Entrepreneurs and service business owners can easily spend money as fast as they can make it. But when business slows down during certain months of the year, these businesses are put into a vulnerable situation without an adequate cash reserve.
Do you have problems planning or managing the finances of your business? If so, you’re not alone because many small business owners struggle with the same problem. Fortunately, you don’t have to be a professional accountant or finance guru to learn how to manage your company’s money better. Instead, you simply need an effective budgeting system put in place.
An entrepreneur named Mike Michalowicz wrote a book called “Profit First.” The book is about a business model he created called the Profit First model, where the business owner takes a percentage from each sale and keeps it as a profit. This model is in contrast to the traditional business model of letting all the sales money add up in a commercial bank account and then using the money from the account to pay your business expenses.
Letting the money build creates the illusion that you have more money to spend than you do. But if you take a percentage profit from each sale right away, you can devote the rest of the money to your business expenses and other entrepreneurial endeavors.
The Profit First model lets you know exactly how much money you have in profit versus how much you can spend on business-related expenses. This will come in handy during the slower months because you’ll still be able to pay yourself a profit on each sale, no matter what.
The Four Steps of Using the Profit First Model
Would you like to know how to implement the Profit First model into your small business? Let’s go over the five steps of this process below:
1) Start Multiple Commercial Bank Accounts
You’ll need to start multiple commercial checking accounts for your small business. Each checking account will be for one particular purpose for your company.
For instance, you’ll divide your checking accounts into categories like Operating Expenses, Owner’s Compensation, Taxes, Income, and Profit. Now go to a different bank and open up two commercial savings accounts, one for Profit and the other for Taxes. It’s essential to keep the savings accounts separate from the checking accounts as much as possible because you don’t want to use this money very often.
First, all the money generated from the sales of your business activities will go into your Income checking account. Next, you’ll transfer all the Income funds into the other accounts about twice per month, usually on the 10th and 25th of the month. The fund transfers will get split according to specific percentages set. Do this until your Income account balance is $0 on each of these two days out of every month.
The Income bank account should not have a minimum balance requirement. So make sure you choose a checking account without a minimum balance requirement when you create your Income bank account.
2) Establish the Percentages of Your Income Fund Transfers
The percentages of the Income money that get transferred into other accounts will be different for every business based on the size of the company. This helps you avoid paying yourself too much gross profit without factoring in the company’s other expenses.
Here are the average percentages set for small business owners:
- Owner’s Compensation – 45%
- Operating Expenses – 35%
- Taxes – 15%
- Profit – 5%
Of course, your percentages might look different and should be adjusted accordingly. It all depends on your level of operating expenses and taxes. But as your company grows and makes more money, you might decide to increase the Profit or Owner’s Compensation percentages and reduce the Operating Expenses percentage.
3) Transferring Your Income Funds Twice Each Month
Now that you’ve allocated the transfer percentages of your Income account funds, the next step is to execute the transfers into the other checking accounts twice per month. Most business owners choose the 10th and 25th to do the transfers, but you can select different days if you desire.
After you’ve moved the percentages into your Taxes and Profit checking accounts, transfer all the funds from both accounts into your Taxes and Profit savings accounts at the second bank. You’re less likely to spend the money prematurely if you don’t have to look at it in your checking accounts. That is the purpose of the transfer into the savings accounts.
The next step is to pay yourself using the funds in the Owner’s Compensation checking account. Don’t pay yourself all the money in the account, though. A good rule is to divide the money in the Owner’s Compensation account by 12 to determine the figure you should pay yourself every month.
In addition, when deciding on the percentage of Income funds to put into your Owner’s Compensation account, it should be based on the income projections you have for that particular year. That way, if business starts to slow down at a specific time of the year, you’ll still have money in your Owner’s Compensation account to pay yourself when times get tough.
Finally, use the funds in the Operating Expenses checking account to pay your monthly business expenses, such as your business credit card payments, utility bills, advertising, transportation costs, etc.
On a side note, you should consider using a Business credit card that comes with rewards points. Then you can use the card to pay for your other business expenses while accumulating bonus points in the process. And as long as you pay down your credit card each month, you won’t incur any interest charges. It’s just something to think about for additional savings on your expenses.
4) Profit
What does it mean to profit in a business? Most small business owners assume the profit amount is the amount you get after subtracting your operating expenses from your gross income. However, you don’t pay yourself this profit amount because your owner’s compensation payment is separate from your company’s profit amount. That is why there are different bank accounts for Profit and Owner’s Compensation.
The Profit amount refers to the amount of money your company has saved after paying all its operating expenses, including the payments to you and the other employees. According to the Profit First business model, you should use the funds in the Profit account for two reasons: an emergency fund and paying yourself a nice bonus every quarter.
Emergency funds are critical for small businesses because they offer cash reserves to pay for unexpected expenses or disasters, such as property damage from bad weather or a COVID-19 pandemic shutdown. No one can plan for these disasters, so you must be financially ready for them by maintaining a fair amount of cash reserves.
The rule of thumb is to have enough cash reserves to cover an emergency in your business for up to six months. Once you have saved six months of cash reserves, you can pay yourself 50% of everything else in your Profit account as a quarterly bonus. Perhaps you could use the money to take a nice vacation or do something fun and exciting. It is up to you.