Harvey G. Beringer, CPA

     When gauging the financial health of your business, you should use ratios rather than absolute numbers.  Profitability, liquidity, operating and solvency ratios should be considered.  These ratios could alert you to trends which would require immediate action.

Profitabilty Ratios

The Gross Profit Margin measures your profit at the most basic level.   Is your sales price reasonable based on the cost of what you are selling?  If this ratio is less than one,  you will never make a profit.  If you sell your product for less than it costs, profitability will not be possible. 

The Operating Profit Margin measures your profit based on your earnings before interest and taxes.  It measures the efficiency of the business before considering any financing.  When comparing the operating efficiency of similar businesses, this ratio can determine the most efficient one.

The Net Profit Margin is also referred to as the “bottom line”.  It considers all expenses including interest.  The net income is also referred to as the “bottom line”. 

Liquidity Ratios

These ratios refer to the ability of an entity to obtain cash to satisfy financial obligations.  Liquid assets would be found in the current assets section of the balance sheet.

The Current Ratio would determine whether your working capital is sufficient to meet your short-term obligations.  A current ratio of 2.0 is a general rule, but this would be subject to the particular industry.  Some industries are more capital intensive.  A current ratio less than 2.0 might indicate difficulty in paying current obligations.

The Quick Ratio or “Acid Test” helps gauge your immediate ability to meet our financial obligations.   It does not include inventory in the current assets.  A Quick Ratio below .5 might be indicative of a shortage of working capital and difficulty in meeting current obligations.

Operating Ratios

The Inventory Turnover Ratio indicates the number of times the inventory “turned-over” during a given period.   A higher ratio would be preferable and indicates that you are not holding an excessive inventory level in your warehouse, and accumulating costs that accompany it.

The Sales to Receivables Ratio measures the turn over of your receivables.  The higher the number the better, which would indicate an efficient collection of receivables.  A ratio that is too high or increasing over time could indicate an inefficient use of working capital.  Like many of these ratios, they should be compared to similar companies in the same industry.

The Days Sales Outstanding measures the efficiency of your collection efforts.  The lower the number the better, and if the number is increasing, more effort should be directed toward collections.

The Return on Assets is one of the most common financial measures and an effective tool to compare the profitability of two companies.  A lower number may indicate that you found a more efficient way to operate through inventory management, quality control, financing, or technology.

Solvency Ratios

The Debt to Worth Ratio may also be known as “Leverage Ratio”.  It describes how much debt is used to finance the business.  It is never advisable to depend too much on debt financing, which can increase risk, and in addition, the related expenses can overwhelm a business.

Working Capital (Net of Current Assets and Current Liabilities) is used to gauge the ability of a company to weather difficult financial periods.   This number, unlike all of the above, is not a ratio but an absolute amount.  It is difficult to predict the ideal amount of working capital for your business, but an increasing trend should be considered a positive sign.

You’re at a fork in the road.  This is no ordinary fork with two choices.  This one has five choices.  Sole proprietor, a C Corporation, an S corporation, an LLC (limited liability corporation), or an LLP (limited liability partnership) are the choices.

Tax issues and personal liability are the key issues in determining the best format for your business.  Choosing sole proprietorship when you are the sole employee is the simple way to go.  If you have a regular job and work on the side as a consultant, this format would let you write off expenses such as the use of computers, phones and car mileage for your consulting and maybe your home office subject to IRS rules.   The big disadvantage is the lack of protection of your assets.  In a dispute that could lead to a lawsuit, your personal assets are at risk.  The other four forms of entity offer the protection of your assets.

If it looks like your business is going to take off, any of the other four forms would be more appropriate. They shield personal assets from suits against your business.  A C corp lets you set up a medical plan.  Then you can write-off all of your out-of-pocket medical expenses.  If you run a sole proprietorship and file as an individual taxpayer, there are limitations on those deductions (excess of 7.5% of your adjusted gross income).

The tax rates for a young C corp with low income can be lower than those on the other four types of businesses.  The first $50,000 is taxed at only 15% while the subsequent $25,000 is taxed at 25%.  The third $25,000 is taxe at 34%.  However, above $100,000, the tax can be as high as 39%.  To lessen the high tax rate on the corporation plus the tax on a high salary, other options might be more beneficial.

An S corp, LLC or LLP might be more appropriate.  All thre are similar since they are pass-through entities in which case income is only taxed once.  Income flows to the individual owners.  The differences have more to do with legal issues.  Family businesses are often S corporations, while investments in real estate are often LLCs.

More and more people are becoming self-employed as workers lose full-time jobs and take longer to find new jobs.  It is more important to stay on top of one’s tax obligations than the skill you’re trying to sell.

It is extremely important to be thoroughly familiar with the world of 1099s.  One surprise for some people is that the self-employed must pay the full amount of payroll taxes, known as self-employment taxes, while a full-time employee typically pays half.

Maximizing deductions, while minimizing the chance of being audited can be simplified by using such software products as Quicken or QuickBooks.

A professional, such as a Certified Public Accountant, stays abreast of any changes, like the recent increase to 58.5 cents allowed, effective July 1, 2008 as a travel deduction.

There are always changes in the tax code you might not be aware of or might have forgotten.  You should have adequate support for all of your deductions.  Such tools as a travel log should support your deductions for travel and entertainment.

Some people may deduct a portion of their living expense but the space must be used exclusively and regularly for work.  You shouldn’t have an exercise bike or TV in that space.

Many of us have received emails looking like they might have come from the Internal Revenue Service. These requests for personal and financial information are an attempt at identity theft in as much as the Internal Revenue Service never requests such information as personal financial information, PIN numbers, passwords or information to access bank or credit cards in an email.

It is important to know your tax rate to determine the tax effect changes in income. While we all welcome an increase in income, we are more concerned with how much of that increase do we have after taxes.

1. Children earning limited amount while students.
   • One can make a limited contribution to an individual retirement account. That amount, however, is limited to 100 percent of earned income or $4,000. Since earned income is not taxed at the “Kiddie Tax” rates, it would make more sense for such a contribution to be made to a Roth IRA instead of the traditional IRA.
2. Students working before going to grad school.
   • The college grads could contribute to a traditional IRA while working. This would entitle them to the contribution deduction which could be converted to a Roth IRA.
3. Employers matching 401 (k) contributions.
   • The employee should maximize, at least to the extent that an employer matches them under the plan. The incremental value of the 401 (k) account balance will be quite rewarding if their contributions, employer matching and the tax deferred earnings are compounded every year.
4. Resist opportunity to withdraw.
   • Once money is withdrawn, it cannot be re-contributed back into the account (except in certain instances when re-contribution is within 60 days or within the same taxable year).
5. Use regular savings.
   • Employees 55 and over may be able to make an additional contribution. The maximum contributions have also increased. The amount for the additional contribution in 2007 is $15,500, and $5,000 for the maximum.

Letter Ruling 200521003 issued by the IRS allowed the parents of two learning disabled children to claim a medical deduction for the school tuition paid for the children. Since regular school is not designed to deal with learning disabilities, regular school education is not medical care.

This ruling dealt specifically with children who were diagnosed with learning disabilities, including dyslexia. The intention of the program was to eventually allow them to assimilate into a regular public school. The parents felt that they were allowed to deduct the full tuition as a medical expense. The fact that the school was designated as a “special school” was not the controlling faction in allowing the deduction. The deduction depends on the curriculum of the school for the children with special needs. The determining questions are, “Is the special education designed to alleviate the disorder ?” and “Why is the student attending that school?”

The dependent care credit is also available for a special needs child. The costs eligible for the credit if the dependent is physically or mentally unable to care for him/herself. Cloverdale education savings accounts (ESA) are also available to parents with children having special needs.

You may be the owner of a small/medium size business and ask yourself, What does SOX (Sarbanes-Oxley Act) have to do with my business? Since SOX was designed to protect investors and creditors of public companies, that does not mean that some provisions of the act cannot help your business. Section 404, specifically, requires management to report on the effectiveness of their internal financial controls.

Being aware of how such controls can impact a business can make the difference between a successful operation and a losing one. The main reasons that a small business may want to create strong internal controls are:

1). The focus of strong internal controls is on getting the financial statements right. This can address and help prevent future or potential problems.

2). An outside party such as a banker or accountant recommends it.

3). It can solve present business problems and/or help prevent fraud.

4). The potential to go public.

5). A Sox-compliant customer may require it.