Doing a financial detox helps you do your taxes accurately and can even save you money by taking advantage of deductions. Plus, you’ll put in place practices that benefit your business years down the road.
The numbers you need to know
If your business is new and things are going well, it’s easy to gloss over the details. Do work, invoice clients, get paid. Restock, sell product, get paid. Simple, right?
But—beware! Unseen forces are lurking in the background. Operating costs, overhead, and cash flow all affect how your business runs. By tracking these, you can plan for growth, anticipate trouble down the line, and file a watertight tax return year after year.
1. Operating costs
Your operating costs are the money you spend to keep your business running. They can be broken down into two categories: Cost of Goods Sold (COGS) and overhead.
COGS (also called Cost of Services [COS] for service-based businesses) is the money you invest in creating value for your customers. For example, if you run a pizza shop, COGS includes the cost of ingredients as well as the wages of the people making the pizza.
Overhead includes the indirect costs of staying in business. Using the example above, think of it as the money you’d have to spend even if you weren’t selling any pizzas at all. For instance, you’d still need a shop out of which to run your business—so rent is part of overhead.
Why operating costs matter
Tracking operating costs lets you see how much money you’re actually making—and how much you need to earn to stay in business.
For instance, let’s say each pizza you sell costs $20. Once you add them all up, the operating costs work out to an average of $8 per pizza. That’s a profit of $12 per pie.
If you need to make a higher profit, you can isolate that $8 and find ways to lower it—by buying in bulk, using less expensive ingredients, or finding ways to make pizzas faster and more efficiently.
You can also calculate your breakeven sales volume so you know how many pizzas you need to sell to stay in business.
Calculating operating costs and breakeven sales volume
The formula for calculating operating costs is pretty straightforward:
Overhead + COGS = Operating Costs
Once you’ve tracked down all your expenses and plugged them into the formula, you’ve got your operating costs.
Breakeven sales volume is a little more tricky—but doable once you’ve calculated operating costs. For this, you’ll need to know your average price per unit.
Overhead / (Price per unit - COGS per unit) = Breakeven Sales Volume
Sticking with our pizza example: Let’s say your annual overhead is $60,000. Each pizza is priced at $20. And you spend $6 (in COGS) to produce each pizza.
$60,000 / (20 - 6) = 4,285
So, in order to cover overhead costs, you need to sell 4,285 pizzas per year.
2. Overhead
Overhead is the cost of keeping your business running, not counting COGS.
Some examples of overhead:
- Property tax
- Insurance
- Administrative costs (like bookkeeping)
- Utilities
- Janitorial services
We’ve already seen that overhead is important for calculating operating costs and your breakeven sales volume. But it serves other purposes as well.
Why overhead matters
Like COGS, overhead affects how much money you make from each item you sell. Once you calculate your overhead—by taking into account all the expenses it encompasses—you can figure out ways to reduce overhead and increase your profit.
For instance, something as simple as making sure all your pizza ovens are turned off every night can reduce the cost of utilities, which reduces the cost of overhead. Or you could find a way to lower the cost of back-office expenses—for instance, by switching to a less expensive bookkeeping system.
You can most clearly see how overhead affects your day-to-day income by calculating your overhead rate.
How to calculate your overhead rate
Your overhead rate is the percentage of each sale spent on overhead.
Total Overhead Cost / Sales = Overhead Rate
For instance, your annual overhead for the pizza shop is $60,000. And last year you made $320,000 in sales.
60,000 / 320,000 = 0.1875
So, rounding up, your overhead rate is 19%. That means that 19% of the cost of each pizza you sell—or about $4 if your pizzas are $20 each—goes to covering overhead.
How to set your ideal overhead rate
Your ideal overhead rate is equal to or lower than the average overhead rate in your industry. Set this rate as your goal, and your business will be set to compete with your peers.
To find your ideal overhead rate, take at least five annual income statements (aka profit and loss statements) from other businesses in your industry, and calculate the approximate overhead rate for each business. Then, add up every rate, and divide that number by the number of businesses to reach an average.
If you can’t get income statements for five or more businesses in your industry, try reaching out personally to other business owners—ideally, not ones you’re in direct competition with. They may be willing to discuss their overhead rates, and even offer some tips on how to reduce your own.
3. Average revenue
Your average revenue is the sales you make divided by a defined number of periods. For instance, your annual average revenue tells you how much, on average, you make every year; your average quarterly revenue how much you make, on average, each quarter; and so on.
Why average revenue matters
Sure, it’s nice to know how much product you’re selling or clients you’re serving. And if you calculate your average annual revenue, you may see it growing each year as your business becomes more established.
But average revenue can also help you month to month. Analyzing it on a monthly basis shows you how much you can expect to earn during each part of the financial year. And that’s especially important if your business is seasonal.
Let’s say that, in addition to your pizza joint, you run an ice cream stand. While pizza is popular year-round, ice cream mostly sells during the hottest months.
By looking back over your financial records for previous years, you can figure out, on average, how much you earn during June, July, and August. So you can anticipate how much you need to earn in the future and what types of sales targets to hit.
Calculating average revenue
Calculating your average annual revenue is straightforward. For example, say you want to calculate your average annual revenue since you started the business. Just add up all the revenue for every year, then divide by the number of years you’ve been in business.
Total Revenue for X Years / X = Average Annual Revenue
Analyzing monthly revenue year-over-year is a bit different. For that, you need to go back and add up all the revenue for the month you’re looking at, then divide that by the number of months.
Total Revenue for X (Months) / X = Average Revenue for (Month)
Keeping with our ice cream example: Let’s say you’ve been in business for three years, and you want to look at your August revenue for each of those years:
- August 2018 Revenue: $12,000
- August 2019 Revenue: $14,000
- August 2020 Revenue: $13,000
Once we add up all those amounts, and divide by three, we get your average revenue for August.
(12,000 + 14,000 + 13,000) / 3 = 13,000
So, in August 2021, you can expect to earn about $13,000. With that simple forecast in hand, you’re now able to plan how you’ll run your business. It’s especially useful for determining your cash flow for that time of year.
4. Cash flow
Cash flow is a measure of how and when money enters your business, leaves it, and how much you have on hand to work with. When you have positive cash flow, you have enough cash on hand to pay your expenses. When you have negative cash flow, you’ll find yourself coming up short.
Why cash flow matters
Let’s say you run an ecommerce store through Amazon. Amazon sends you your income from sales every 14 days. Last week, you made $1,000 in sales.
However, you’ll have to wait two weeks for that money to arrive. For now, that $1,000 in sales is just a number. In the meantime, you have vendor invoices you need to pay. Unless you’ve already got cash on hand, those invoices are going to have to wait—and your vendors won’t be happy about that.
Managing cash flow well guarantees you have money on hand when you need it, so you’re never left digging in the sofa for pocket change.
How to pulse check your finances
If you’ve been falling behind on your bookkeeping or calculating your monthly income on the back of an envelope, it’s time for a pulse check.
Checking in on your business’s financial well-being shows you the next steps you need to take to reach tip-top health. Bookkeeping records totally out of touch with reality? Time to hire a professional. Financial forecast showing a flatline? Could be time to invest in growth.
Here are three simple steps you can take to check the health of your business.
1. Do an internal audit
Don’t let the word “audit” scare you—many large businesses conduct internal audits regularly. An audit:
- Detects any discrepancies between your financial records and what you have in your bank accounts
- Makes sure you’re paying employees correctly for the amount of time they work
- Checks to see that invoices are being paid accurately and on time
- Accounts for all your assets
- Counts your inventory and checks for missing items
2. Prepare financial statements
Monthly or quarterly financial statements take info from your bookkeeping records and turn them into reports that tell you how your business is performing. At the end of the year, annual financial reports can be used to help prepare your tax returns.
If you haven’t been preparing financial statements, this is your chance to produce them retroactively. Having reports for each month or quarter lets you track changes in your finances over time. Later on, if you decide to apply for a loan or bring on investors, historical financial statements are key to getting funding.
The three key financial reports are:
- Income statement: Tells you how much you’ve earned over a certain period, how much you’ve spent and, and where it went.
- Balance sheet: Breaks down the assets, liabilities, and equity of your business
- Cash flow statement: Shows how money moves in and out of your business and how much cash you have to work with.
You can prepare financial reports using accounting software. Otherwise, your bookkeeper or accountant can handle them for you.
3. Create financial forecasts
Internal auditing and financial reports tell you how your business stands in the present. However, financial forecasts help you see into the future.
To create a financial forecast, you look at financial reports for past months or years, crunch some numbers, and find trends in how your business is performing.
For instance, you may discover your profits are increasing about 6% every year. Or you may discover that COGS is going up and cutting into your profits. By creating a forecast, you can see how those trends will affect your business one year, two years, or even five years into the future.
Then, you can try out hypotheticals. If you reduce your overhead by X amount, how will that affect your business in two years? If you reduce staff, what impact will that have?
By forecasting now, you can anticipate problems down the line and course-correct in the present.
How to make tax season easy(ier)
One of the most rewarding outcomes of a financial detox is an easier tax season. Completing a few simple steps during the detox will make it faster and easier to prepare and file your business taxes. You’ll find the first few months of the new year less stressful than usual—and have more time to spend helping your business grow.
Set up an expense tracking system
While you can track the bulk of your deductible expenses by keeping your books up to date, certain expenses—mileage, business meals, and office supply runs—can easily slip by the wayside. Setting up an expense tracking system now saves you time digging for receipts at the end of the year.
Expensify is a popular, freemium app you can use to track expenses on your phone. With higher-tier plans, you can bring employees onboard as well. Filing an expense is as simple as snapping a picture of the receipt and choosing a category. With all your expenses in one place, you can be sure you won’t miss out on any deductions.
Keep financial records
Keeping organized tax, bank, and bookkeeping records helps insure a painless tax season. You’ll have all the records you need to file your taxes—like expense receipts and financial reports. At the same time, in the (unlikely) case of an IRS audit, you’ll be protected.
Go paperless
When your books, financial records, invoices, and banking go digital, your life becomes easier. You can organize and search through records more easily, share them with your accountant, and keep backups in the cloud.
Your paperless office replaces staples and filing cabinets with apps and services. Some, like Expensify for expense tracking or Freshbooks for invoicing, make basic day-to-day tasks simpler. Others, like Bench or Gusto, form part of the bedrock of your business, helping it run more smoothly and reliably.
Here’s how to go paperless:
- Make a list of all the tasks you handle (or records you keep) using paper.
- Determine your budget for upgrading to a paperless system—keeping in mind the money you’ll save in time and effort by going digital.
- Seek out and compare competing digital services, and choose the ones that suit your business.
Hire an accountant
Many small businesses handle their day-to-day bookkeeping throughout the financial year. Then, come tax season, they dump all their records on an accountant and leave them to sort out the rest.
While having an accountant do your taxes definitely makes the job easier, finding and hiring an accountant familiar with your industry, and consulting them throughout the financial year, can help you save money and make smarter business decisions.
Think of an accountant like a doctor. You can go for a checkup every six months to catch problems before they grow and get advice on living a healthier life. Or you can wait until you’re really sick and then ask them to fix you.
Regular checkups from an accountant fulfill the same purpose. They help you keep your business on track, plan for the future, and insure you have all the info you’ll need to accurately file taxes and save money with deductions.
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Not unlike in real life, a financial detox can seem a bit daunting. But in the long-term, digging into that daunting work can have really big payoffs. Our advice? Hire someone to do it for you, and stick to what you’re best at—running a killer business.
If you’re anything like a lot of business owners out there, chances are you’re falling behind on your books (or, at the very least, you’ve thought about letting them slide for awhile). The good news? It’s easy to get an expert to catch you up on your bookkeeping—even if you’re years behind. And since tidy books are pretty much the bedrock for financial organization, getting caught up might just be your next financial health move. Here’s how.
