Your CFO Education: Cash vs. Equity
Welcome to my tenth and final newsletter.
These newsletters are more like white papers than newsletters. There’s not that much new news in accounting; a debit is a debit and credit and is a credit. But if you take each of my newsletters and follow the advice, you should be able to manage your business with a virtual accountant.
I love accounting and helping people, so if you need help, give me a call. And if something new and exciting comes up, I will do another newsletter.
Be sure to read all the way through to learn news about bulk pricing of my book and my speaking availability.
As always, enjoy!
P.S. You can access all of the newsletters on my website: www.continuousfi.com/newsletters/
Cash vs. Equity
How do you measure yourself? How do other people measure you? How do banks measure you? Which one is the most important?
First, let’s tackle how you measure yourself. Some measure their worth by the amount of cash they have in their bank and their 401k. Some measure it by the amount of possessions they have. (It is so hard not to get political here but I won’t go there.)
The general public and friends may judge you by your possessions, that old ‘keeping up with the Joneses’. As the devil says in the movie Devil’s Advocate, “Pride, it gets them every time.”
If you are an entrepreneur, you are measured by your worth.
So let’s talk numbers. Since small business owners feel like they are constantly paying bills, cash is a never-ending responsibility. It weighs many business owners down. Since some accounting firms know this, they market “Cash is King” and promise to help you.
But as with many things, lack of cash is just a symptom. With my training in root cause analysis, I know there is more to the story. You have to go back to the beginning. Is your product or service priced properly? If you have to worry about cash and it is not a seasonal or inventory issue, then you probably have a problem. Your product or service is supposed to be generating the cash. You shouldn’t have to go to the bank for money unless you are buying a long term asset or you need temporary funds to buy inventory.
As the accountant, I can look behind the curtain. And sometimes I see that, in spite of all the possessions someone has, they really aren’t worth anything. My daughter says who cares? They get to use all that cool stuff. I guess that may be true, but how long can you fool yourself, your family and friends? Ask Madoff (then again, don’t.) Unfortunately, the family doesn’t usually find out until the parent dies.
How do banks measure you? By equity. People talk about equity a lot. They pretend like they know what it is, but very few people really understand it.
Simply put: take everything you own and subtract everything you owe, and that’s your equity.
Banks and the internet have good worksheets to help you figure this out. If you have a financial statement from an accounting system, it should be labelled equity. That’s what you are worth. If it is negative, you’d better do something about it.
Let’s do an example. You own a home worth $350,000. You owe $350,000 on a mortgage. You are worth zero. During the housing bubble, the home may have dropped in worth to $300,000, but you still owe $350,000. Now you have negative equity in your home. I don’t know where the term under water came from, but that’s what it means when people say they are under water.
Your business is the same. You can have $350,000 in inventory and accounts receivable, etc. But if you owe the bank $350,000, you are worth zero.
Let’s hope you never get there, and if you are, you can turn it around.
Cash Corner: Cash is King
Money makes the world go around, and that is why Cash is King.
You may have also heard the term he/she is cash poor. It means they may be rich, but their money is all tied up in their business, either in assets or inventory, the two big eaters of cash.
Make sure you don’t get yourself in that position. How do you avoid it? Either make enough from your product to buy more inventory, or leave profit in the company to reinvest back into the company to buy equipment.
Some people don’t like that advice because you may have to pay taxes on the profits.Your CFO is telling you, let’s buy the equipment out of the profits of the business because money is tight at the bank. Do what is right for you. But don’t get cash poor.
How Much Cash Should You Have?
There are many philosophies on this, but since you are reading my newsletter and you want my advice, here it is.
I would have a minimum of 4 weeks’ expenses. If you can do more than four weeks, great. This is in addition to the cash you are setting aside for taxes.
Some say that this is idle cash. It is, but it is there for a reason. When the banks tightened their lending in 2008, those that did not have any cash went out of business. Sorry, Bank Friends, but it’s true: banks want to have a relationship with you until you need cash.
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