiving them increases your total cash.

In addition, dividends paid to shareholders do not decrease your profitability. Dividends are paid from retained earnings (past income) and does not show up on the income statement as an expense. Dividends paid is a reduction of equity.

Investments

Cash flow from investments is mainly used to ensure that the required assets needed to support efficient operation are acquired and maintained. Investments are made to increase a business’s competitiveness in the market place. When you buy assets, these amounts do not flow to the income statement right away. However, the cash decreases when investments are made.

These are a few reasons why your bank statement gives one number and your income statement gives another. Understanding how these numbers are related is essential to succeeding in business.

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Bad Accounting, Bad Information, Wrong Action!

By | 2016-02-04T15:49:48+00:00 February 4th, 2016|

Accounting is the language of business. To make good business decisions you need to understand this language. Take for instance the difference between the cost of making your product and the cost to support the existence of your product. Both are vital information but mistaking one for the other could be very costly mistake.

Cost of making your product

The cost of making your product also called your product cost should consist of the cost you absolutely need to make your product available to the market. Due to the nature of the cost, it is often stored as an asset on the balance sheet statement until it is sold. This is an accurate depiction of how the cost behaves. Just like an asset, product cost has future value and should not be expensed right away.

So what happens if you include cost that are not absolutely needed to make your product? For starters, you do not know what it cost you to make your product. Product cost should be examined on its own merit. Knowing what it cost you to make a product, would help you examine if there are better more productive ways to create the same thing. It also helps you determine the profitability of each product on an individual basis. Adding cost that are not essential to making the product distorts this cost.

Cost to support the existence of your product.

On the other end of the spectrum, a business cannot exist with product cost alone. If this was so, there will be no such thing as a broke entrepreneur. Every product needs a support system and this is what we call your period cost. Unlike product cost, period cost is expensed at the time they happen. A good example of a period cost is marketing. We all know that marketing is the life blood of any business. While it is not part of your product cost, your business will not survive very long without it.

Also, note that period costs exist to support the product. This is key because I see a lot of financial statements with cost that have no bearing to any revenue stream. This is why it is very important to fully understand the way the cost in your business behaves. Accounting for cost in the wrong way, would lead to bad information and finally taking the wrong action.

If you want more, get my free e-book categorizing transactions.

Image courtesy of Stuart Miles at FreeDigitalPhotos.net

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