Small Business Tax Profit – What Does it Tell You?

It is that time of the year – getting the tax returns done for your small business. For some, it’s also time to ponder the difference between cash and accrual. Let me throw some variables into the mix to help you with your decision.

Many (too many) small business owners see the Profit and Loss statement for their business as the means to get their taxes done. They feel as if it were its only purpose and reason for being. Perhaps we should even call the Profit and Loss statement the “Small Business Tax Profit Statement”?

And many also believe that every decision made for tax purposes will automatically affect the way books are kept as well, because, after all, the only reason to even keep books is so you know how much taxes you need to pay, right?

Not quite… Not if you want to really maximize your potential in business.

Many small businesses are better off using cash basis accounting for tax purposes. That doesn’t mean, however that they have to use the same basis for their book purposes. You see, your own, internal accounting does not have to follow what you do for tax purposes. In fact, in most cases small business tax profit is not what you want to look at when making your business decisions.

Actually, when all you know is your small business tax profit at the end of the year, you are not using your financial information at all to help you make your business more successful and profitable.

Your Monthly Profit and Loss Statements are a Goldmine of Information
This is true, but only if your Profit and Loss statement is prepared correctly and then used as it is meant to be used.

When you follow cash accounting method for internal reporting purposes, most of your financial ratios will be distorted. For example:

  • If you have prepaid your rent in January for the next 16 months, that entire cost will appear only in that month and not show up at all in any other month this or next year
  • You will not know your monthly overhead costs or your true monthly profit
  • Your comparisons with prior periods will be useless
  • Your material costs will not correspond to your revenues and therefore
  • You will not have any reliable margin information

All this means that you will be in no position to manage any aspects of your business and monitor your results against any financial targets.

For some small business owners that’s not really a problem. They generate a certain amount of cash which makes them happy and that’s it. Their operation is still small enough to be very transparent to them without any monthly financials.

But if you have grown beyond that point, or if you want more, if you are interested in finding out why you have generated this amount of cash and not more, or why all of a sudden the amount of cash your business brings is shrinking, you will need to turn to your financial information and the small business tax profit will be of little help.

Small Business Tax Profit and Small Business Book Profit need not be the same and probably should not be the same. Remember, internal financial reporting and managing your business is the first and most important purpose you even gather any financial information at all. The rules that govern financial accounting may not be perfect, but they are aimed at giving you the most reliable financial picture of your business activities.

Tax returns are governed by the tax law. Also, the taxes you pay is just one of your business expenses, but often not the largest one. It’s just that they are paid only once a year. Imagine if you had to pay all your material costs or all your rent only once per year…

Your cost of sales and your payroll are often the largest expense items on your Profit and Loss statement. Without proper financial analysis you will not have the means to control and manage them as well as you could.

Getting your tax return done is certainly one of the purposes for your financial statements, but not The Only One.