Traditional accounting defines profit as sales minus expenses. This approach makes profit an after thought that can only be achieved after all expenses are tallied up. It can take small business owners years to achieve profit (or even their own payroll), which is discouraging. But what if you—the small business owner—made a profit with every sale? That’s the concept of the book Profit First: Transform Your Business from a Cash-Eating Monster to a Money-Making Machine by Mike Michalowicz.
Today, we’ll talk about what Profit First is, how it can ease financial stress for small business owners and where to find out more about it.
(This article is designed to provide general information regarding the Profit First system; it’s not intended to serve as legal, tax or other financial advice.)
Why generally accepted accounting principles don’t give small business owners financial clarity
Accountants use generally accepted accounting principles (GAAP) to create corporate financials including profit and loss (P&L) statements, balance sheets and statements of income and retained earnings. While this methodology is essential, these financial statements leave too many business owners scratching their heads every month, quarter or year. Following this system, a business owner can have thousands of dollars of profit on their P&L and an empty bank account. How discouraging!
When we leave profit to the traditional formula of Sales – Expenses = Profit, achieving profit is difficult because we keep spending until the corporate bank account hits the panic level. Then we furiously go into sales and collections mode to bring the bank account up to the non-panic number. And the cycle continues.
This stressful cycle doesn’t show up on corporate financial statements. For owners, it shows up as not taking a proper salary and/or quarterly dividends, increasing business spending as revenue increases, thinking about getting a normal job again and developing various stress related ailments.
You can’t avoid generally accepted accounting principles (nor would you want to) but you can implement a system that puts profit first and financial stress last.
Why Profit First?
The author of Profit First, Mike Michalowicz, came to this methodology the hard way. By age 35, he created and sold two multi-million-dollar businesses and spent all the money he made from them. Mike’s second-lowest point was having $10,000 in the bank, owing $28,000 in taxes and telling his wife and family they were broke. His lowest and most-humbling moment was minutes later when his nine-year-old daughter, Adayla handed her piggy bank to him and said, “Daddy, we’re going to make it.”
Mike experienced the financial and stress rollercoaster that comes with building and running a business and knew he wasn’t alone. He built Profit First to get business owners off the rollercoaster, once and for all. (Mike’s tagline is “I eradicate entrepreneurial poverty.”)
What is Profit First?
Profit First is basically the pay-yourself-first/envelope system for managing business finances. But instead of stuffing cash into categorized envelopes every month, you use multiple bank accounts to divvy up your revenue into income, profit, owner’s compensation, tax and operating expenses. This separates your money into two psychological categories: money you can spend (operating expenses) and money that’s off-limits because it’s basically spent already and shouldn’t be touched except for those purposes (profit, owner’s compensation, tax).
Much like a grandmother wouldn’t take money from the mortgage envelope to pay for anything else, Profit First enables this same discipline.
To start the Profit First process, you figure out what percentage of your revenue to allocate to each account. These are your current allocation percentages (CAP) which will increase or decrease in modest increments each quarter until you reach your target allocation percentages (TAP). (Profit First recommends TAPs based on business revenue ranges from zero to $50M annually. For example, the TAPs for businesses with annual revenue of $250K to $500K are 10% profit, 35% owner’s compensation, 15% tax and 40% operating expenses.)
At the beginning, your profit allocation will likely start at a modest 1% and your operating expenses will likely be bloated, perhaps totalling 75% (or more) of your revenue.
On the 10th and 25th of each month, you move ALL the money from your income account into the other four accounts based on your CAPs.
At your business bank, set up these (chequing) accounts:
- Income – This is where all revenue arrives.
- Profit – This account is used for quarterly distributions to the owner(s) and serves as an emergency/rainy day fund.
- Owner’s compensation – Your salary (and any other owner’s salary) comes out of this account.
- Tax – This is the holding account for money you owe the government.
- Operating expenses – This is the account you use to pay for all operating expenses including staff and contractor salaries.
Profit First gives you a clear picture of the financial health of your business every time you log into your bank account and for many business owners, that makes a big difference. The system works even if you have debt.
Profit First resources
If your financials are a hazy source of stress and/or confusion, consider learning more about and applying the principles of Profit First to your business.
Profit First resources:
- Profit First: Transform Your Business from a Cash-Eating Monster to a Money-Making Machine – Get the book at your favourite bookstore or library.
- Profit First resources – Download resources like the instant assessment, overview, FAQs, starter kit and graphics on the Profit First website.
- Profit First Professionals – Find a certified Profit First professional to help you implement Profit First in your business.
Building a profitable business isn’t easy but as Mike Michalowicz demonstrates in his book, using the Profit First system allows you to achieve profitability within one quarter, even with debt. If that sounds better than your current system, why not try it this month?
And, if you’d like to provide your employees with a simple, flexible and affordable employee benefits program, take 10 minutes today to get a quote. (Whether you decide to try Profit First or not, remember that with a BeniPlus Benefit Wallet, you can be reimbursed for fees associated with personal tax and financial advice through your Wellness Spending Account.)