Personal and Business: The Importance of Separating Your Finances
We have discussed the benefits of good financial reporting on the blog before, and today’s topic is not too far from it. For small businesses, one of the biggest things that gets in the way of having organized, quality financial reporting, is the mixing of business and personal income and expenses. At the end of the day, all profits go back to the owner, so why would it matter? We will discuss later, but first let’s look at how they get mixed to begin with. This issue usually shows up in a couple key ways:
In the Beginning: In the early stages of a new company, there is no established checking account, credit card, line of credit or other business named financial source, so the owner must pay for business expenses themselves. Then, as the company gains traction, they can begin to pay their own bills, but often some expenses continue to be charged to the owner and slip through the cracks.
In Capital Infusions: Working capital ebbs and flows throughout the lifetime of the business and often owners are on the hook to fill in the gap when extra cash is needed. Either the owner deposits cash directly into the business, or they start to cover expenses on their own, both methods can quickly lead to confusion as to how much the business is able to cash flow itself and where the owners equity stands. If you start involving other people, it gets even murkier. Is the cash a loan? Is it an equity portion? Clear documentation is needed whenever financing is established, no matter how casually.
In Last Minute Decisions: It’s a fire drill at work and the supplier needs to be paid NOW. You don’t have your company credit card on you, there isn’t enough in checking and so you pull out your personal credit card to get the problem solved. While you plan on being reimbursed, it may take a few weeks. Or, you may net it together with your paycheck at the end of the week and take a larger disbursement. And you may round down to make it easier. These small short cuts can add up to big issues down the road, especially if they are happening often and with different owners.
It’s tempting to think “my personal finances are my right pocket, and my business finances are my left pocket - it’s all going to the same place! What would it matter if I paid expenses, or received income out of one versus the other.” But this type of thinking is a slippery slope. Let’s talk about why.
A Clear Financial Picture of the Business is Important
As we mentioned in our blog post about good financial reporting, it is important to have a true and honest picture of how the business is doing. Is it self sustaining? Could you afford to pay yourself a true market rate salary? It is also critical, down the road, when a company is looking to raise additional financing to have strong financials. You need to prove your income and expenses are accurate and be able to monitor trends over time. Your balance sheet needs to accurately reflect your current equity, including all net profits or losses and all distributions and cash infusions over time. Loans to other shareholders need to be accurately documented as well. Too much sloppy accounting can muddy the water so much it’s difficult to clean it up.
The IRS Cares
More so than a lender you may be trying to access capital though, all businesses need to file an annual tax return and the IRS requires that it is accurate. You may be missing out on crucial business expenses that could lead to a lower overall tax bill if they show up on your personal credit card. Too much lumping together or rounding leads to inaccurate accounting and makes it more likely to draw scrutiny or an audit.
What To Do
Although it can at times feel frivolous, a paper trail back and forth between personal and business finances is important. To do this, keep track of receipts and reimburse the correct person for the exact amount. Then, be sure to account for that reimbursement correctly, as the original expense it was for. Track payroll and disbursements separately to keep owner’s capital accounts accurate as well. Do not pay for any personal expenses with business dollars. Take a disbursement and pay for them personally. There should be no shopping trips, grocery runs or weekend vacations on the business P&L - all it does is discredit your other, legitimate expenses. While it can be tedious to write checks, basically to yourself, back and forth - it keeps your business books cleaner and more useful.
No matter how small, consider your business a stand alone entity! And as it gets bigger and cash flow ebbs and flows, be strict about correctly documenting dollars going back and forth.
