Rich Business, Poor Business

I've titled this posting based on the bestseller by Robert Kiyosaki, “Rich Dad, Poor Dad.” If you have not read this book yet, I suggest you take a trip to your local library or book retailer and get a copy. Pardon the pun, but it provides a wealth of good advice on finance that I am going to apply to small business operations.

A good deal of this book focuses on understanding the concept of a balance sheet. I have to admit, as a young small business owner, I made the mistake of not paying enough attention to my balance sheet. To be honest, I did not truly understand the concept of a balance sheet until about 5 years into my career as a business owner.

For those who are not familiar with a balance sheet, it is based on the basic accounting principle that:

Assets = Liabilities + Net Worth

Using an arithmetic formula, this also equates into:

Net Worth = Assets – Liabilities

The goal in building wealth is to have a higher net worth, which means to have more assets than liabilities. The most important thing to remember about the balance sheet is that it is a snapshot of a given point in time. Every single business transaction you make will change your balance sheet in two places, hence the term “double entry accounting.”

Obviously, your goal in business is to increase the amount of assets on your balance sheet without increasing your liabilities. But new assets don't just appear magically onto your balance sheet. They can be introduced in three ways:

1. New investment from ownership
2. Appreciation in value of assets (i.e.: you have gold in inventory that you bought at $700/ounce and gold is now worth $900/ounce)
3. Net income from business operations

There in lies the key to using the balance sheet as a tool to make better informed business decisions. Something needs to happen to increase your businesses' assets. While it is true that some assets can appreciate in value, the reality is that most assets tend to lose value over time. Things like vehicles and operating equipment will depreciate in value. Inventory tends to “leak” over time and the older your accounts receivables get, the more likely that they are going to be converted into bad debt. The “rich business” owners know that the key to success is to invest in assets that will generate more net income.

Here is a simple example. After opening my second bagel store, we did pretty well. Aside from my salary that I was taking from the business, at the end of the year, there was an additional $20,000 in my share of the profits. Having been the driver of the company minivan for the past few years, I decided to use this opportunity to put a down payment on a brand new Mustang GT.

A little more than a year later, my wife and I were expecting our second child and the Mustang just wasn't looking like the smartest of decisions. I was schooled quickly on the concept of depreciation when I traded the Mustang in for a new mini van and only received $10,000 trade equity.

Had I reinvested this $20,000 into new revenue generating assets or even into an interest bearing account, our business would have had more revenue and more liquidity the following year. I would have been in a better position to support my growing family with this business. By taking that $20,000 distribution for personal use, I removed the new asset that my business had generated to my balance sheet from operations. The other assets we had depreciated in value, so even though my business did well, we actually lost total net worth compared to our starting point once we distributed those earnings. That put us at a disadvantage once we started making better decisions and tried to expand our business. We didn't have enough net worth available to grow our business.

Don't get me wrong, I am not trying to make business owners feel guilty about enjoying the fruits of their labor. I am just encouraging them to think before they act. At the least, a business should pay attention to their balance sheet and have a small gain in net worth every year. If not, the long term success of the business will be jeopardized.

I will continue with another post soon that will discuss some more details of what “rich business” owners pay attention to on their balance sheets to make better informed business decisions.