WHERE DID ALL THE MONEY GO?
in this article:
Franchise Accountants offer advice for franchisees on managing cash flow
Where did all the money go? As accountants, this is a question we are often asked by our clients when we present the end-of-year financial statements and advise the profit they have made and, crucially, the tax they have to pay.
Sometimes it seems to come as a nasty shock. ‘There’s no money in my bank account – I can’t possibly have made all that profit!’ The assumption here is the profit made on paper is not reflected in the bank balance so it can’t be true. But profit and cash flow are two different things, so let’s see if we can offer some practical insights into key financial matters that affect the cash flows of a business.
First, it’s important to understand what profit and cash flow actually mean.
Next, we need to look at where the cash actually goes to. The cash flow a business generates is used to fund four areas of a business:
• Working Capital
• Capital Expenditure
• Owner’s Drawings
• Servicing Debt
Working capital is the cash you need to cover the timing differences between when you pay for the product or services you are reselling, along with the wages used to deliver them, and when you get paid for those products or services. You also need cash to pay for overheads such as rent, insurance, etc.
So while you might have made a profit by selling something for more than it cost you, it takes time before that profit materialises into cash in your bank account. The longer it takes, the more working capital you need to cover the gap. This is why a profitable business may be cash flow poor. You can read more about working capital at www.franchise.co.nz/article/1872.
The cash the business generates may also need to be used towards capital expenditure, such as buying assets. I recall one business owner who came to me in distress at having to put money back into the business to fund taxes and pay suppliers. His business was making a profit, so where had the cash gone? On investigation, he’d taken cash out of the business to buy a new car earlier in the year – cash the business needed. Instead, he had to take out a loan for the car so that the cash flow worked. Remember, just because the cash is there doesn’t mean you can spend it. It may be already committed to pay your taxes or service your loans.
It’s common practice for business owners to draw money from the business to live on. This is called drawings. The tax on these drawings is paid at specified times throughout the year and the owner is what is called a provisional tax payer. The IRD are introducing a new method of paying provisional tax, called AIM, on 1 April 2018. Read more about this at www.franchise.co.nz/article/2643
When taking drawings, business owners must allow for the need of the business to pay its taxes, fund the working capital and service its debts. The most common source of cash flow pressure is when all the cash in a business is sucked out without properly budgeting for these.
Operating a business often requires taking up loans to fund capital expenditure on equipment, vehicles or the franchise itself. Setting the repayment terms to fit the cash flow of the business is critical. Trying to repay loans too fast will drain off much-needed cash; repaying them too slowly will see the assets they funded wear out and need to be replaced before you have finished paying for them.
Consulting a franchise-specialist accountant before you set up your business is hugely important to your chances of success. On an ongoing basis, reports such as the cash summary report or the cash flow reports that your online accounting software produces are excellent tools to help you diagnose where the cash in the business is going.
Death and taxes are things none of us can avoid, so knowing your tax obligations is essential for all franchisees if you want to operate sustainable businesses.
It might sound hard to believe, but paying tax is a good thing – it means you are earning a profit. However, you don’t want to pay more than your fair share, so this is where you can benefit from an accountant’s expertise to minimise your tax spend within the boundaries of the tax laws. We recently prepared a set of accounts for someone who previously did their own tax returns. While ensuring they were compliant with tax requirements, we found more savings than we charged in fees. Good advice pays, not costs!
Operating a sustainable business requires sustainable cash flows to fund it. We recommend that, as a franchisee, you invest in having budgeting and cash flow reports prepared right from the start, with an explanation of how to read them and update them as reality unfolds. It’s a worthwhile investment that will help you with your decision-making in operating your business.
For those who want to up-skill themselves, the award-winning Franchise Accountants team is now offering financial literacy courses. See the contact details box to find out more.
This advice is of a general nature only and expert advice should be sought to get the right advice for your specific situation.
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This material is copyright © Franchise NZ Marketing Limited, Franchise New Zealand ™ magazine and Franchise New Zealand On Line . While it may be downloaded for personal use, no part may be reproduced in any form whatsoever without the specific written permission of the publisher.