I love the song from the musical Evita, written by Andrew Lloyd Webber and Tim Rice, where Evita’s charities are making money hand over fist and they sing that accountants aren’t necessary, and will only slow down the process. I wish that were the case. We could just work really hard, doing what we are best at, and watch as the cash starts pouring into our bank accounts. Unfortunately, business rarely happens that way. For the rest of us, maintaining our accounting records is a mandatory requirement.
As Independent Contractors we want to rush in and focus on making money and providing value for our customers. Tracking expenses, monitoring budgets, and maintaining cash flow seem to be things that can be pushed to the side as we focus on making our customers happy. Unfortunately, this couldn’t be farther from the truth. You are the only person responsible for managing the finances of your business. If you aren’t managing your accounting at the outset, you are allowing the fruits of your labor to fly through your fingers. The end result is that you can’t provide value to your customers if you can’t afford to keep working.
According to Capterra Finance, in 2014, the IRS assessed $2.1 billion in civil penalties against business income tax filers. Tax liability alone should provide the impetus to set up and maintain an accurate accounting system. I have included additional aspects to keep in mind as you develop the financial infrastructure needed to maintain the lifeblood of your independent contractor business. While not an exhaustive list, this includes many resources as well as key accounting and financial factors I have encountered as both a financial professional and as an independent contractor.
Setting accounting policies and procedures:
Every business needs accounting procedures, no matter what the size. Even if you have no employees, and are paying yourself from your profits, you need procedures in place to ensure that you are charging your customers enough to cover all of your expenses (and hopefully have a little left over). You want to stay on top of tracking where your money goes and how much is invested back into your business, including paying your salary. This will ensure that you have adequate cash on hand to maintain operations throughout the year. In addition, you will be required to file taxes at the end of the year. Keeping organized accounting records ensures that you are able to take advantage of all possible tax deductions. It also ensures that you have maintained enough cash reserves to pay your tax liability at the end of the year. No matter how simple your finances appear to be, you need to have practices in place to manage them accordingly.
A wonderful resource for any small business owner is the US Small Business Administration website. Besides providing a wealth of resources for starting up a business, they also list the key financial infrastructure you will need in order to set up and manage your business. They provide guidance for everything from financing your business with your own money to obtaining a small business loan. They also list various financial reports you can prepare for your business, including balance sheets and income statements.
Determining what your time is worth:
Whether calculating an hourly rate or a fixed fee, you need to know how much it costs for you to provide your services. I have met contractors who set their fee based on how much their competitors charge. Knowing what the market will bear is a good start, but each business is different. Your costs for doing business may be higher or lower than your competition. How can you determine if their fee will net a profit for your business?
Steven Fishman, J.D., of Nolo Law lays out a simple yet effective method for determining your cost per hour. The steps include: a) determine your annual salary; b) compute your cost of doing business (overhead); c) calculate your desired profit; and d) estimate your billable hours. You then divide your total annual costs by your total annual billable hours to determine your rate. This sounds fairly straightforward, but this crucial step is often overlooked or under calculated. Be sure to take the time to thoroughly calculate these costs and be conservative in your estimates.
In determining a figure for your annual salary, be realistic. Chances are, you won’t be earning that six-figure income right away. Research the salaries for similar positions in your local market. The Bureau of Labor Statistics provides databases full of wage data by state, region and metropolitan area. You can also do a search on various job and employment boards to see how much employers are paying for similar positions. Be sure to factor in the cost of benefits and employment taxes paid by employers. According to Joseph Hadzima with the MIT Sloan School for Management, this is approximately 1.4 to 1.6 times base salary (for example a position listed for $50,000 a year actually costs an employer between $70,000 to $80,000).
In computing your annual overhead, take all of your expenses into account including insurance, travel, professional associations, and advertising costs. Be sure to include fringe benefits including medical and dental insurance, short term and long term disability insurance and estimated taxes. Some of these items may be hard to determine when you are first starting out. Research the blogs and message boards of other Independent contractors. The Freelancers’ Union is an excellent resource for networking with other independent contractors and gaining information and best practices from your peers.
Make sure that you add in a profit margin for your business. Profit is not your salary, that is a business cost. Profit is your reward for the risks you take in owning your own business. According to Stephen Fishman, a 10% to 20% profit margin is common. You can further refine that figure, by referencing other Independent Contractors in similar fields.
The last step to calculating your hourly rate is determining how many billable hours you will work in the upcoming year. Be sure to add in time for vacation and illness. Don’t forget to budget some time for clerical, administrative, and marketing tasks (around 20% of your time). Once you have your total annual billable hours, you will divide that figure into your total annual costs in order to come up with your rate per hour.
Your rate per hour is essential for a number of reasons. First, it is the amount you will charge your clients. It is also your weighted cost per hour and can be used to calculate the impact of business decisions, like when it makes sense to bring on additional help or to calculate opportunity costs for a particular course of action.
Maintaining enough cash to keep your business afloat:
Whether you're dealing with loan payments, interest charges, fixed or variable costs, or you want to know how much money you have coming in during an average month, a budget can help you to track your income and expenses. As the saying goes, “if you fail to plan, you are planning to fail.” Your budget is your plan of expenses and estimated revenues for the upcoming year. Your budget ensures that you are bringing in enough income to pay all of your obligations. Without a budget, you would be unable to manage your financial future as an independent contractor.
You should prepare your budget at the start of the year and return back to it at least once a month to measure your actual expenses and revenues against your budget. Reconciling your budget at least once a month is crucial to ensuring your financial health. It gives you time to review your progress and make changes to your budget plan in order to reflect your actual financial condition.
To any small business, cash is the blood of your business. It is essential that you track your cash flow, including the timing of when to expect payments and when to pay liabilities. The U.S. Small Business Authority is an excellent financial resource for any small business. Their guidance on developing a cash flow analysis for a small business is excellent. As stated on the SBA website, “Cash flow analysis statements display not only changes over time, but also available net cash.” As you can’t operate your business without cash, an ongoing cash flow statement is a crucial part of your financial plan.
You are required by law to pay annual income taxes. It is crucial that you file your taxes or you can face penalties up to federal prosecution for tax evasion. Keeping detailed records makes filing your tax return much easier. Most small business accounting systems also provide the reports you need to file your income taxes.
By tracking your finances throughout the year, you can also opt to pay smaller portions of your income tax on a quarterly basis in order to reduce the lump sum payment April 15th of the following year. You won’t lose any money this way, anything you overpay will be returned to you as a refund (and in today’s financial market, you will receive almost the same rate you would receive if you invest your funds in the bank or in a money market account.)