Back when you started your business, you may have been advised to create a cash flow projection that showed the cash inflows and outflows of your business. SCORE provides a free Excel cash flow projection template that makes it easy to complete that analysis. Whether taken through a salary or a draw, compensation to the owner is one of the items included.
When the owner takes a salary, it is considered an operating expense that is deducted from gross profit to arrive at net income. When you, as the owner, take a draw, it is considered a reduction in retained earnings and comes from net income after operating expenses are paid. Regardless of which method you use, the cash effect of these transactions is clearly shown on a cash flow projection.
Why does this matter? When cash comes out of your business, above and beyond what is supportable by cash inflows, another outside source of cash must replace it. This is what causes many business owners to take loans just to support their living expenses. And this is a red flag for lenders because it doesn’t help your business grow.
A Real Life Example
I received a loan request from a retail store that was owned by two partners. Sales had grown each year and the company was profitable. They needed funds for inventory because they said they could never keep enough on-hand to meet customer demand. At the time of the loan request, they had just taken out a loan from a short-term lender less than one month prior. Why wasn’t thatloan adequate to meet their inventory needs? Because the money was being taken out of the business.
After reviewing the company tax returns, I could see that each year the owners were taking out $100k in total draws. The problem was that the company was only netting a profit of $20k. The difference of $80k had to come from somewhere, so they continually took out short-term loans to support their cash flow gap.
I discussed this with one of the owners who didn’t understand why they couldn’t keep inventory in stock. I told her that since she was taking too much money out of the business, she wasn’t able to reinvest in inventory.
The partners were operating a business that clearly did not have the capacity to support their desired level of compensation. Each time they took out a short-term loan, they needed another loan even sooner. So, in addition to the compensation cash flow issues, the high cost of the short-term loans had even more detrimental impact on cash flow. Unless they were willing to make some major cutbacks in compensation, this team would ultimately borrow their way out of business.
How can you avoid borrowing yourself out of business?
Do a cash flow analysis – Complete the cash flow analysis that I provided by SCORE. Use that as a basis to work with your accountant to establish whether you should take a salary or a draw to compensate yourself. You should consult your accountant because there are tax implications for the method you choose.
Be prepared to make adjustments – Business owners know that revenues can fluctuate. In a tough year, be prepared to cut your pay to a supportable level. Planning for such a cut back by establishing savings is a good idea and it will help you avoid borrowing to support living expenses. The up-side here is that, in good times, you can look forward to paying yourself more.
Keep Business and Personal Expenses Separate – Establish a business checking account and use it for business expenses only. Avoid the temptation of swiping your business check card next time you go grocery shopping. Swiping the company check card all over town is an easy way to lose track of that supportable level of personal expenses, and exceeding them can put significant strain on your business.
In the end, we want to help you get the financing you need, but you have to help yourself first.