Small Businesses in Need of Financing Should Develop a Strategy

Get ready for some hard work if you expect to need bank financing to expand your business in 2001. The economy seems to have slowed across the board, making it a good bet that small business will find it harder to borrow money this year than last.

This doesn’t mean that bankers will close up shop, of course. Instead, it means that business owners will have to work to make themselves good risks in the eyes of lenders.

How? You can start with a simple accounting strategy that seems to have disappeared from the radar of many small-business owners, among them many who rely on such popular software programs as QuickBooks or Microsoft Office to keep their books.

The strategy: Report income and expenses as a cash-basis business when filing your business income tax return and as an accrual-basis business when preparing your financial statements.

The strategy doesn’t work for all businesses, but it is perfectly legal and gives you the best of each accounting method, according to David Nadel, whose Encino accounting firm, Entous, Entous, Nadel & Co., specializes in tax planning for small and mid-size businesses and individuals.

Nadel cites two specific benefits of the strategy:

* It allows you to minimize taxation by reporting business income only when received.

* It also allows you to maximize profit on your profit-and-loss statement by showing income when earned.

As this implies, the strategy makes the most of the distinction between cash-basis and accrual-basis accounting, as recently outlined. With cash-basis accounting, business income shows up on your books when you actually receive it. With accrual-basis accounting, it shows up as soon as you earn it--for example, when you ship goods.

“If you can file your business income return on a cash basis, you’re entitled to generate your financial statements on an accrual basis,” Nadel says. “This can result in financial statements showing a greater profit, thereby making your business more attractive to a lender.”

There are some caveats, Nadel adds. For one thing, cash-basis accounting is an option only for businesses with no inventory and average revenue of less than $5 million over the last three years. Larger businesses must keep accrual-basis books, and they may show only accrual-basis financial statements as well.

The strategy works best if your accounts receivable exceed your accounts payable. To explain, Nadel gives the example of a fast-growing business with $2 million in sales, $500,000 in accounts receivable and $100,000 in accounts payable.

Under cash-basis accounting, the business shows $1.5 million in gross income for income tax purposes--that is, $2 million in sales less $500,000 in accounts receivable.

Under accrual-basis accounting, the business shows $1.9 million in revenue--that is, $2 million in sales less $100,000 in accounts payable--even though $500,000, or fully one-fourth of its gross revenue, remains outstanding in the form of accounts receivable.

For such a business, cash-basis accounting is a boon at tax time because it minimizes profit, Nadel says. Accrual-basis accounting, on the other hand, maximizes profit and makes the business more attractive to a lender.

To be sure, bankers want to see strong cash flow because it helps them to judge your ability to repay a loan, Nadel adds, and in many ways cash-basis accounting shows bankers the picture they want to see. But you can forecast cash flow even with accrual-basis accounting if you track and analyze your receivables carefully, showing your banker just how long it takes to turn them into cash.

“For those businesses that qualify, it’s perfectly kosher to use cash-basis accounting for income tax purposes and accrual-basis accounting for financial statements,” Nadel says. “In fact, it’s prudent to do so--and quite a few business owners don’t know that they can.”

The difficulty, Nadel adds, is that although accounting software programs such as QuickBooks and Microsoft Office permit you to follow this strategy, you must elect to switch from one method to the other when you generate your financial statements.

Tax law gives the business owner similar options when calculating depreciation costs, according to Nadel. For example, you may choose a depreciation method giving you a bigger write-off in the early years for tax purposes, then switch to a different method showing a lesser cost for your financial statements.

Similarly, you may capitalize certain leases, treating them as purchases and “stacking” your depreciation in the early years for a bigger write-off.

These options require some study, however, and your best bet is to consult closely with your accountant or tax advisor to make sure that you structure a strategy that makes sense and keeps you on the fair side of the law, he adds.

“The credit markets are tightening,” Nadel says, “and since small-business lenders make their decisions mostly based on the credit history of the business owner, not the business itself, I can’t underestimate the value of keeping your credit history as clean as possible. You have to do whatever you can to keep it clean, including tracking and correcting errors in your credit report.”

Next: How a Rancho Santa Margarita consulting company crafted an accounting strategy to make itself a good bet for a lender.

Recent Financing and Insurance columns are available at www.latimes.com/finin. Juan Hovey can be reached at (805) 492-7909 or at jhovey@gte.net.