It’s easy to feel sidelined with business expenses and other obligations that stifle growth and eat into your company’s revenues, and unfortunately for small business owners, nearly 4 out of 5 small businesses fail in large part due to poor cash flow management. That’s where the Profit First approach to accounting can come in. This relatively new approach for modern entrepreneurs can provide a budgeting solution that promotes financial security and growth, and helps business owners take a smarter approach to managing their money.
As the name suggests, the Profit First business model can help increase profit, which can help your organization flourish in today’s competitive climate. Here, we’ll help you understand how the profit first method works and how it can contribute to the financial health of your small business.
What is the Profit First Method?
Mike Michalowicz, a successful serial entrepreneur and former small business columnist for the Wall Street Journal, launched three multi-million dollar companies before he turned 35. He later set out to pass on what he learned to other entrepreneurs through a series of best-selling books that outline a new way for business owners to think about revenue and profits.
In his book Profit First, he lays out a strategy to “transform any business from a cash-eating monster to a money-making machine.” The book’s radically simple central idea came out of Michalowitz’s own struggles with maintaining cash flow with one of his earlier business ventures.
Rather than chasing the next big sale or expansion, Michalowitz decided to flip the typical accounting process on its head and set aside his “profits first.” He would take a percentage from each sale as profit, and then he focused on scaling expenses around that benchmark.
In a relatively short time, this method has earned acclaim from accountants and other financial professionals for introducing an innovative, effective budgeting strategy for business owners. It may sound counterintuitive at first, but if you focus your business around profit, everything else follows—including more profit.
How does the Profit First Method work?
To understand the Profit First business model, it’s important to review how profits typically work for small businesses.
Traditionally, most business owners structure their budgets as follows:
Income – Expenses = Profit
In other words, you simply take your income and subtract your expenses, and whatever is left—which, for many business owners starting out, may not be that much—gets chalked up as profit.
The Profit First business model shakes things up a bit, changing the formula to:
Income – Profit = Expenses
In other words, instead of immediately trying to account for your business expenses, you set aside a designated amount of cash to serve as profit.
For example, you might commit to setting aside 30% of revenue and designating it as profit, before your expenses have a chance to take a bite out of their earnings. This method may take a little getting used to, but over time, it starts to change how you think about the money coming into your business. Specifically, it encourages you as a business owner to prioritize your own pay (something which often gets overlooked) and being more thoughtful about the expenses you’re accounting for.
And even if you’re not managing the books or are relying on the help of an accountant to keep things in order, Profit First encourages you to maintain a closer relationship with your business finances, which is critical when it comes time to scale.
How can you optimize your banking practices for Profit First?
Using the Profit First Method requires having strong control over your cash flow and being able to adequately separate out money based on different buckets. The best way to achieve that is to distribute your funds into five separate accounts:
- Income: This account holds the revenue that the business earns.
- Profit: This account holds an allocated percentage from revenue earned to count towards your business’s profitability and/or be used when unexpected expenses arise.
- Tax: This account is where you’ll set aside a fixed amount to go towards taxes.
- Operating expenses: This account holds cash meant to go towards salaries, rent, office supplies, business travel, marketing, and other bills etc.
- Owner compensation: This account is where your salary as the business owner would go.
Because separate accounts are so central to the Profit First strategy, it’s important to look for a bank or banking platform, like Bluevine, that supports easy account management, such as through offering the ability to open a series of sub-accounts within your main account. Keep in mind that you won’t necessarily have to open all five accounts right away. You can start small by simply designating accounts for profit and tax, then work towards adding the others as your business grows.
Did you know?
Bluevine Business Checking offers a robust Sub-accounts feature that offers business owners many of the same great benefits as their main checking account—including fee-free ACH transfers, bill pay, and 2.0% interest for eligible customers1—with the added benefit of easier budgeting and cash management.
How much should go into each separate account?
Figuring out how much of your cash should flow into each of the aforementioned accounts starts with first understanding two types of goals: current allocation percentages (CAPs) and target allocation percentages (TAPs).
Your CAPs reveal how your money is being spent right now, based on your current income and expenses. Your TAPs, on the other hand, reveal your desired budget and show what your business would look like if it were operating at peak performance and efficiency.
Michalowitz helps break down allocations based on TAPs, with examples of adjusted percentages based on your business’s yearly income:
|Real Revenue Range||$0-$250k||$250-$500k||$500k-$1M||$1M-$5M||$5M-$10M||$10M-$50M|
Notice that, as your business grows, it will impact the amount of money that you should be allocating to different buckets. For example, as your business grows and starts bringing in more revenue, the more money you’ll be putting towards operating expenses (and the less you’ll be adding to the owner’s comp bucket).
Michalowitz recommends that business owners make a habit of allocating money into profit, tax, operating expense, and owner’s pay accounts on the 10th and 25th of every month. However, the specific days aren’t as important as making sure that you have a system in place that works for you.
In order for this method to be effective, you need to ensure you use each account to pay the bills designated in each category. At the end of every business quarter, you can go back and review your budget and make any adjustments as necessary.
Did you know?
As a good rule of thumb, if there is money left over in the “profit” sub-account at the end of a quarter, you as a business owner can claim 50% of that as a bonus but should put the other half in a long-term storage or savings account to build a capital reserve for your business.
Every business is different, and sometimes it takes a little testing to figure out the right approach to managing your business finances. Profit First is a method that, when implemented correctly, can help support sustainable long-term growth. And while it may take some getting used to and can stall immediate growth, this approach to financial planning for your business is designed to set you up for ongoing success in the long run.