Are you a small business owner struggling to make payroll or just survive until the next quarter? Are you looking for a way to make your business profitable? If you need help with how to manage your money in your business, you've come to the right place.
Because I will let you in on a business world secret. A money management system that will ensure you are profitable from the start of your business.
The struggle. The stress. The worry. I'm sure this is not what you dreamed of when you started your business.
And luckily for you there's a way out. It doesn't have to be this way. And it shouldn't.
So what's the secret to managing your money for a profitable business? Taking your profit first.
Yup. That's it. It's so simple that it seems too easy. But this money management system works. I'll explain how below plus give you the step by step so that you can implement it successfully in your business.
Traditional Accounting Methods for Managing Your Money
If we are going to be talking about managing your money for your business, it would be remiss if we didn't at least touch on the traditional accounting methods used by all businesses. Yes. Even the small ones.
While these methods don't actually provide you with the real insight into your businesses profitability, it is necessary to understand and use them in your business.
The Balance Sheet
The Balance Sheet gives you a snap shot of your business at a specific point in time. This is where you will keep track of your assets and liabilities.
The governing equation here is: Assets = Liabilities + Owner's Equity. Where assets are things such as cash, inventory, equipment, etc. Liabilities are debt, loans, or any thing your business owes.
And equity is all the money that you (and other owners) contributed to the business to get it up and running. It also includes all the money, or earnings, that you decided to keep in the business.
The Income Statement
In the traditional world, you would probably use the income statement to help you manage your money in your business.
Why? Because it is here where you'll find all the key financials such as revenue and expenses. And it is here where you can get a sneak peek at your company's profitability. Because as it is definite traditionally:
Income - Expenses = Profit
The downside of this though is that this profit is only profit on paper. It is not actual profit that you can touch, feel, and taste (should the mood strike you).
That's why this money management system, called Profit First, is so important. Because if you do it right, you will be able to see your profit, touch your profit, and spend it as you see fit.
Talk about living the dream!
The Cash Flow Statement
Definitely the most objective of the 3 financial statements, the cash flow statement tracks the flow of money in your business so it is also a useful tool for managing your money (on paper).
With it, you can see where your money is coming in and where it is going out.
It gives you a look at your cash flow in 3 main categories: Operating Activities, Investing Activities, and Financing Activities.
Overall, the cash flow statement gives you insight into just how liquid your business is.
The income statement is traditionally how you would determine how well you are managing the money in your business.
Cons of the Traditional Methods
The problem with the traditional accounting methods are that while they are supposed to give more transparency to a companies financials, companies have found loopholes to get around this.
They often engage in some creative accounting, off-balance sheet financing, etc. to make their company financials look better than they actually are.
Because these statements can be tweaked and rearranged depending on how a company chooses to report certain events, they are not very reliable.
And the problem for you as a small business owner is that these documents, while necessary, do not give you what you actually want.
Which is to know exactly where your company stands financially.
The traditional methods may not give you an accurate account of how well your business is doing. And it will be hard to determine how profitable your business actually is.
That's why this money management system is soooo important. It will help you keep accurate tabs on the things that matter to you most ... your money and, more specifically, your profit.
And not just paper profit, I mean, real profit.
Because, let's be serious, you probably did not go into business to be broke.
What you focus on grows, so don't focus on your expenses focus on your profits instead.
Profit First (Money Management System)
A new money management system is in town. And it goes by the name of Profit First. Okay... well maybe it's not so new.
This money management system, invented by Mike Michalowiscz, and popularized by his book, Profit First, was published in 2014.
It changed the game in how everyone viewed profit and managing your business income. It truly changed how businesses were run and very much for the better.
The idea behind Profit First
Profit first works on the premise that you, as a business owner, need to take your profit first. Before you pay your bills.
If you have heard of the personal finance strategy "Pay Yourself First", this is exactly like that but for businesses.
Profit first takes the traditional profit equation:
Income - Expenses = Profit
and flips it, such that it is now:
Income - Profit = Expenses
This means that as the income from sales come in you are not going to use it to pay your bills.
First, you will take your profit. Then you will use what is left to cover your expenses.
This reminds me of the great quote by Warren Buffet: "Do not save what is left after spending but spend what is left after saving." No truer words.
Profit First requires a mind shift, where you are no longer focusing on your expenses (and simply trying to earn enough to cover them), but focusing instead on making your monthly allocations.
Focusing on your expenses ensures that you will get just enough to cover them. But then where does that leave your profit and your income?
By shifting your focus to your desired allocations you make sure you hit those monthly goals. Goals, which, of course, includes your target profit and salary.
Why should you take your profit first?
Because it gives you the best way to manage your money in your business.
By taking your profit first, not only are you ensuring that you will be profitable, but you are making sure you don't fall into the trap of having to chase sales just to keep your business running.
When you are chasing sales, your are more likely to do stupid things in your business, make mistakes, and ultimately lose sight of your mission and core values. Or the reason you started your business in the first place.
Furthermore, when you are too busy just trying to stay afloat, you can miss out on amazing opportunities that could really help your business grow.
So by ensuring the profitability of your business, you are able to run your business more efficiently and with purpose.
You can focus on the things you want in your business and not have to worry about how you are going to make payroll or survive until the end of the quarter.
Taking your profit first pushes you to think outside the box and innovate.
It helps you run your business much more efficiently because when you have to work with the money that is left over, you figure out ways to get much more bang for your buck.
Profit first prevents you from just blindly plowing your profits back into your business without first thinking about how to best use your money.
When you just plow money back into your business trying to force growth, it allows for inefficiencies to arise and take hold in your business.
But when you remove that temptation, you begin to see what things you're doing in your business that actually contribute to your bottom line and which things don't.
This gives you clarity about how to handle future expenses and commitments.
What are the benefits of using profit first?
When done correctly, using profit first provides some amazing, life-changing slash business-changing benefits.
And because I love a good list. Check out this epic one below.
Profit First does it ALL. What else do you possibly need? So what are you waiting for? Let's get started!
How to get starting using Profit First
If you want to start using profit first to manage your money for your business, you are going to need to start by opening up these 5 bank accounts:
- Income
- Profit
- Owner's Comp
- Tax
- Operating Expenses
Why so many accounts? Because you want to make sure you don't dip into funds that you shouldn't be dipping into (especially your profit and your tax accounts).
So by separating your money into different accounts you can make sure 1.) that everything is adequately funded and 2.) place a limit on your operating expenses.
Because once the money in the operating expense account is gone, that's it. At least, until more money comes in.
This helps you rein in your spending and makes you run your business more efficiently.
One thing to note, however, is the order in which these accounts are listed. Because, this is the order in which you should fund each account.
So you would take the money that comes in to your income account and put a percentage into your profit account and so on down the list.
Then you will put whatever is left over into the expense account.
And that ladies & gents is Profit First in a nutshell.
Of course there is more to it than that. So we will go into a more step by step detailed approach below.
What banks should you use to manage money from your business?
In my opinion, you should get a bank that allows you to open up multiple savings accounts or even better, one which allows you to separate your money into buckets.
Of all the banks that can do this, here are my two favorites: Ally Bank and Capital One.
Capital One 360 allows you to open up multiple savings accounts while Ally Bank allows you to simply make as many buckets as you'd like. What's more, you can name these buckets yourself.
Alternatively, you could open up these accounts at your local bank but you'll want to make sure that your tax and profit accounts are as inaccessible as possible to prevent yourself from cheating and dipping into them.
So my vote is for an online bank.
The step by step guide to using Profit First
Okay so you've opened your accounts, now what?
Well, first you're going to need to determine your target allocations for each of your buckets (profit, owner's comp, tax, operating expenses).
They have a generic list of target allocations over on Mike Michalowicsz's website. So feel free to check those out and use them.
But you may want to calculate your target allocations so that they are more specific to your industry.
Step 1. Calculating your target allocations
Profit
To calculate your target profit allocation, you could look at a few companies' financials that are in your industry and calculate their profit percentage.
To do this take their profit and divide it by their total sales. Then multiply by 100%. And voila you have their profit percentage.
Do this for each company. Then take the average.
Owner's Comp
Okay, for calculating your compensation, or that of the other owner's in your company, you are first going to look at what your main job is in the business.
From there, you are going to determine a reasonable salary based on industry averages. Then break this up to figure out how much that would be monthly.
Next, calculated what percentage of your monthly business income that would be. Do this by dividing your monthly salary by your business' monthly income and multiplying by 100%.
Note: As the revenue in your business increases, your salary from owner's comp will decrease as you will start getting most of your money from profit distributions.
Taxes
As far as taxes are concerned, you will want to check out the taxation rates in your country. For America, it was 35% but, for now, is 21%. Thanks to the Tax Cuts and Jobs Act.
In Japan, the corporate tax rate is 10.3%.
But you should remember that the amount taxed is not your total revenue but that amount minus your expenses. So you have a bit of wiggle room.
I think starting out with a 15% allocation is good. Then you can adjust accordingly.
Alternatively, you can just get these numbers from your accountant or your previous year's tax return. Just be sure to make adjustments for this year's projected revenue.
All said, it is best to make sure you have more than enough for the tax man. So when in doubt, save more.
Operating Expenses
Essentially you won't really need to determine the percentage amount for this as it will be what is left over after subtracting out your profit, owner's comp, and taxes.
So simply take 100% and subtract your profit, owner's comp, and tax percentages and you'll have your number for Op Ex.
** Remember these are just your goal allocations and not what you need to be doing right now in your business. **
Step 2. Assessing / Choosing your current allocations
So once you have your target allocations figured out, you'll want to do an assessment of your current situation. Or if you are just starting out, you're going to want to choose your starting allocation percentages.
In either case, it is best to start small as far as taking your profits. And that means setting it at 1%, maybe 2%. Do this just to make sure you can implement Profit First successfully and not stress yourself out.
Also, if you are in the early stages of your business, you'll want to make sure you are giving your business the financing it needs to grow.
For the other buckets, I'd suggest keeping 15% for your taxes and taking an assessment of how much you're getting paid now and putting that in as a starting point for owner's comp.
Mike has an assessment worksheet on his site if you want to take the initial assessment and see how your business stacks up in comparison to other general businesses.
Step 3. Choosing your allocation date and time
A key part in managing your money for your business depends on being consistent. So next, you'll want to choose a date and time for you to do your allocations.
This is when you will move the money from your income account into your other 4 buckets based on the current allocation percentages you chose above.
It could be once or twice a month. Though doing it any more than that seems a bit unnecessary. But, in choosing your dates, you'll want to tailor it to your specific business needs.
So choose a date and stick to it.
Step 4. Review your finances and increase your allocations
Every quarter you'll want to review your finances and make increases to your allocations to start moving them towards your target allocations.
These increases should be small and incremental. I would caution you not to go too hard, too fast because you don't want to discourage yourself. You want this to be a success.
So increasing your profit allocation by 1% each quarter would be sufficient. The same goes for your owner's comp.
This is also when you will make your quarterly estimated tax payment.
Step 5. Take your profit & Celebrate
Bonus point good news! Every quarter you are going to take 1/2 of the amount in your profit account to go out and celebrate.
However, you're going to leave a bit in the account so it can act as your emergency fund as well. Later, you can always set up a separate emergency fund account but for now this will do.
It is important to celebrate your wins. So use that money well since it is proof of all the hard work you've been putting in.
A Word About Debt
If you are in debt, you will definitely want to get out if it ASAP. It is a drain on your business' financial health. So, take most of the money from your profit account and use it to pay off that debt!
Step 6. Review your system at year end
At the end of the year you will review your system and make adjustments accordingly.
If you find you are a little short on taxes, use what is in your profit account to cover it. Then adjust your tax percentage higher.
If there is still extra money in your profit account, use that to pay off debt.
Additional Profit First Accounts
The 5 main accounts listed above may not encompass all of the needs money managing needs in your business. So you may want to consider using additional accounts as well.
Here are some accounts you may want to consider adding:
- Emergency Fund - For short-term emergencies, need at least 3 months of expenses
- Sales Tax - If your business is required to collect sales tax, put it here. DO NOT leave it in your income account.
- Stocking Account - To save up for big purchases / stocking your inventory
- Pass-Through Account - For expenses that were reimbursed by a client etc. *Note: This is not income and would be transferred to OpEx.
- Materials Account - Specifically for the purchase of materials
- Subcontractor/Commissions - To save up the money to pay commissions or subcontractors
- Payroll - For payroll and payroll taxes
- Equipment - To save for big equipment purchases
- The DRIP Account - For when you get paid in advance for a project that you will complete over a long period of time. Break it up and allocate it monthly.
- Petty Cash - For client/employee lunches, transportation, and other small items
- Pre-pay Account - To take advantage of discounts offered for prepayment
- Outside Capital - If you decide to take on outside funding, use this to keep the cash separate and while you wait for an opportunity to put the money to good use
Now you won't need to use all of these accounts for your business. Only implement the ones you need for your particular business.
You can find more details about these accounts in the book Profit First, or feel free to write a comment below and I'll get back to you.
Don't start adding these accounts though until you've been using the profit first system for a while. You don't want to overwhelm yourself in the beginning.
Mike recommends doing 2 quarters of regular profit first first then adding additional accounts to the mix.
Important notes about Profit First
One thing I loved about the book and the Profit First method is that it is not just about the numbers. It's also about making sure you have a plan of action should your ish hit the fan.
Mike really stresses the importance of having a written procedure for how you are going to manage your money and your business, if, for instance, you do have to dip into your emergency fund.
What steps are you going to take to make certain this won't happen again or at least so that this situation doesn't get worse?
Things to think about and, of course, write down for future reference.
Profit first is not only about how to manage your money in your business but also about developing a plan of action before a crisis occurs.
Have you heard of the nav.it money app? Check out How Small Businesses are using nav.it.
All in All
Using profit first doesn't mean you can now neglect doing your income statement, cash flow statement, or balance sheet. While they may not be useful in managing your actually money, they are still a requirement for doing business.
One thing's for sure, if you want a sustainable, healthy business, implementing profit first seems to be the way to go. It is the best way to manage your money. So start small, start now.
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*DISCLAIMER: The Information provided in this post is simply the opinions of the blogger and is given in the spirit of educational fun. It is not investment, tax, or financial advice. Please do your own research and decide what is right for you before investing in any asset or deciding how to manage your money. If necessary, seek the help of a certified professional in discussing your options. Also, I am not a Profit First Advisor so please consult with one should you choose to implement Profit First.