My last blog described the importance of EBITDA as both a profitability metric and as a tool for estimating the value of a company. EBIT, its close cousin, is simply EBITDA minus depreciation and amortization expenses. It is also a crucial profitability measure but, for many small, virtual or service businesses, EBITDA and EBIT can be same. So, that’s why this blog is about the bottom line, net profits, instead.
Net profits, or net earnings, are what’s left over after all cost of goods, operating costs, taxes, interest, and depreciation have all been subtracted from its total revenues. Revenues minus all expenses. It is the famous “bottom line” on any profit and loss statement.
Entrepreneurs often contact me describing their “profitable” new ventures. Most have a very good handle on their company revenues and expenses. Yet, when they send me their financial projections, net profits are overstated. Production, labor, and operating expenses are covered in detail. As are capital expenditures and, hence, depreciation expense. Even intangibles, like patent expenses, are addressed. Just not interest expenses and taxes.
It is as if these entrepreneurs lose interest by the time they reach the bottoms of their projected income statements. The interest expense oversights that I most often see are unbooked, accrued interest, and a failure to document and charge interest on shareholder loans. The latter problem can fester, as it is usually an informal arrangement. There are no loan officers to send reminders. Undocumented shareholder loans were less concerning when the IRS short term AFR (applicable federal rate) was below 2%. Short term rates are now at 4.5% and likely to rise. This oversight can impact both corporate and personal tax returns.
Failing to plan for and project tax expenses properly is also common among startups. Some young managers simply assume that early year losses will offset (all) future tax expenses. It’s a mistake that can have a significant impact on a company’s projected cash flow. For instance, the combined Federal and state tax rate here in Massachusetts is 27%. In New Jersey it is 30%. In other words, that $1 million projected annual profit in Year 3 is really $700,000. It’s a critical oversight.
The bottom line, after all, is that one must also pay attention to what appears just above the bottom line.
Worldwide Local Connect works with entrepreneurs to resolve these and other, net profit impacting issues. For more detailed tax planning, we work closely with a small network of experienced CPAs/tax advisors. To find out more, contact us.