Cause and solution of business losses

The cause of companies’ losses

All companies incur losses after a few years. There are two reasons for this:

  • People make mistakes, so products are damaged and cannot be sold, resulting in income loss to the company.
  • It is not possible to reflect lost income in the accounting.

Thus, at the close of the accounts, companies discover that revenues are less than expenses. Usually, this concerns a (relatively) small amount of money―just big enough to ensure that February salaries cannot be paid. But of course, that’s unacceptable, so businesses cut back.

No entrepreneur ever considers the best way to cut back before he runs into a loss. As a result, companies commit weird cutback mistake. These mistakes only ensure that the problems get bigger. As a result, more and more employees are laid off.

To cover losses without the need for budget cuts, a company needs to apply three techniques:

  1. During the year, it has to gain an insight into its profits or losses.
  2. It has to have reserve capital to which it regularly adds funds to cover losses.
  3. It needs a way to prevent business owners and CFOs from inadvertently spending this reserve capital.

The reserve account

Include the general ledger for profit and loss in your accounting. Book the balance of the cash/bank journal against the general ledger for profit and loss daily/weekly/monthly to establish the amount of profit or loss.

To establish the reserve necessary to cover losses, companies can use a reserve account. In order for companies to cover losses and prevent cutbacks, they need a new kind of account in their accounting. A reserve account is a type of general ledger account that is never closed off and to which a savings account is linked. On the last day of the month, the new balance is calculated and brought forward to the next month. On December 31, a new balance is calculated that is brought forward to January of the next year. The balance of the reserve account should always be equal to the balance of the savings account. The reserve must be in a savings account to avoid that the errors that led to the loss, also lead to the reserve being accidentally spent.

Small businesses need to add a value-added reserve account in their accounting. They have to book 5% of their added value to the value-added reserve account and savings account every month. At the end of the year, at the close of the accounting, if they discover they have incurred a loss, they can use the reserve account to supplement the balance of the current (bookkeeping) account and then transfer the same amount from the savings account to the current (bank) account. When companies have liquidity problems, they can also use the reserve account to supplement the balance of the current (bookkeeping) account and transfer the same amount from the savings account to the current (bank) account. Thus, cutbacks can be avoided.

Companies that use equity capital must add a value-added/dividend reserve account and a share capital/losses reserve account in their bookkeeping. The share capital/losses reserve account must be linked to a savings account.

The share capital is booked on the share capital/losses reserve account. This account is used to cover losses and liquidity problems.

Then 5% of the added value is booked to the value-added/dividend reserve account monthly. This amount is used to pay out shareholders’ dividends. Companies that pay out 2.5% of the added value as dividend annually can cover losses up to about 80% of the turnover. (Currently, the dividend/distribution of profits is about 2% of the added value once every two years.)

Companies may decide to reduce or increase their reserve after a few years.

Given the enormous damage cutbacks inflict on the economy and society, this must be avoided at all cost. For this reason, we recommend the government of your country exempt the balance of the reserve account from taxes. This will allow companies to use all that money to prevent cutbacks.

New companies do not incur losses during their first two to eight years. As long as the market is growing by more than 2% a year, the growth in turnover is sufficient to cover losses. As a result, the losses are invisible, and the company shows a profit for a few years. These profits can be used the traditional way, and in that case, the company pays tax on this money. Or the profit can be booked to the reserve account.

Covering existing losses

A company includes the general ledger for profit and loss in its accounting, and uses it to calculate the loss. The loss then appears to be much larger than 5% of the added value of the past year, or the share capital the company had access to over the past year.

Companies that have implemented cutbacks never use the proceeds to cover their losses. As a result the current loss is not the loss of the past year, but the total losses of all the years since the moment the company first incurred a loss. In the same way that the €6 billion Rutte II deficit was not the budget deficit of the previous year, but the previous 30 years, the current loss for small companies is the losses of the last 2–15 years. For large (American) companies, it is the losses of the last 5–150 years.

Some companies have seen an opportunity to increase their sales by offering advertising, for example, besides the sale of their core product. But since losses constitute a percentage of sales, this decision leads to even bigger losses. The extra work required to achieve additional sales, generates additional errors, which lead to additional losses in income that cannot be processed in the accounting.

Companies will never be rich enough to cover their current loss in one go. But if they continue to cut back, their revenue will continue to fall. Small companies have the additional risk that they may make a fatal austerity error and go bankrupt, without ever discovering what went wrong.

There is only one way to solve this dilemma. Companies with existing losses will have to include their loss in their accounts as a ‘debt to their future selves’, and handle this debt in the same way that they handle other debts. 

Smart savings ensure companies become healthy

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