A few years after opening our Truckee, California yarn shop, I made a mistake that almost cost us our business. It was 2005 and the height of the yarn bubble (you didn’t realize there was such a thing, did you?). We had two retail locations and were closing in on $1 million in sales. Life was good… until April of the following year. Tax time. Our accountant called to tell us that our tax bill was significantly greater than the cash flow generated by the business that year. Significantly.

Luckily, my husband and business partner Doug still had a full time job as a software engineer and had a salary that could support us. Luckily, we were working so much that we had no time to go on vacation or spend any of our disposable income on non-essential items, hence allowing us to save some money. And luckily, most luckily, Doug has always saved for a rainy day. He’s from the Midwest.

Here’s what happened:

For the first few years of the business, and after we paid ourselves back for our original investment, we reinvested every single dollar back into the business (no paychecks for us!). When we opened in 2002, we had a very small amount of inventory and knew that in order to grow the business, we needed to increase the amount of yarn that we carried. We opted to spend money on inventory instead of nice pens, cute shopping bags, and advertising.

Creating customers wasn’t the problem. Having enough yarn to sell to them was. So I bought a lot. Heck, we were at the top of the yarn bubble, sales were at an all-time high, we never ran out of cash, and we were reinvesting our profits back into the business. I didn’t give it a second thought. I thought I was doing the right thing. Until April, when our accountant called.

You see, what I didn’t realize was that all of the money we were putting back into inventory was considered taxable income. Technically, it was profit that we reinvested into the “assets” of the business (even though the “assets” were only held for a few months).

To use some simple math, let’s assume that our net profit for the year was $150. Let’s also assume that our revenue grew 25% and our inventory grew 30%. In this case, we invested $125 of the $150 profit back into inventory, leaving us with $25 in cash. See the problem? Our tax liability on $150 in profits is going to be at least $50 (twice the cash that we had reserved). Yikes! That’s the scenario if our profits and sales only grew a mere 25% year-over-year. Can you imagine if we had grown 200%? Triple Yikes!

Call me naïve (because I am), but I thought that the whole point of starting a business was to grow it, hire more people, contribute more to the economy, and so forth. And I thought that people were to be applauded if they could do it from the ground up, and without the burden of debt. I thought that we were supposed to reinvest!

Luckily, we were able to cover the taxes with our personal savings. Luckily, we didn’t have to take out a loan to cover it. And luckily my husband is a very forgiving man (provided I don’t make the same mistake twice).  Since then, we have learned a very valuable lesson and have changed our approach to inventory and cash flow management. Good thing, too, because the yarn bubble burst shortly after that tax season. If I had kept running the business using the same approach, I would be unemployed right now… and probably divorced!