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May 5, 2011 - 2 minute read - Comments - legal

Corporations

There are basically three legal forms of business ownership; sole proprietorship, partnership, and corporation. A corporation is a legal entity that is distinct from its shareholders. In Canada, corporations can be incorporated federally or provincially. A shareholder is not liable for the debts or obligations of the corporation. Advantages

  • Liability. The shareholders of a corporation are shielded from the liabilities of the corporation. This provides a measure of projection for the personal assets of the shareholders. Note that most banks will make shareholders personally guarantee the debts of a corporation, particularly if it is new or lacks capitalization. This effectively eliminates the liability protection.
  • Taxes. A corporation can lower your tax burden. For example, the top marginal tax rate for people in Saskatchewan earning over $128,800 in 2011 is 44%. In comparison, the federal tax rate on small business income on the first $500,000 of income is 11% in 2011. The Saskatchewan tax rate on the same income is currently 4.5% and will lower to 2% after July 1, 2011. The combined rate of 13% after July 1st will allow more capital to remain in entrepreneur’s control than declaring large amounts of income personally through a sole proprietorship.
  • Clarity. Because the corporation is a distinct legal entity, it is easier to keep personal and business activities separate. All accounting and banking will be separate.
  • Transfer of ownership. In some instances it can be easier to sell shares of a corporation rather than the assets of a business.

Disadvantages

  • Complexity. An entrepreneur has to go through the incorporation process either federally or provincially. If the federal process is chosen, the entrepreneur will have to register the company in the provinces in which It does business. Corporate returns will have to be filed annually.
  • Cost. It costs a bit more to start a business as a corporation than a sole proprietorship or a partnership. Incorporation costs can run from $1,000 to $3,000 or more depending on the complexity involved. Provincial registration costs for a federal corporation would be extra. There are costs involved with filling the annual returns and maintaining provincial registrations.

There is no one right form of business ownership. It is dependant on your personal situation. You should talk to your accountant and lawyer before making a decision. Their fees will be a small price to pay to ensure that you have the legal form of ownership that’s right for you.

May 4, 2011 - 2 minute read - Comments - legal

Partnership

There are basically three legal forms of business ownership; sole proprietorship, partnership, and corporation. In a partnership, you and your partners own the business and its assets directly. All business income would be reported and declared on each partner’s personal tax return. Each partner would take a percentage of the net income or net loss based on his or her share of the partnership. For example, if a partnership was shared 50/50, each partner would have to pay tax on half of the net income of the partnership. Because you and your partners are inseparable from your business, you each have full liability for the obligations of your business. A lender could make a claim against your personal assets for business debts. An exception to this is a limited partnership where the individual is not involved in management of the business. His or her liability would be limited. There are a number advantages and disadvantages to a partnership:

Advantages

  • You have a partner. There is someone to assist with funding the start up of the business. You have someone to help you make the decisions. This can be especially useful if your strengths lie in different areas.
  • Taxes. You have the ability to split income and this may reduce your overall taxes payable. This can be an advantage, especially to members of the same family who are in business together.
  • Simplicity. Starting a partnership is about as simple as starting a sole proprietorship. Registering a partnership is fairly straightforward.

Disadvantages

  • You have a partner. If you have not chosen your partner wisely, you might find that he or she is more of a hinderance and less of a help. For this reason, among others, you should have your lawyer draft a partnership agreement at the beginning of the partnership. It should describe what will happen in the event the partnership breaks up.
  • Liability. Like a sole proprietorship, you are fully liable for the business debts, even those your partners incur. If one of your partners signs for a debt on behalf of the partnership (even though you didn’t even know about it) you are still liable.

There is no one right form of business ownership. It is dependant on your personal situation. You should talk to your accountant and lawyer before making a decision. Their fees will be a small price to pay to ensure that you have the legal form of ownership that’s right for you.

May 3, 2011 - 3 minute read - Comments - entrepreneurship

Know Your Financial Statements - Part Three: The Cash Flow Statement

If you have read the first two postings in this series, you know what the balance sheet and income statement say about a business. These two pieces do not tell the whole story. For that you need the cash flow statement. Why? Because you can’t buy groceries with inventory and you can’t buy gas with net income. Cash is like blood to a business - without enough even the healthiest business will come to a screeching halt.

Cash flow for your business is like blood flow in your body.  Without it, you die

The cash flow statement has three main components corresponding to the three sources of cash: Operations, Investment and Financing.

Cash Flow From Operations The first classification of cash flow comes from operations. The components are:

  • Net Profit - From the Income Statement.
  • Depreciation - This was subtracted from Revenue in the Income Statement, but it is not a cash cost. It is therefore added back to Operating Cash Flow.
  • Change in Inventory - If inventory increases, the business must spend cash to pay for this. If it decreases, it returns cash back the business.
  • Change in Accounts Receivable - Accounts receivable are bills owed to you from your clients. Like inventory, an increase will detract from cash flow. A reduction will return cash.
  • Change in Accounts Payable - Accounts payable are bills you owe to your suppliers. This is like a line of credit that you get from your suppliers. Like inventory, an increase will contribute to cash flow. A reduction will reduce cash.

A normally operating business will have a positive operating cash flow. A business with a negative operating cash flow is either in a period of rapid expansion or in serious trouble.

Cash Flow From Investing This is the section where a company buys or sells it’s assets. This is negative when buying because buying is a use of cash. It is positive when selling the assets. When these assets are bought or sold, the adjustments are made on the assets side of the balance sheet.

Cash Flow From Financing Equity and debt financing make up this portion of the statement.

Equity financing comes into the business in the form of stock sales. Equity financing leaves the business in the form of dividend payments. Any equity financing coming into or out of the business is recorded here as well as the equity side of the balance sheet.

Debt financing comes into the business in the form of bonds, mortgages, lines of credit, capital leases, etc. It leaves in the form of bond maturities, mortgage payments, lease payments and operating line repayments. These are accounted for on balance sheet’s liabilities section.

Cash flow from financing is typically positive when the business starts and when it is expanding. If the business is at a steady state, financing cash flow is positive, as the bank gets its loan paid back and owners receive dividend payments.

When the three cash flows are added up, we get the net cash flow for the company. This total is added or subtracted to the cash total on the previous year’s balance sheet. Now that the three pieces are described, tune in tomorrow to see how they all fit together.

May 2, 2011 - 3 minute read - Comments - entrepreneurship

Know Your Financial Statements - Part Two: The Income Statement

Unlike the balance sheet, the income statement summarizes activity for a period of time. This is most often a year, but can the owner specify any time period. It has three major sections: Revenue, Expenses and Net Profit.

Revenue A company’s revenue is the sales for the particular time period. Simple as that. For those of you that like buzzwords, this is referred to as the company’s Top Line, because it is the first line on the income statement.

Expenses Cost of Goods Sold The first expense line comes with the raw materials, shipping, labour and supervision of the work to make the products. If the company provides services, the term is Cost of Sales. A couple of things of note:

  • A key term is cost of goods sold. Any products that are produced and not sold go into inventory on the balance sheet. It’s strange, but if you have poor sales, the income statement doesn’t show the true story of how bad the situation is. For that you need the cash flow statement.
  • These costs are generally assumed to vary with Sales. Raw materials, shipping and some utilities behave this way. Labour and supervision generally don’t, unless you are paying by piecework instead of a wage.

A common measure used with this is called the gross margin. This is simply Revenue - Cost of Goods Sold. These results vary widely by industry, so for this to make sense, you need to compare yourself to others in your line of business.

Knowing your income statement gives you a deeper understanding of your business.

Sales, General and Administrative These are the fixed costs associated with running the business. They generally are the same whether you are operating or not. Sometimes these can vary with sales, however, with commissions or bonuses.

Depreciation or Amortization This cost comes from accrual accounting, whose main point is we account for an expense as we use the asset, not when we pay for it. For example, take a $100,000 building a business builds to run their business. If the expected life of the building is 20 years, the owners would record a $5,000 depreciation expense every year instead of a $100,000 expense in the first year. This is to allow for analysis without the extra complication of investment in the company. In addition, this isn’t a cash cost: we don’t have to write a cheque each month to Depreciation, and we account for this in the cash flow statement. When we subtract Sales, General and Administrative and Depreciation or Amortization from Gross Profit, we get the Operating Margin, or EBIT (Earnings Before Interest and Taxes). This measure shows how the company operates without the complications of financing (the amount of debt versus equity) and taxes (due to location and accountant skill). Like Gross Margin, Operating Margin varies by industry.

Interest This is the interest portion of the debt of the company. One note: Unlike dividends, that you pay owners, interest is tax deductable. It comes off before taxes are calculated. With dividends, the tax is paid beforehand. This phenomenon is known as an Interest Tax Shield.

Taxes This comes at the end. The government takes a piece of anything left over. If you have a negative balance between your sales and expenses, you don’t get a cheque from the government. You do, however, get to use these tax credits against future profits. These tax credits sometimes show up in the assets side of the balance sheet.

Net Profit Finally, when you take your sales and subtract all of your expenses, you are left with Net Profit. This figure is used in the cash flow statement as well as the balance sheet. The buzzword for this is the Bottom Line.

Tomorrow, we will look at the Cash Flow Statement.

May 2, 2011 - 2 minute read - Comments - legal

Sole Proprietorship

There are basically three legal forms of business ownership; sole proprietorship, partnership, and corporation. In a sole proprietorship, you own the business and its assets directly. All business income would be reported and declared on your personal tax return. Because you are inseparable from your business, you have full liability for the obligations of your business. A lender could make a claim against your personal assets for business debts. There are a number advantages and disadvantages to this form of ownership: Advantages

  • Simplicity. You can get started after registering your business name and obtaining a business license.
  • Taxes. If you are running a business part-time while working full-time, you can write off any business losses against your employment income.
  • Decision making. Because you are the business, you make all the decisions and you can make them quickly.

Disadvantages

  • Liability. Default on business debts or lose a lawsuit and your personal assets like your house or car could be in jeopardy.
  • Taxes. If you are working a full time job while operating your business on the side, any profits will be added on top of your employment income and taxed at your full marginal rate. This leaves you with less money to invest back into the business.
  • Confusion. Sole proprietors often have trouble keeping their personal finances separated from their business finances. This makes it more difficult to tell how a business is performing. It also makes bookkeeping and accounting more difficult. Sole proprietors should always maintain separate personal and business bank accounts in an effort to avoid this.

There is no one right form of business ownership. It is dependant on your personal situation. You should talk to your accountant and lawyer before making a decision. Their fees will be a small price to pay to ensure that you have the legal form of ownership that’s right for you.

Apr 29, 2011 - 4 minute read - Comments - business planning

Know Your Financial Statements - Part One: The Balance Sheet

Many small business owners know next to nothing about their financial statements. So what? Why is that a problem? Financial statements can tell you a lot about your business. To the right reader, they communicate the health, strengths and weaknesses of the business. They also go a long way in determining the value of the firm. Whether you are selling, buying, financing or operating a business, learning the language of financial statements is a must for any good manager.

A look at your financial statements can shed light on the health of your business.

This blog post will give the basics of the balance sheet. The balance sheet is a snapshot of the business. It shows:

  • The size of the business
  • The financial structure of the business
  • The short-term health of the business
  • A partial look at the riskiness of investing in the business

These are all useful things to know. The first side of the balance sheet includes a listing of assets. Essentially, an asset is anything that the company owns that could be sold for cash. There are two types of assets: Current and Fixed.

Current Assets These include anything that is expected to be turned into cash within the year. Things typically listed are:

  • Cash - Your bank balance.
  • Accounts Receivable - Outstanding invoices owed to you by your customers.
  • Inventory - Anything that you have bought or made and have not yet sold.

These assets are listed in their preference. Cash is king because you have it. Accounts receivable are next because the product is sold and delivered. Inventory is the least desirable because it isn’t sold yet and can get stolen, go obsolete or get ruined.

Fixed Assets The other type of asset is fixed. They include your land, buildings, equipment and other things that are needed to produce sales, but are harder to turn into cash in a hurry. You will often see a line titled “Less Depreciated Assets” right under your capital equipment. This is due to our system of accrual accounting. It assumes that each year, a portion of your infrastructure gets used up. This is meant to spread the cost of the fixed assets over several years. On the other side of the balance sheet are two categories: Liabilities and Equity. Liabilities, like assets are classified as current or long term.

Current Liabilities These include anything expected to be paid within the next year. They include

  • Accounts Payable - What you owe your suppliers.
  • Short Term Debt - Debt that is intended to be repaid in a short period. Lines of credit balances show up here.
  • Current Maturities of Long Term Debt - The principal payments due in the upcoming year.

One important measure to note here is the current ratio. This is the ratio of current assets to current liabilities. The ratio should be higher than 1, meaning that the business could raise enough cash quickly to settle the current accounts if need be. If this is below 1, you could have trouble meeting your payments.

Long Term Liabilities This usually includes the portions of debt that won’t be paid in the next year.

Equity When you subtract the liabilities from the assets, the remainder is equity. This has two components. The first is paid-in equity. This is the investment made by the owner(s) of the company. The second is retained earnings. Retained earnings are the accumulated net profits of the company minus any dividend payments made to the owners. A good way to check the riskiness of your business is to compare your debt to equity ratio. The higher the ratio, the riskier the business. This is due to the fact that bank will get paid their interest and principal, regardless of how well the business performs. When times are good, the owners do extremely well, because they keep everything beyond their debt obligations. But, if the business does poorly, the owners get hit harder because the bank will get their money, one way or another. This concept is called financial leverage. So there are some of the basics of the balance sheet. Next week we’ll cover the income statement and the cash flow statement. Have a great weekend!