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The Different Types of Business Bankruptcy

September 28, 2021

8 min read

For small business owners, bankruptcy can feel like an obscenity to say out loud. When you read about big corporations going bankrupt in the news or hear entrepreneur friends share that their small businesses filed for bankruptcy, it sounds like they’ve reached a tragic end.

The truth is that bankruptcy doesn’t mean you’ll never work again—it doesn’t even mean that your business has to shutter for good. While the bankruptcy process for small businesses can be traumatic, expensive, and financially damaging, there are ways to mitigate the stress of bankruptcy as well as methods to protect your business and your assets during the process.

Knowing the different options available for small businesses considering bankruptcy is the first step. Before you contact a lawyer or your creditors, think about which type of bankruptcy might fit your situation best.

What Is Bankruptcy?

Bankruptcy is a legal proceeding decided in federal court involving an individual or company that is unable to repay outstanding debts. Typically, the process begins with a filing on behalf of the debtors, although occasionally debtors can begin the process with the court. During the process, the court takes into account the debtor’s assets. Depending on the type of bankruptcy, the types of debt involved, and the business’s structure, the court may decide that the assets are used to repay debts.

It’s common knowledge among entrepreneurs that most small businesses fail: Bureau of Labor data shows that about 50% of small businesses close within 5 years of opening. However, not every business that closes files for bankruptcy. Most companies that consider bankruptcy are having issues with repaying debt.

Still, small business bankruptcies happen all the time. In the first quarter of 2021, a study found that there were 6,289 commercial bankruptcies in the United States.

You often hear the different types of bankruptcies referred to as “chapters”—this refers to their chapter in the US Bankruptcy Code. Another recent survey of small businesses found that of respondents that filed for bankruptcy, 51% filed for Chapter 7, 22% filed for Chapter 11, and 27% filed for Chapter 13. We’ll talk more about these chapter types below.

When Should a Business File for Bankruptcy?

Instead of thinking about how successful—or not—your business is, when considering bankruptcies, think most about your debts and your ability to repay them.

“The truth is, if your business is consistently unable to keep up with your debts and expenses, it’s already bankrupt—or on a very short trajectory towards it,” explains Meredith Wood in AllBusiness. “Filing for bankruptcy protection is meant to help you get out of this untenable situation and keep many of your personal assets. You may be able to keep your business open while you pay off debt by reorganizing, consolidating, and/or negotiating terms.”

Filing for bankruptcy can lead to the closure of your business, but it can also be used to save your company by allowing you to renegotiate your debt situation. Either way, it doesn’t foreclose your ability to start another business in the future.

“While filing for bankruptcy does take recovery time, it isn’t the all-time credit-wrecker you may think,” Wood continues. “Typically, after 10 years, it is removed from your credit history, and you’ll likely be able to get financing several years before that.”

If you feel like your debt and business expenses are overwhelming your small business’s ability to continue, you should think about bankruptcy. The next step is to determine what type of bankruptcy represents the best way to move forward.

The 3 Types of Small Business Bankruptcy

The 3 main types of bankruptcies utilized by small businesses are Chapter 7, Chapter 11, and Chapter 13. There are even more forms of bankruptcies for individuals, companies, and cities, but these 3 types are the main commercial options available to you.

The type of bankruptcy you pursue will mostly depend on how your business is structured and how you plan to move forward after filing bankruptcy.

Importantly, any bankruptcy filing places a temporary stay on your creditors and puts your repayments on hold while the court considers your situation.

Chapter 7: Liquidation

In Chapter 7 bankruptcy, a company is closed and its assets are liquidated in order to pay off its debts. In the popular imagination, this situation is likely the one most people think of when they think about bankruptcy. If you believe your small business has no viable future, Chapter 7 might be your best option. Chapter 7 might also make sense if your business doesn’t have a lot of assets to begin with.

Sole proprietorships file a personal Chapter 7, which takes into account both personal and business debts.

When Chapter 7 proceedings start, a “means test” is conducted on the applicant’s income. If the income is over a predetermined level, the application is denied. Next, the court appoints a trustee to take over the company’s assets, liquidate them, and distribute them amongst the creditors.

If it is a sole proprietorship case, a discharge is issued after the creditors are paid, meaning the business owner is no longer obliged to pay any more of the debt in question.

Chapter 11: Reorganization

If you think your business can continue after bankruptcy, filing for Chapter 11 might represent your best choice. In this type of bankruptcy, the debtor plans to reorganize so that it can repay its debt while continuing operations. Working with a trustee and your creditors, you’ll have to devise an expansive plan that shows how you can repay your debt. Your plan must ultimately be approved by your creditors.

Chapter 11 is commonly talked about in the financial press, but it can be a hard process to navigate for small businesses.

“While Chapter 11 is designed to give distressed but viable businesses a second chance, it has a very poor track record with small and medium-sized companies,” a report from the Brookings Institute notes. “The costs of bankruptcy for small and medium-sized businesses are substantial—often 30% of the value of the business—and two-thirds are liquidated rather than reorganizing.”

There are good reasons to suspect that a Chapter 11 bankruptcy might work best for you if you don’t want to shut down. However, going this route can be expensive and lengthy—many proceedings take a year or longer to complete. It’s worth it to contact a qualified bankruptcy attorney if you want to explore Chapter 11.

Chapter 7 vs. Chapter 11

As complex as it is, you might want to research Chapter 11 if you feel like your business can continue with restructuring.

“The only reason you need to use Chapter 11 at all is to deal with recalcitrant creditors,” bankruptcy lawyer Bob Keach told the New York Times. “If creditors won’t negotiate with you, bankruptcy allows you to cram down a plan of restructuring.”

Remember, filing for Chapter 7 doesn’t mean you can never open another business, although financing might be more difficult to find at first.

Chapter 13: Reorganization for Sole Proprietors

If you’re a sole proprietor with a high income, you can file Chapter 13 bankruptcy. This allows you to keep your assets and property if you agree to a new repayment plan with your creditors. These plans usually last 3 to 5 years.

Does Filing for Bankruptcy Mean Going out of Business?

If you file for Chapter 7 bankruptcy, your business is closed and its assets are liquidated. If you file for Chapter 11, you’ll be allowed to keep your business open under a new plan with your creditors.

Will Business Bankruptcy Affect Me Personally?

A business bankruptcy could impact the business owner if your personal assets were used as collateral for your debts. Importantly, though, you will not go to jail for not paying a business loan.

“It depends on what personal guarantees you made,” Amy Haimerl writes in the New York Times. “Most small business owners put up their home or some other asset as collateral for start-up loans…If you used your house as collateral, it’s possible you would be forced to sell it as part of a Chapter 7 settlement. Under Chapter 11, you may have more luck.”

If you’re a sole proprietor and you file for Chapter 7 but fail the means test, you can file for Chapter 13. However, your repayment plan will be based on your income.

One of the big differences between personal and business bankruptcy is the means test. Individuals have to participate in a means test to determine if they are eligible for a Chapter 7 or a Chapter 13, while businesses do not have to undergo this for a Chapter 11 filing.

If your business is structured as a limited liability company (LLC) or a corporation, then your personal assets should be protected unless you used them to secure a loan.

If you file for bankruptcy as a sole proprietor, your personal credit score will lower significantly. Chapter 7 and Chapter 11 bankruptcies stay on your credit report for up to 10 years, while Chapter 13 bankruptcies stay on your credit report for up to 7 years.

If your business is an LLC or a corporation, its bankruptcy filing shouldn’t impact your personal credit score. However, if you personally guaranteed one of the company’s loans and you fail to repay, your credit score could be dinged.

What Is Gross Revenue? Understanding Net vs. Gross Revenue

August 15, 2021

6 min read

Running a successful business is more than just selling a great product or service. Even if you’re recruiting customers and exceeding their expectations, you could still fail. Business owners need to understand the inner workings of their business intimately in order to make better strategic decisions.

This process typically relies heavily on business financial metrics. Gross revenue is one of the most important variables for business owners to grasp, as it’s a number that you’ll use in many equations to determine different trends within your company.

Let’s take a deeper look at gross revenue and why it’s important for small businesses.

What Is Gross Revenue?

Gross revenue, also known as gross sales, refers to the amount of money you bring in before you deduct your expenses. This concept contrasts with net revenue, also known as net sales, which refers to the amount of money you bring in after your expenses are deducted.

In most cases, net revenue offers a clearer picture of how much money you have. For example, if you make $10,000 in sales but have $6,000 in expenses, then you would likely have $4,000 on hand. However, there are significant reasons to record your gross revenue and report these numbers.

Find Gross Revenue on Your Income Statement

Both your gross revenue (gross sales) and your net revenue (net sales) can be found on your income statement. They are traditionally located at the top of the statement reporting the revenue you made during that specific time period. Revenue serves as the starting point for determining your profits—after you calculate your gross and net revenue, you can subtract the cost of goods sold (COGS), operating expenses, and other costs to determine your net profit.

Most small businesses review their income statements monthly, quarterly, and annually. This allows them to view a small window of profits from the past few weeks (especially during a peak sales season) along with a big-picture view of revenue growth over time. These documents can guide organizational change to cut expenses or seek more revenue-producing opportunities.

If you work with investors or seek out a loan, you may be asked to present your current and past income statements for review. These parties also look at your balance sheets and cash flow statements to track the health of your organization.

Investors Look at Gross Revenue

Gross revenue highlights the potential for your business to make money, especially when it first opens. Investors look at gross revenue to understand if there’s a demand for your products or services.

When businesses first open, they often have higher expenses than those in operation for some time. You might have business loans to pay back, startup costs like equipment, and other operating expenses like increased marketing fees for your business’s debut.

All of these costs will drive down your net revenue and make it look like you aren’t making money. However, just because you aren’t making money when you first open doesn’t mean your business isn’t an immediate success. Most companies operate at a loss when they first open—this is why investors look at gross revenue.

Gross revenue can paint a picture of how customers react to your business. Your gross revenue will likely spike during a grand-opening event, for example, because you’ll bring so many people to your business. Each month, your gross revenue should increase as more people learn about your company and enjoy what you offer. Even if you aren’t making money yet, gross revenue can speak to sales and revenue growth.

Investors look at gross revenue to understand demand and potential. You can prove that you’re driving more customers to your business each month and selling more items with each new and repeat customer who walks through your doors.

Lenders Use Gross Revenue to Evaluate Risk

Even if you aren’t planning to work with vendors to fund your business, you may need to report your gross revenue to lenders if you want to secure a small business loan. Lenders evaluate gross revenue when calculating the risk of giving money to your business.

If you can prove that your revenue continues to grow, a lender is more likely to give you a loan—this is because the odds are higher that you’ll be able to pay them back. However, if your revenue has been stagnant or declining, then the loan holds a higher level of risk. This is true even if you want to use the loan to grow your business and increase your revenue. As a result, you may get approved for a smaller loan or less favorable terms.

This doesn’t mean you need to worry if you want to secure funding for your small business: your gross revenue is just one factor that lenders look at when approving loans. There are also multiple reasons why you might have lower revenue levels in the past few months or years—like a global pandemic. You just need to find the right lender who is eager to help.

Add Context to Your Accounting Materials

Accounting can be intimidating to business owners who don’t have strong financial backgrounds. However, you don’t have to be a numbers expert to put together clear reports and provide their context.

It’s not uncommon for income statements to come with a page of commentary: a separate sheet that provides context about the numbers to third parties. This commentary can help investors or lenders to better understand your reports. For example, you can explain why your advertising costs increased or your insurance costs went down. You can review revenue changes with investors and discuss your pandemic reopening levels.

The numbers in your reports tell a story. You have the opportunity to interpret the information and take action based on what you think.

Learn More About Other Key Accounting Terms

At Lendio, we’re passionate about helping small business owners achieve financial success. To learn more about the basics of accounting and bookkeeping, check out our resource center. We can also help you learn about different funding opportunities to grow your business. From short-term loans to business credit cards, our team is here to help you.

Guide to Reimbursable Expenses

July 28, 2021

5 min read

Reimbursable expenses are charges that you accrue when working for a client or an employer. They are the costs that come with completing a job or task. Instead of paying for those charges out of pocket, you will submit the costs to your employer or client for repayment—often with copies of the receipts.

Keeping track of reimbursable expenses is important if you want to save money and manage your business effectively. Let’s review some common reimbursable expenses and how to get paid for them.

What Does Reimbursable Mean?

A reimbursable expense means a company will pay the employee or contractor back for accruing it. It is different from you covering costs yourself. These are also called business expenses in some cases, though most companies prefer to differentiate between general business costs and reimbursable costs.

You may encounter many examples of reimbursable expenses within your business. For example, if an employee travels to a conference for work, they can report the hotel stay and airfare as a reimbursable expense if they pay for those travel costs with their personal accounts. If an employee visits a print shop or picks up catering ahead of a staff meeting, these charges may also be reimbursable expenses.

Companies need to set clear guidelines for what counts as reimbursable. For example, most companies have guidelines for reimbursing mileage rates when employees use personal vehicles for business purposes. They also set per diem amounts for what employees can spend when they travel. These guidelines prevent team members from spending $200 at a steakhouse and then asking their employer to pay them for it.

Most businesses will ask employees to gain approval on costs before charging them. This prevents conflict between employees who have already spent the money and employers who didn’t approve the costs. Pre-approval can also speed up the reimbursement process.

How Do You Invoice for Reimbursable Expenses?

Every organization has its own policies for reimbursement invoices. If you work as an independent contractor, you may be able to set up your own process or you will have to work with the employers who hire you.

Typically, each reimbursement invoice will have the same pieces of information for company review. These can include:

The purpose of the charges (ex. February conference)
The category of the expense (ex. Hotel stays, gas mileage, printing costs, etc.)
The cost of each expense (ex. $250 for hotel stays, $50 for gas, etc.)
The date of the expense
Receipts for each of the charges confirming the amount, the items purchased, and the date.

Some invoices might only have 1 or 2 line items if the expense was related to a quick errand or purchase. However, for long-term travel (like a 2-week business trip), these invoices can be several pages long and include dozens of receipts.

If you operate a business where you frequently reimburse employees, or if you seek out reimbursements from clients, consider downloading an app that specifically records business expenses.

There are tools like BizXpenseTracker and Expensify where you can scan receipts and record expenses while you are on the road. You can even auto-generate invoices and send them to clients from the app. This can save money and reduce the frustration of filling out invoices after a trip.

Are Reimbursable Expenses Income?

Reimbursable expenses are not considered income. Your employee did nothing to earn that money—and they should not use their own personal money to cover business expenses.

For example, let’s say you ask an employee to order business cards with a plan to reimburse them. The employee doesn’t profit from the business cards and doesn’t get any money from the process of buying them. They essentially loan your business money by paying for it out of pocket. You are not paying them a salary to purchase the business cards but rather repaying them for the cost of doing business.

Reimbursements should not be recorded as income because it will have tax implications if that is how it’s organized. Your employee is not earning higher wages because of the reimbursement, so it shouldn’t be considered income.

Are Reimbursable Expenses Taxable?

Expense reimbursements are not considered taxable. This means employees and contractors should not pay taxes when you pay them back for their business expenses.

First, this is not actual income. You are simply paying employees back for your cost of doing business. Next, employees use their already-taxed income to pay for your business expenses. Adding taxes to that is double-taxation.

As an employer, it’s up to you to make sure you separate your reimbursable income from your wages. It may be convenient to combine invoices or include reimbursements in payroll, but this can make your taxes more complicated when you submit them. You can’t expect to remember which income is reimbursed, and your accountant won’t know either.

Instead, continue to pay employee wages as you normally would, even if your team members are owed reimbursements. Then, create a separate accounts payable account for team reimbursements.

Your accounting department can write checks to your employees (or deposit them directly from your account) in order to keep the funds separate. This way when you submit W-2 or 1099 forms in the spring, the business expenses won’t be part of the income.

Keeping separate accounts can also protect your business. If you are audited by the IRS, you can prove that your wages are accurately reported and your reimbursable expenses are organized and paid out.

Categorize Your Expenses With Lendio's Software

If you plan to have more expenses as you grow your team—and particularly reimbursable expenses related to travel and general operations—then use an app that helps you stay organized financially. It’s easy to get overwhelmed with receipts and charges, but a software system can keep everything in place.

With Lendio's software, we have auto-categorization features that can help you sort through your expenses. With just a few minutes each day, you can stay on top of your books. Try our service out to see how you like it—it’s free for small businesses.

How to Calculate Your Cash Conversion Cycle

July 27, 2021

6 min read

As a business owner, you have a lot of financial matters to balance. Maintaining financial health, stability, and growth involves calculating many different metrics to make sure your business is on the right track to hit the goals you’ve set for yourself.

An important metric to track within this process is your business’s cash conversion cycle. This number can help you understand how well you’re managing the process of buying inventory, collecting payments from customers or clients, and then paying your vendors for that inventory.

Getting a better grasp of the cash conversion cycle and how it demonstrates the financial health of your business can help you stay on top of cash flow and inventory management, among many other important facets of your operations.

Let’s explore the cash conversion cycle, how to calculate it, what a good cash conversion cycle looks like, and why this metric matters to your business.

What Is the Cash Conversion Cycle?

The cash conversion cycle (CCC) is a metric that indicates how fast a company is able to convert its initial capital investment into cash. This cash flow metric can tell you how efficiently your business uses its short-term assets and liabilities to maintain liquidity.

In other words, the cash conversion cycle tells you how much time is between paying for inventory and/or supplies and getting paid by customers or clients.

Typically, you only calculate your CCC if you run a business that regularly handles inventory or materials, such as a retail business or construction company.

You may also know this metric by its other names—cash cycle, cash-to-cash cycle, or net operating cycle. However, it shouldn’t be confused with the operating cycle, which is a different metric altogether.

Operating cycle refers to the total number of days between when you purchase inventory and when customers pay for the inventory. In contrast, net operating cycle (aka CCC) is the length of time between actually paying for the inventory and collecting the payments from customers who’ve purchased inventory. This timeframe can include net-terms with you and vendors or your customers.

How Do You Calculate Cash Conversion Cycle?

You must use a few different operational ratios, including accounts receivable, accounts payable, and inventory turnover, to find the numbers you need to input into the CCC formula. You can find these elements on different financial statements, such as your balance sheets and income statements:

Revenue
Cost of Goods Sold (COGS)
Starting and ending Accounts Receivable (AR)
Starting and ending Accounts Payable (AP)

You must also determine the period for which you want to calculate the CCC, such as a whole fiscal year or a quarter. Use the number of days in the period you’re measuring, such as 365 days for a year or 90 days for a quarter. Make sure that you use the same period for every step to get the most accurate CCC calculation.

Here are the 3 elements that make up the CCC formula and how to calculate them:

Days Inventory Outstanding (DIO): This number is the average time it takes to convert inventory into goods you then sell. Find the DIO by taking your average inventory for the period you’re measuring, divide it by the COGS, and then multiply by the number of days in the period you’re measuring.

(Beginning inventory + ending inventory) / 2 = Average inventory
(Average inventory/COGS) x number of days in period = DIO

Days Sales Outstanding (DSO): This is the average number of days it takes to collect AR over the same period. First, divide your AR by net credit sales. Then, multiply that by the number of days in the period to find the DSO.

(Beginning AR + Ending AR) / 2 = Average AR
(Average AR / net sales) x number of days in period = DSO

Days Payable Outstanding (DPO): This is the average number of days it takes your business to order from vendors and then pay your AP to them. Take the ending AP and divide it by COGS to get the DPO.

(Beginning AP + Ending AP) / 2 = Average AP

(Average AP / COGS) x number of days in period = DPO

Or, you can calculate it with this formula:

Beginning inventory + Purchases - Ending inventory = Cost of Sales
Average AP / (Cost of Sales / number of days in period)

Now that you have all the parts, you can use this formula to determine your CCC for a given period:

DIO + DSO - DPO = CCC

What Makes a Good Cash Conversion Cycle?

Companies with a low CCC typically have higher liquidity, meaning they have more cash on hand, which is a sign of great operational and financial management. When a CCC is high, that means a company is taking too long to convert inventory—that they’ve bought on credit that is to be paid back when customers start purchasing goods—into usable cash.

That means the goal is to have as low of a CCC as possible to ensure the best possible financial health of your business. Having a negative CCC is even better because it means your cash isn’t tied up for long at all. In fact, there’s no time spent waiting to get paid.

However, it’s important to note that online retail businesses are more likely than others to have a negative CCC. That’s because these businesses typically use drop shipping, meaning they don’t hold inventory and don’t have to pay for inventory until customers pay them first. This process also helps e-commerce stores manage a lot of the working capital problems that come with traditional brick-and-mortar retailers.

Here are some elements that make up a good CCC:

Lower inventory turnover
Correctly forecasted inventory needs
Collecting outstanding payments on time
Paying bills more slowly than collecting payments

Why Your CCC Is Important

Keeping an eye on your cash conversion cycle is important to growing and sustaining your business. Investors, lenders, and other financial resources typically review a company’s CCC to determine its financial health and its liquidity. And the more liquid a company is, the more likely it is to pay back loans and grow investments. That makes for a great financing opportunity for lenders and investors.

You also can use your CCC to compare your business’s financial state to that of your competitors. It can give you a better idea of where you stand in terms of business practices and market share.

When your CCC is solid, it often means that you are managing your business operations, including inventory acquisition, turnover, and client or customer payments, well. That can make you feel more confident about the state of your business.

Understanding the 8 Fields of Accounting

July 23, 2021

7 min read

When you picture an accountant in your mind, what do you see? Perhaps it's someone studiously reviewing spreadsheets on a computer. Or you might envision a more hard-copy-reliant individual sitting at an oak desk surrounded by massive piles of papers. Regardless of the specifics, your image probably involves lots of numbers and documents.Truth is, there are 8 different types of accounting. Some are dedicated to helping small business owners prepare their taxes. Others have a passion for nonprofit work and know how to use accounting operations to put these organizations in a position to thrive. Others specialize in catching criminals. It’s safe to say that, yes, nearly all of them crunch numbers and deal with documentation.

While there may be common threads between the different fields of accounting, most accountants become specialists and don’t bounce around from one field to the other. The various branches involve enough nuances that it would be challenging to just decide that you wanted to start doing 1 of the others.

The 8 Fields of Accounting

Let’s take a quick look at the 8 different types of accounting:

Financial accounting
Tax accounting
Cost accounting
Managerial accounting
Forensic accounting
Fiduciary accounting
Auditing
Accounting information systems

You’re likely familiar with some of these types of accounting, as they have more relevance to your role as a small business owner. But others, such as forensic accounting, might seem a bit nebulous. Let’s dig a little deeper into each of them.

Financial Accounting

Your small business racks up transactions each year. Whether you’re purchasing products from a supplier or selling services to customers, these transactions need to be properly documented. Financial accounting ensures that your business’s dealings are all categorized and reflected in the relevant statements such as income statements, cash flow statements, and balance sheets.

Some business owners tackle these financial accounting tasks themselves. Others use bookkeeping services.

Tax Accounting

This branch of accounting is specifically tied to the tax side of business. Chances are high that you’ve filed your own taxes at least once in the past, but you’ll want to turn to dedicated professionals to ensure that your documents are in order and your tax returns are flawless.

“Tax laws often undergo changes and can be complex,” explains an accounting report from Rose Johnson. “Tax accountants ensure that companies and individuals comply with tax laws by filing their federal and state income tax returns. Some tax accountants also offer tax planning advice to help businesses and individuals save money in taxes. A career in tax accounting is challenging but also rewarding. A tax accountant career requires following a specific education and career path. It is important to understand the job requirements.”

With a tax accounting professional on the job, you can rest a lot easier when tax season rolls around. For starters, they will help you identify legal methods for lowering your tax bill. And when it comes time to file, you can trust that all the details have been handled with care.

Cost Accounting

If you’re in the manufacturing industry, you’re likely familiar with this branch of accounting. At its core, cost accounting is all about processes and operations. So it would be relevant if your business purchases materials and then manufactures new products from them. The more operations you have running, the more essential this accounting could be.

Through cost accounting, you’re often able to identify areas that can be more efficient. When all your variable and fixed costs are broken out, you can see their correlations and where improvements can be made.

For example, you might realize that you’re paying too much for shipping. By dropping off packages earlier in the day and reusing shipping materials, you could begin to decrease these costs. Or your rent might be higher than market rates, so you could work on renegotiating the lease.

Managerial Accounting

If you make important discoveries aided by cost accounting data, managerial accounting is where the rubber meets the road. All those insights need to reach the right people in order to enact change.

“Managerial accounting, also called management accounting, is the process of gathering, organizing, and reporting the company's financial data for the purpose of managerial decision making,” explains a tax analysis from The Balance Small Business. “Both financial accounting and cost accounting provide their financial data to management to assist them with decision-making. The reporting functions of financial and cost accounting are important to managerial accounting since raw financial data is summarized for the managers in report form. Using the data provided by financial and cost accounting together, management can look at a broader picture of the firm's financial performance.”

The better the accounting insights, the better the business decisions. Thus, managerial accounting is a critical way to analyze, forecast, budget, and ultimately strategize your business to a whole new level.

Fiduciary Accounting

Here’s a less common type of accounting that you might not have heard of. A fiduciary is someone who is obligated (legally or morally) to maintain the trust of a client. Fiduciaries are held to a high standard and must not seek their own gain in their business relationships. The dynamic between an attorney and her client is an example of a fiduciary relationship.

With fiduciary accounting, an accountant handles certain aspects of a business’s finances. Depending on the situation, the arrangement might involve receivership, trust accounting, or estate accounting.

Forensic Accounting

All of the branches of accounting listed above have dealt with the reviewing, managing, and analyzing of financial elements. But when the accounting was done inaccurately, be it intentionally or by accident, a forensic accountant might be called in.

Whether it’s fraud or a lawsuit, certain scenarios can require the assistance of these specialized professionals who know how to look for clues and reveal bad data. It’s fortunate that forensic accountants are around to help clear up some of the messes caused by those who don’t care about keeping their finances orderly and legal.

Auditing

Another way to uncover fraud, inaccuracies, and incompetence is auditing. Internal auditing is where a business’s own professional scrutinizes how the business handles its accounting operations. These inquiries often reveal bad practices, inefficiencies, and dishonesty.

External audits are obviously conducted from the outside. A third-party evaluator comes in and checks for issues and areas of improvement, which isn’t necessarily as painful as it sounds. In many cases, an external audit can help you uncover new ways to improve your business and become more successful.

Accounting Information Systems

The final branch of accounting that we’ll discuss here is accounting information systems (AIS). As the name suggests, these systems are usually powered by software. By managing financial data, they offer great insights to everyone involved.

“Most accounting tasks these days are processed in a computer, so information systems have a huge impact on how accounting is done and what reports are generated,” says business bookkeeping guru Sheila Shanker. “Not only are accounting tasks performed at a high speed, they are also made easy to do for most businesses. Calculations are done automatically with fewer errors than manual accounting, greatly improving efficiency.”

As with other automated systems, it’s been shown that an AIS is exceptional for securely storing data and unlikely to make errors. Obviously, the human element of accounting is also important, so these systems work best in conjunction with other accounting professionals.

Accounting for What Matters Most

All the branches of accounting feed into the same tree. They have different perspectives and functions, but all are intended to help keep your business organized, efficient, lawful, and primed for success. So make sure you’re leveraging the different types of accounting in order to get the most value from all your hard work.

What is a Letter of Credit?

July 19, 2021

5 min read

A letter of credit is a statement by a bank or financial institution on behalf of a customer. This is typically used in B2B transactions when one company wants to assure another that it will pay the full amount agreed to in the transaction. When your business receives a letter of credit, it comes with the promise that the bank will pay the balance owed in full, even if the customer cannot.

A letter of credit can be used to move a sale forward. The letter recipient can rest assured knowing that they’ll receive payment, and the buyer can receive the goods they need to grow their business.

Learn more about the process of issuing and receiving a letter of credit during a sale.

Defining a letter of credit.

A letter of credit is defined as “a statement issued by a bank to the buyer of a good stating that the seller will receive payment on time and in the correct amount.” You might also see the term “irrevocable letter of credit” to describe this financial concept.

Letters of credit are often used for major business transactions. When you’re purchasing thousands of dollars in goods, it helps to have the backing of a bank to prove that your vendor will get paid. If you don’t have the funds on hand to make the purchase, this letter can ensure that your vendor gets paid on time—given the net terms established in the contract.

Because small businesses typically don’t have a lot of working capital around to cover materials or inventory, they usually purchase on credit—and a letter of credit from a bank can provide peace of mind to vendors that they’ll be paid in full.

These letters are more common with international trade. When companies work with customers in different countries, they’ll receive letters of credit from banks—often international firms that specialize in trade—proving that the companies they work with are good for the money.

Who issues a letter of credit?

The most common source for a letter of credit is a national or international bank. These companies are used to working with large businesses and enterprises that engage in large-scale trade.

The letter of credit will often cover more than just the payment amount to the seller. It will also include important details that are relevant to the exchange of goods. For example, it will include when the business will receive payment (before the delivery of goods, after, or half-and-half) and when the seller will deliver the goods to the buyer. These terms were likely already discussed by the two companies involved, but the bank will work to confirm the details.

Like any other loan, there is a process to issuing letters of credit. The bank will conduct background checks on the buying company, check the credit of the business, and possibly ask for deposits as a way to hold the company accountable. These steps all reduce the risk levels of issuing a letter of credit and increase the chances of repayment.

While it can take time to issue a letter of credit, it still allows buyers to get the goods they need faster so they can continue operating their businesses.

What is the cost of an irrevocable letter of credit?

Banks agree to issue irrevocable letters of credit because they profit directly from funding the transaction. This is no different from a bank issuing a loan or mortgage: they’re happy to provide the money because they benefit from the interest you pay on the loan.

The standard cost of a letter of credit is around 0.75% of the total purchase cost. For letters that are in the 6 figures (typically around $250,000), these fees can add up and benefit the bank. In some cases, the letter of credit commission could fall close to 1.5%.

The buyer typically picks up the costs associated with the letter of credit. However, the seller may receive some charges as well. These include charges related to wire transfer costs, courier fees, and bank fees. By the time the transfer is complete, the seller can expect to pay between 5 to 10 fees—most ranging from $25–$150.

On top of the fees, the buyer will typically need to put down a deposit on the letter of credit. This is usually around 1%. A deposit proves that the buyer is serious about repaying the rest of the money to the bank.

Know your funding options.

Letters of credit aren’t limited to international trade deals worth hundreds of thousands. You may be able to use this option as a way to buy materials and close deals with local vendors. If you need cash to complete business purchases, talk to your local bank—they can walk you through the letter of credit process.

Alternatively, you can look for short term loans and other funding choices to increase the capital of your business. Explore the online loan center at Lendio to find financial institutions that want to help you. Use our services to grow your business.

Economic Profit vs. Accounting Profit

July 9, 2021

4 min read

As you develop your business accounting processes, you may notice different types of profits in your reports. Each of these metrics serves a different purpose in providing insight into the financial health of your business.

Economic profit and accounting profit are 2 important business measurements for you to understand. Learn the difference between economic and accounting profit below.

How Is Accounting Profit Calculated?

Accounting profit also goes by the term net income. It is the final number you calculate after subtracting various costs from your total sales.Accounting Profit = Total Revenue – Total Explicit Costs

For example, you will start with your total revenue and then subtract wages, raw materials, marketing costs, and other overhead. These are the explicit costs of running a business.

Typically, you can find the accounting profit (net income) on the company’s income statement or profit and loss (P&L) documents.

What Is Meant by Economic Profit?

Economic profit is more theoretical than accounting profit. This number reviews the costs and potential revenue had the company made one choice over another through the course of the year. It is the accounting profit minus the opportunity cost of doing something else.

Economic Profit = Total Revenue – Total Explicit Costs – Total Implicit Costs

A common example of implicit costs that you won’t see on the income statement is when a small business owner works overtime or works for a period without drawing a set salary. If you’re an owner doing this, you are not directly costing your business any money, but you are incurring implicit costs because the opportunity cost of your labor is equal to what you could be earning at a regular, salaried position.

Implicit costs are often hard to evaluate and measure, but they are extremely real aspects of running a business. Choosing to use your warehouse to store inventory vs. converting it to a storefront is a decision that has an opportunity cost. Deciding whether to hire employees or outsource work creates implicit costs, too. There are many examples of decisions small business owners have to make that carry implicit costs.

This year, businesses are likely considering economic profit amid the COVID-19 pandemic. What if the store had remained closed longer or opened up faster? What if the company invested in curbside delivery?

Economic profit relies on implicit costs, using the company’s resources in different ways to maximize potential growth.

Can Economic Profit Ever Exceed Accounting Profit?

In short, the economic profit should never exceed the accounting profit.

The economic profit comes from subtracting the opportunity cost from the accounting profit. For example, a restaurant earns $60,000 running a food truck over a year but had the potential opportunity cost of $50,000 from launching a catering arm instead. The economic profit is $10,000 to the company because it profited from the food truck opportunity.

Economic profit can be a negative number. If the economic profit is positive, then it is in the best interest of the business to keep making money in the field. If the economic profit is negative, then the business should exit the market and look for other income sources.

For example, a freelance web designer earned $75,000 in a year. However, if most people in their field earn $100,000 annually working for an agency, there is a negative economic profit and the freelancer should consider seeking full-time employment.

There is also no such thing as a negative opportunity cost. There are always profits for potential opportunities. The opportunity costs track the options that businesses did not choose (or couldn’t choose), not penalties that held them back.

Use Both Types of Profit Calculations

There’s no need to pit accounting profit vs. economic profit on your accounting sheet. You can use economic profit to determine whether or not your company is making smart decisions and whether you should consider pivoting.

You can also use this theoretical process to forecast potential revenue if you change your business plan or make a future investment. Economic profit and accounting profit are both helpful metrics to use when evaluating your financial health and how to best take your business forward.