Why Not Paying a Market-Based Wage Distorts Your Financial Statements

The owner’s salary is not just about how much you’re taking home each month. It’s a key component of how you understand your business's performance. When you don’t pay yourself a market-based wage, the financial data you’re relying on to make decisions about your business is likely inaccurate. This article dives into why paying yourself a fair salary is crucial, how to determine the right amount, and how it influences your business valuation and long-term success.

The Difference Between Salary and Return on Ownership

Many entrepreneurs confuse salary with return on ownership, often treating both as one and the same. In reality, these are two separate financial concepts:

• Salary: This is the wage you earn for the work you do in the business. It reflects the market-based compensation for the roles you perform (e.g., CEO, operations manager, marketer).
• Return on Ownership: This is the profit you earn as the business owner, separate from your salary. It’s essentially the return on the investment you’ve made in the business and the risk you take as an entrepreneur.

While it might be tempting to think of these two elements together, doing so can lead to significant financial misunderstandings. Failing to separate your salary from the business’s profits results in inaccurate financial data, making it difficult to evaluate the business’s true profitability.

The Impact of Not Paying a Market-Based Wage

When you don’t pay yourself a wage that reflects the true value of your work, you distort your financials in several key ways.?

1. Artificially Inflated Profitability

The most obvious consequence of underpaying yourself (or not paying yourself at all) is an inflated view of your business’s profitability. When your financial statements show a high net income because your personal labor isn’t properly accounted for, you may think your business is doing better than it actually is. This creates a false sense of security and can lead to poor decision-making.

For example, if you’re underpaying yourself, your net income might look like it’s 20% of sales. However, if you adjust for a fair market wage, that figure could drop dramatically, perhaps to as little as 5% or less. By not accounting for your real labor costs, you are essentially providing "free" labor to the business, which inflates the business's profitability on paper.

2. Misleading Financial Comparisons

When you compare your financial performance to industry benchmarks or competitors, your analysis is only valid if you’ve accounted for all relevant expenses—including a fair wage for yourself. If you’re not paying yourself properly, you’re skewing your data, making it difficult to compare your performance to other businesses.

For instance, industry profitability figures will generally assume that business owners are paying themselves a market-based salary. If you aren’t doing this, you may falsely believe your business is outperforming others when, in reality, your numbers are artificially high because you haven’t accounted for the true labor cost. This leads to an inaccurate comparison and can make it difficult to gauge how well your business is truly performing in relation to the broader market.

3. Distorted Cash Flow Statements

Another critical area that suffers from not paying yourself a proper wage is cash flow. By not taking a salary, your cash flow may appear to be more robust than it actually is. This can lead you to believe that you have more liquidity than you do, or that your business can sustain more expenses than it realistically can. In reality, if you were paying yourself properly, you might find that the business struggles to maintain healthy cash flow.

For example, if you’re keeping personal costs low by avoiding a salary, your cash flow statement may reflect a much more positive scenario than if you were drawing a wage. This can mislead potential investors or buyers, who might not realize the business is only able to maintain positive cash flow because it isn’t covering the true cost of your labor.

4. Skewed Decision-Making

Business decisions are often based on the assumption that the financials accurately reflect the health of the company. If you’re underpaying yourself and inflating net income, you’re making decisions based on faulty data. This can lead to dangerous choices, such as overinvesting in new ventures, expanding too quickly, or taking on debt you might not be able to afford in the long term.

When your financial statements reflect a truer picture of the company’s operations, it’s easier to make sound strategic decisions. For example, you might choose to hire additional employees or expand into new markets, knowing that your current wage is being covered and your financial statements are accurate.

5. Lower Future Business Valuation

If you plan to sell your business or bring on investors, the valuation of the business will be based on the financial performance as reported. Underpaying yourself can inflate net income, but potential buyers or investors will likely adjust your salary to reflect a fair market wage during their due diligence process. This adjustment can drastically lower the perceived profitability of the business, ultimately resulting in a lower offer or a smaller return on investment for you as the owner.

A business that looks highly profitable on paper might appear far less appealing to buyers once a realistic salary is accounted for. Investors and buyers are looking for a sustainable, long-term operation, not one that relies on the owner providing free or undercompensated labor.

6. Impact on Retirement Benefits

An often overlooked consequence of not paying yourself a market-based wage is the effect it has on your long-term financial security. Many entrepreneurs compensate themselves through distributions rather than a regular salary. While this may seem beneficial in the short term—potentially lowering immediate tax obligations—it can negatively affect your future Social Security benefits.

Your Social Security payments are based on your recorded wages. If you consistently underpay yourself, your earnings will be lower, and your future benefits will be diminished. Over time, this strategy may reduce the financial security you can expect in retirement.

Peacocking with Inflated Profit Figures

Many entrepreneurs are tempted to flaunt profit numbers as a sign of success. However, these figures are irrelevant if they don’t account for a realistic wage for the owner and all related parties. Inflated figures may look impressive, but they are meaningless without considering whether the business can support a fair wage and still be profitable.

How to Set a Market-Based Wage for Yourself

Determining the right wage for yourself isn’t just about picking a number out of thin air. It requires thoughtful consideration of your role within the business and the market rates for someone in your position. Here’s how you can arrive at a reasonable wage:

1. Research Industry Standards: Look at what others in your industry are paying for similar roles. This information can be found through industry reports, salary surveys, and job listings.
2. Assess Your Role: Be honest about the work you’re doing. If you’re handling management, operations, sales, and customer service, your wage should reflect the various roles you’re performing.
3. Consider Comparable Jobs: Think about what it would cost to replace yourself. If you were hiring someone to take over your role, how much would you have to pay them? Use this figure as a baseline for your own salary.
4. Don’t Undervalue Your Time: Entrepreneurs often undervalue their time, especially when they’re focused on building a business. Make sure that your wage reflects the time and energy you put into the business.
5. Factor in Hours Worked: If you’re working long hours, you should compensate yourself accordingly. The more hours you put into the business, the higher your wage should be to reflect the true cost of your labor.

Conclusion: Accurate Wages for Accurate Financials

The importance of paying yourself a market-based wage cannot be overstated. Failing to do so distorts your financial statements, misleads you about your business’s true performance, and can lead to poor decisions. Moreover, it impacts the long-term value of your business and your financial security. By compensating yourself fairly, you ensure that your financials reflect the true state of your business, providing you with the clarity needed for sound decision-making and strategic planning. Pay yourself what you’re worth, and your business will be stronger for it.

Accurate financial statements are not only crucial for day-to-day business decisions but also essential when it comes to the broader picture—such as valuing your business, preparing for growth, or planning for a sale. At Business Valuation Advisors , we specialize in helping business owners navigate these complexities. We offer detailed analyses that ensure your financials reflect the true value of your business, including a comprehensive review of compensation practices and other key financial drivers. Our expertise will guide you in setting the right benchmarks and ensuring that all elements, from owner compensation to long-term growth plans, are accurately reflected in your financial statements.

If you're ready to understand the true value of your business, we invite you to visit our website at www.valuationadvisor.com to learn more about how we can help you achieve clarity in your financials and take your business to the next level.