Own Thy Home

For most Americans, when they retire, their biggest asset is their home. It has appreciated a lot since they bought it and if they have borrowed against it as the value went up, they have a lot of equity in it. This equity in their home is often their retirement money.

What about your place of business? Do you rent it or own it?

There are reasons not to buy it, such as – you are growing and will need more space soon, you don’t want to tie up capital to pay a down payment, or you really aren’t sure what the future will hold.

However, if you are going to occupy a building anyway, you may as well own it and build equity with each payment, instead of paying rent to a landlord who builds the equity for themselves. If this is right for you, in 20 years you’ll own your facility and it alone can be a source of value for retirement, even if you don’t sell your business.

The key to successful commercial real estate investing is to have a good tenant for the long term. If you are one, you may as well be your own tenant and start building equity.

"Chart of Accounts"

An “account” is where you’d record all the transactions relating to a company’s assets, liabilities, owner’s equity, revenue and expenses. Each of these accounts can be divided into sub accounts to show these transactions in whatever level of detail you wish.

All the accounts together are part of the “general ledger.” How the general ledger is broken into individual accounts is referred to as the “Chart of Accounts.”

The five main categories of the Chart of Accounts that appear on your financial statements are:

Balance Sheet – Assets, Liabilites, Owners Equity

Income Statement (P&L) – Revenue, Expenses

Your accountant uses a numbering system for these accounts, but the account numbers typically do not appear on your Income Statement or Balance Sheet. For example, Assets are any account beginning with a 1. Liabilites are accounts beginning with a 2. Owner’s Equity accounts begin with a 3. Revenue accounts begin with a 4, and expense accounts begin with a 5, 6, 7, etc.

Your chart of accounts can be expanded to show what you want, or simplified by collapsing accounts together.

For example, your Asset accounts on your Balance Sheet may be –

Assets

Current Assets

   Cash

   Petty Cash

   Accounts Receivable

   Notes Receivable

   Inventory

   Prepaid Insurance

   Prepaid Deposits

   Prepaid Other

Fixed Assets

   Buildings

   Machinery and Equipment

   Vehicles

   Computer Equipment

   Furniture and Fixtures

Accumulated Depreciation

So let’s say you’re looking at your financials and you see that you never have any “Notes receivable.” To make your financials simpler, you may ask your accountant to get rid of that account.

Let’s say you also notice the “Pre-Paid Other” has something in it but you don’t know what it is. Ask. Say you find out it’s mostly rent, but occasionally she has something else in there too. You may ask your accountant to name an account “Pre-Paid Rent” so you can see that each month, and still have the “Other” account for miscellaneous.

Let’s say you see a lot of assets under vehicles. You want to see more detail so you ask for two accounts – one for trucks and one for cars.  

You see, you can and should make the chart of accounts work for you. Make it show you what you want to see, but not so many accounts for every little thing that it gets too complicated. Your call!

Helpful?

Where the Balance Sheet is Blind

While the value of assets is shown on the Balance Sheet, your most valuable asset is not.

Can you guess what it is?

It’s your people. Trained and experienced people are not shown at all on your Balance Sheet. If you have them, and a healthy positive culture they work in, it is of great value.

Let’s say things are rolling along great and your customers are being served well by your wonderful experienced employees who know their jobs and want to be there. Now let’s say on August 31 they all leave the company. On August 31, your Income Statement says you made a healthy profit in August, and your Balance Sheet has grown a bit from the month before. But what are the chances that September will be any good?  

Slim.

Develop your talent. Train them. Motivate them. Don’t de-motivate them. Have contests and keep score on what is most important for their performance. Help them succeed at your company. Make them feel like winners.

Without good people, you’re done. A leader is not needed without them.

Total Liabilities and Equity

At the end of your Balance Sheet, it will say “Total Liabilities and Equity.”

This is Total Liabilities plus Total Equity. I recall long ago I said, “what do I care about these two added together?” Well, remember, the Balance Sheet IS Assets = Liabilities + Owners Equity. So this means that your total assets have to equal liabilities plus owners equity.  

That’s why they call it a “Balance Sheet.” The two sides have to balance.

If your Balance Sheet is “growing,” it means that the number the two sides are balancing at is a higher number than the year or month before.

If Assets = Liabilities + Owner Equity, then Assets – Liabilities = Owners Equity also.

To create more Equity, we need to add to our assets while adding to our liabilities at a slower rate, or reduce our liabilities. If we take less money out of our company than the company earns on its Income Statement, that will do it too.

Do we want to increase our equity? If we want the company to be worth more, we do. In the end, if we sell our company, the buyer will look at your Balance Sheet to see the overall health of the business. At the same time, they don’t necessarily want your assets, they want the profits they produce.

Helpful?  

Total Equity

On your Balance Sheet after Distribution to Shareholder, it will say “Total Equity.”

Total Equity is made up of Your Original Investment to start the company + Retained Earnings + Current Year Earnings – Distributions you took this year.

If you are taking less money out of your business than it is earning or investing in assets, then you’ll see your total equity number go up each year. You can look at this month by month during a year and see what the net effect of your business performance is relative to any amounts you are taking out in distributions.

Has your company’s Total Equity gone up or down in the last year?

"Distribution to Shareholder"

Owners can take money out of their company legally as a “draw” or “distribution.” There is no payroll tax withheld, but you will pay tax on an estimated quarterly basis. The amount of distribution you took this year to date, shows here in the equity section as a negative number, because it reduces the equity in your company.

So, for example, let’s say your Retained Earnings from being in business for five years is $400,000, and your current year-to-date earnings are $100,000. You see that you have plenty of cash and your current liabilities are low. So, you want to take a “draw” or a “distribution.” If you take $40,000 in one lump sum, it will show here on your Balance Sheet. The distribution will offset your Current Year Earnings, and reduce the equity in your company.

On January 1, your current year earnings and distributions get rolled into retained earnings and those two accounts go back to zero.

Retained earnings only change once per year – on January 1, and this number stays the same for 12 months. It represents performance from inception to the last day of the previous year.

So, let’s recap this equity section of the Balance Sheet. Common stock is that first check you ever wrote to open the business’s checking account. Equity Investments is any more money you put in after that to keep your business going. Retained earnings are how much profit is left in your company from previous years. Current Year earnings is how much profit or loss you have from Jan 1 of the year you are in, to date. Distribution to Shareholder is how much money (besides weekly paychecks) you took out of the business this year. It shows as a negative number.

On January 1 of each year, Current Year earnings and Distributions are rolled into Retained Earnings and they go back to zero.

So, let’s say it’s December 31. On your Balance Sheet under Retained Earnings, it says $500,000. It has said that every month this year – because the Retained Earnings number only changes once a year – on January 1.

Your Income Statement says your company made $400,000 this year. That exact same number appears on your Balance Sheet under “Current Year Earnings.” Under Distribution to Shareholder, it says you took $300,000 out of the company this year.

So tomorrow, January 1, you add Retained Earnings of $500,000 to Current Year Earnings of $400,000 and subtract Distribution to Shareholder ($300,000) and you get a new Retained Earnings figure to carry for the next year of $600,000. The Current Year Earnings and Distribution to Shareholder accounts go to zero and will change each month based on what activity goes on.

Get it?

Balance Sheet – Equity – Current Year Earnings

“Current Year Earnings” is the same as Retained Earnings, but it is from January 1 of the year you are in. This number that appears in the Equity section of your Balance Sheet should match up with the year-to-date net income number on your latest month’s Income Statement.

Assets – Liabilities = Owners Equity

The Equity section of your Balance Sheet is telling you where the equity came from. Under Current Year Earnings, it is saying “This much of the equity in the company is from profits we made this year.” Under Retained Earnings, it is saying “This much of the equity is from profits we made before this year, that are still there because the owners have not withdrawn it.”

That’s the subject of the next line – “Distribution to Shareholder.”

More tomorrow!

Balance Sheet – "Equity"

This may also be called “Shareholders Equity” or “Owners Equity.” It is always found at the bottom of the Balance Sheet after Liabilities. Assets = Liabilities + Owners Equity. 

Equity is simply what’s left over after liabilities have been deducted from assets; what’s left when you subtract what a business owes from what it owns.

This section of the Balance Sheet will show the equity the owner has in the business and where it came from.

Under “Equity” you will see the following parts: Common Stock, Retained Earnings, Current Year Earnings, and Distribution to Shareholder.

Common Stock is the very first money you put in to start the company so long ago. Remember a Balance Sheet shows activity for the business from inception.

You may have another line called “Equity Investments” that shows additional money you put into the company after the original investment.

Retained Earnings – if you add up all the net income that has been generated since inception, then deduct any money the owners have taken out as a distribution, you will get retained earnings. Remember those years there wasn’t any cash for you to take out, but your Income Statement said you made money? It’s here.

Retained Earnings are the accumulated profits or losses from your Income Statement since you started your company. They live in the form of vehicles, cash, receivables, inventory, etc. These are “Retained Earnings” and the Balance Sheet is referring to all retained earnings since you started your business, with the exception of what it earned from the start of the calendar year you are in. That’s the subject of the next line – “Current Year Earnings.”

More tomorrow!

"Operating Note Payable" vs. "Capital Note Payable"

We’ve been talking about accounting lately here. It’s not to teach you how to be an accountant, but to understand your own financial statements well.

It’s important to know the difference between an “Operating Note Payable” and a “Capital Note Payable.” A Capital Note Payable is a loan for an item you bought that has to be depreciated, such as a truck or computer system. (We discussed depreciation a few days ago.)

An “Operating Note Payable” example is a lease on a vehicle or piece of equipment. Since you don’t own the vehicle, you can’t depreciate it. Instead, you just expense the lease payments as they come due on your Income Statement.

It’s the same for a copier or a tractor. Just expense the lease payments monthly on your Income Statement, and they don’t show up on your Balance Sheet.

More tomorrow!

Long-Term Liabilities on your Balance Sheet

Assets = Liabilities + Owners Equity. Assets – Liabilities = Owners Equity

As we said, there are two kinds of liabilities. Current Liabilities and Long-Term Liabilities.

Long-term liabilities are loans and mortgages you have taken out with a term greater than twelve months. They may include vehicle loans and long-term notes payable such as a credit line or mortgage. 

If it was a mortgage for example, as you make payments the balance on the liabilities section of the balance sheet would go down, and the equity on the asset side would go up. Interest paid would be shown as an expense on the income statement.

More tomorrow!