Updated: Sep 21
One of the biggest learning curves for business owners is understanding the distinctions between business and personal finances; specifically, how to manage the two differently.
Grasping Business vs Personal Finances
There are some tactics that work well for both individuals and businesses, including reducing expenses and long-term investing, but most other tactics simply don’t. Here we’ll walk through some key areas of focus to keep in mind as you manage your business finances.
A prime example of a practice that doesn’t work well for an individual but helpful for a business is leverage, for example, borrowing money to multiply gains. Even though gains can be multiplied through leverage, so can losses. In personal finance, leverage is generally a bad idea because it can result in losses that put even more financial stress on an individual and their assets (such as their car or house).
However, business is a different story. There are many situations in business where leverage makes sense financially. In fact, most businesses use leverage to access capital and increase profit margins. Leverage allows for businesses to grow and progress.
Two important concepts in leverage are debt and equity. Leverage is measured through the debt to equity ratio. This ratio is a tool that measures the liabilities/debt (for example, short and long term loans) a company has to the retained earnings and amount of assets owned by the small business (equity). The debt to equity ratio reflects the total debt divided by the total equity. The smaller the ratio is, the safer the small business is seen by loan officers, and the more capital they will give you access to.
Managing your finances responsibly is a critical path to accessing powerful capital through leverage.
A Business Plan
Although you may have a 5 year goal for yourself personally, or even a vision board, you probably don’t track your goals in incremental percentages of effort in and results out. A business plan does just that. Even if you’re just starting out, creating a basic business plan will help focus your energy and clarify your goals, but through a financial lens.
The business plan should cover: revenue, expense, and profit. Your profit is the money left over after you deduct your expenses from your revenue. In order to make more money, you will want to improve your small business’s gross margins. The gross margin is the number of total sales revenue after accounting for all of the costs necessary to produce your goods or services (this is called the cost of goods sold, or COGS). The gross margin is calculated by subtracting COGS from revenue, and then dividing this number by the revenue.
If that sounds like too much math, there are profit margin calculators online to crunch the numbers for you. Either way, by keeping track of revenue, costs (including COGS), profit, and gross profit margin, you will be able to understand the true health of your business finances and make informed decisions about leverage, investments, and growth strategies.
Taxes and Accounting
If you thought your personal tax deadline was a headache, business taxes and accounting can be much more complicated. You’ll need to set aside time to rack your expenses, set up payroll systems, and determine your tax obligations in order to plan your finances responsibly.
If you are paying yourself, decide whether you’ll manage accounting yourself or use an accountant. With accounting, you should also decide which method you want to use: cash or accrual. With the cash method, you recognize revenues and expenses when they are received and paid. With the accrual method, revenues and expenses are realized when the transaction actually occurs; this method will require you to track receivables and payables as well. If you are managing your accounting yourself, there are a number of tools available, such as Shoeboxed, Quickbooks®,or Xero which help keep track of your business finances.
Reminder: business and personal don’t mix
It’s important to separate your business and personal finances as completely as possible, which for most small businesses includes a business checking account and credit card, and often leverage in the form of a small business loan at some point. Avoid paying personal debts or bills from your business accounts and vice versa. Make sure your business finances are official by registering your business and obtaining a federal tax identification number.
This approach will make book-keeping easier, filing your taxes less complicated, and will make you a more credible candidate for loans and other financing.