By Tom Grandy
A few months ago you had your annual meeting with your CPA and he/she told you the same thing they tell you year after year. “John, you had a great year. Your net profit was $88,000 last year which you will pay taxes on.” Wow, that made you feel really good until you looked in your checkbook. The checkbook didn’t have anywhere near that amount of money in it. So where is it?
Debt, in the form of loan payments is the silent killer, kind of like carbon monoxide. You feel good while it’s sucking the life out of you. Every loan payment is made up of two parts. The first is principle. That is the portion of the loan payment that actually applies towards paying for the vehicle or piece of equipment you purchased. The other part of the loan payment is interest. This is the amount of money it is costing you to borrow the money from the bank or lending institution.
“Ok, I get that but how does that hurt my profitability and taxes?” The problem is that principle and interest are handled DIFFERENTLY from an accounting/IRS standpoint. The interest portion of the loan payment is treated as an expense in terms of your P/L statement. The principle portion of the loan goes off to never-never land. Sure, it’s in your assets and liabilities but it does not show up in your P/L Statement and THAT is what your profitability is based on for tax purposes.
Let’s walk through an example. Our sample company grossed a $1,000,000 in sales. At the end of the year the net profit shown on the P/L statement was $73,500. This same company has the following loan payments:
Principle Interest Total Loan Payment
Vehicle Loan #1 $ 567 $ 123 $ 690
Vehicle Loan #2 463 99 562
Vehicle Loan #3 614 137 751
Equipment Loan 512 107 619
The total interest for the year is $5,592 ($466/month X 12 months = $5,592). Interest is treated as an expense by Uncle Sam and shows up that way on your P/L statement. The total principle paid was $25,872 ($2,156/month X 12 months = $25,872) but it does NOT show up in your P/L statement. That’s right. You wrote the check and the money came out of your checkbook but you are not allowed to count the principle as an expense. Only the $5,592 interest showed up in your P/L Statement. Ouch!
Now, back to our CPA’s annual review. Based on Uncle Sam’s rules the company made a $73,500 net profit. However, from a cash flow standpoint (real dollars in and real dollars out) the company made a $47,628 net profit ($73,500 – $25,872 = $47,628). This dollar figure should be somewhat closer to what you really had in the company checkbook.
Taxed on Money You Don’t Really Have
The above helps explain the difference in the profit that your CPA and/or Uncle Sam say you have, verses what’s really in your checkbook. However, it’s telling you something else as well. It’s telling you you’re actually paying taxes on money that is not in your checkbook. Double ouch! “But Tom, that is not fair.” I agree 100% but guess what, life is not fair.
What we discussed above was loans. However, general debt repayment is even worse. By general debt, I am talking about paying back money on a line of credit or a personal loan from you, a friend or investor. General debt also includes paying back money you owe the supplier, or paying off a line of credit and/or credit card debt. These types of “loans” are pretty much all principle. That means any money flowing out to pay for these things is pretty much completely ignored in terms of being able to count it as an expense.
The solution is really pretty simple. Stay out of debt! In order to do that the company needs to properly price their products and services. That covers two areas:
- Equipment Replacement vs. Depreciation – Depreciation is an accounting term that allows the company to write off a portion of the original purchase price, normally over a five-year period. But even that is looking at original costs, not future replacement costs. Equipment replacement cost deals with what it is “going” to cost you to replace it years in the future. For example, let’s assume an existing truck will last the company three more years and will cost a net $30,000 after trading in the old vehicle. You then take the needed $30,000 and divide it by the three years you have left before replacement. That means the company will need to set aside $10,000 per year over each of the next three years in order to have the money to replace the current vehicle with cash.
That sounds like a great idea, but as usual there is a catch. The Equipment Replacement dollars you put back is an expense to you (from a cash flow perspective) but to Uncle Sam it’s profit and he will tax it!
- Earn A Reasonable Profit – Be sure to price your products and services at a proper net profit from a cash flow perspective. A well-run company should generate roughly a 12% net profit or more. The net profit generated covers company growth. It will fund increased inventory and your growing accounts receivable while at the same time providing cash to purchase new equipment and vehicles. Generating a significant net profit will help keep the company out of debt.
Now you know where the profit dollars your accountant said you had, went. You also know how to stay out of debt. Remember, there is a huge difference in knowing what to do and doing it. The choice is yours.
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