Wednesday, March 4, 2009

30-Day Economic Stability Challenge: Financial planning 101

Often, people go into self-employment because they love doing what they do, says Sherrill St. Germain, MBA, CFP®, is founder and principal of New Means Financial Planning, a Hollis, NH-based, fee-only financial planning firm. She provides financial advice on an hourly, consulting basis.

"The thing is, the skills required to be a good writer or a good financial planner are often different than the ones required to run a viable business. Plus, they compete for your time and mindshare."

So how do you put on your business cap if you've never had one? St. Germain, who especially enjoys working with career changers to develop financial plans that enable them to transition to their dream job and the life that goes with it, answers some of finance 101 questions below.

If you haven't done all of them, don't panic. The point of this challenge is to learn and start applying the principles now.

Heather: How is managing finances different for a newly self-employed person than it is for people with full-time jobs?

Sherrill: Ultimately, it’s about taking responsibility for managing things previously managed, if not actually paid for, by your employer:
  • Changes in the business’ ability to make money;
  • Income tax withholding;
  • Retirement savings;
  • Health insurance; and
  • other insurances, etc.
Further increasing the challenge, this usually has to be done in an environment with fewer economies of scale. So if, by self-employed, we are mostly talking about solo or very small business, that self-employed person will not be as likely to get a good a price as is offered to those buying in quantity, whether the item being purchased is insurance, widgets to be used in a product, or marketing materials.

The plus side: The self-employed have increased control over their financial destinies. In particular, as a full-time employee, you can be laid off at any time, resulting in income going from nice predictable stream to $0 almost overnight. As a self-employed (if you’re doing it right and not relying too much on any one customer), the loss of a single account hurts but you don’t go immediately to $0. Also, working harder/smarter has the potential to have a direct, fairly immediate impact on income, whereas a full-time employee may have to wait until who-knows-when to get a much-deserved raise.

What are the biggest challenges people face, and what should people do to address them before they become a problem?

It all comes down to cash flow, and I think I may have addressed how those challenges arise (probably ad nauseum!) elsewhere.

As far as what to do about it, the answer is to do cash flow projections on a frequent enough basis to catch a shortfall before it starts to cause ripple effects, such as bounced checks that result in angry suppliers no longer willing to provide widgets required for you to deliver product which results in angry customers or maybe former customers. This might be monthly, weekly, or even daily, depending on the kind of business and the size of the cash cushion.

Don’t like keeping a constant eye on the financials? Better have a bigger cushion.

What are the most common financial mistakes made by newly self-employed people?

Not doing nearly enough math to determine whether their plan will generate enough money in the time frame they need it to, in order to support themselves without a lot of angst, financial and otherwise. In my experience, people often want to shift to self-employment so bad, they avoid running the numbers (or they are overly optimistic) so as not to find out things aren’t as rosy as expected and be faced with a difficult decision.

My take: However painful it might be to delay a shift to self-employment to allow for the numbers to work, it’s always less painful than making the leap and finding out later, once thousands of dollars poorer and much more discouraged, that it won’t work. Here are some common gotchas:
  • Making the shift to self-employment without enough cash to get through the lean beginning period, which can last 3 years or more.
  • Not knowing how much income from the business would be enough, because you don’t know what you spend now or how it will change after becoming self-employed.
  • Not keeping business and personal finances separate.
  • Not keeping enough of a cash cushion in your business account
  • Confusing sales (money you are paid by a client) with net income (the amount that you actually make AFTER you pay all the costs of doing business). For example, if you have a $15,000 contract but it costs you $12,000 to deliver on that contract, you only end up with $3000 as income. From that, you’ll need to pay a portion in taxes. The rest is yours to do what you like with: take as salary, reinvest in the business, whatever. But don’t plan on $15,000!
  • Forgetting to set aside money for income taxes that will be due on any money you get paid, and getting an unpleasant surprise the following April.
  • Not planning for the employer’s portion of payroll tax, a.k.a. the self-employment tax.
  • Forgetting to save for retirement – No matter how perfect a fit your work, you will someday want or need to retire.
  • Not getting professional liability, disability, or life insurance (or – God forbid – health insurance) if your family situation calls for it.
What advice do you give to freelancers about managing cashflow? What kind of system do you recommend?

Try to mimic the model of people with full-time jobs. That is, treat the business as a completely separate financial entity. This includes setting up a separate business checking account with enough cushion to allow for expenses to get paid during down, as well as up, periods. This might be something like $3000 – 5000 or more (depending on how big your biggest expenses are and how reliably and frequently new cash flows in.)

I also like the idea of paying yourself a salary, e.g. setting up an auto-transfer of a certain amount of cash each month (or every 2 weeks) to your personal account for use in paying the mortgage, etc. It might not be possible to do this out of the gate, but it’s a great goal, as well as a strategy for insulating your personal finances from fluctuations in the business.

In this credit crunch, do you recommend people use credit cards? Why?
I’m a big proponent of “pay it off in full every month” credit card use for both business and personal, because I so rarely see an interest rate that’s reasonable and that sticks around for long enough. In a pinch, if someone can make a clear business case for using a credit card for an expense (i.e. “I’ve done the math, and it’s going to cost me more NOT to buy this big piece of equipment than it will to pay for it + interest on the credit card debt.”), then it might make sense.

How can self-employed people make reasonable budgets for themselves? What do they need to include?

There are two ways to consider this:

If you mean personal budgets, I’d recommend they start with an inventory of what they’re currently spending, either by reviewing Quicken data or using my Career Changer’s Cash Flow Worksheet (in Excel). The worksheet has columns for before, during, and after calculations across typical spending categories, including the ones that people often forget because they don’t happen on a predictable monthly schedule, e.g. real estate taxes, vacation, etc. I’d also recommend they include a figure, maybe 5 – 10%, for “unexpected” or “one-time” expenses. Turns out these are never really “one-time” – they’re just different from year to year.

Next, they need to ask the question: “Can I reasonable expect to cover these expenses after a shift to self-employment?” (Again, not forgetting taxes and saving.) If the answer is no, then they need to take a pass through the list of expenses and decide what things they can/want to cut out in favor of opting for self-employment. Best resource for this: Your Money or Your Life, a book that helps readers sort out what’s worth paying for and what isn’t, in alignment with their values and short- and long-term goals.

The goal for a self-employed person, once the business is established, is to have a budget that is a solid, say, 10% below the average monthly income (after taxes and savings) that can reliably predicted on an ongoing basis. So for example, say you are confident the business will do well enough for you to pay yourself $4000, $1000, $3000, $7000, $1000, $2000 in the first 6 months of the year, for an average monthly income of $3000. A wise self-employed would plan to spend no more that $2700 per month. Then if things go better than expected and there’s a surplus, great problem to have: Buy those things on your “maybe” list, or further beef up your cash reserve. If they don’t go as well, you’re better positioned to survive.

Prior to getting established, you will have to cover expenses with money from other sources besides your self-employed income, whether that’s a spouse’s paycheck, savings, part-time work, or some combination. It’s important to do the math to determine how much will be needed to fill the gap and identifying where it will come from (savings, loan, etc.) before making the leap to self-employment, while you still have a chance to save more to cover shortfalls.

Anything I didn't ask that you want to add?

The number one biggest stumbling block I see with self-employeds is accepting the fact that you’re not just a writer, financial planner, marketing consultant, social worker, whatever, but that you’re running a business and need to put on your business owner hat on a regular basis. Even when you have plenty of business. This means planning time to think about things like:
  • Business planning – How will I structure my business to make money? How will I monitor and, if necessary, adjust that plan on an ongoing basis before things go awry financially?
  • Marketing – How will I attract enough clients to make that plan work?
  • Sales – What process will I follow to ensure that those who are interested and a good fit end up deciding to go with me?
  • Operations – How will I deliver on commitments made, and do it efficiently and accurately enough even when things get crazy busy?
  • Finance – How do I make sure I have enough breathing room so that, if cash comes in more slowly or goes out more quickly than anticipate, I won’t suddenly be out of business?
…and all the rest of those things that larger businesses know they have to consider to be sustainable.

Yes, they can be done on a much smaller and more informal scale, but ignoring any of them is likely to result in financial trouble eventually.

Photo by borman818.


Susan Weiner, CFA said...

I agree that it is so important to remember that you're running a business.

Disability Insurance said...

Thanks for this article, you present some great information here. There are many things to be mindful of when you are self employed. I'm glad I came across your blog, I will be sure to bookmark.