Profit First approach makes sense
Late last year, a friend and former MBA classmate who owns several small businesses with 40-plus employees in total, introduced me to Profit First, a book by Mike Michalowicz.
This book describes a simple approach to cash management for small business owners. My friend found that the principles introduced by this resource had had such a transformative impact on his own business interests that he gifted me with my own copy.
The base premise of the Profit First approach is that “in the real world”, the owners of most small/midsize businesses do not spend time poring over their financial statements, delving into the details of income statements, balance sheets and cashflow statements. They do not monitor financial ratios on an ongoing basis, or conduct a quarterly DuPont analysis. Many SMB owners will use their bank balance as their guiding light, with perhaps a quick look at monthly/quarterly top-line sales figures.
The author suggests that business owners are challenged by the conventional definition of profits as the remainder — what’s left over after deducting expenses from sales. He instead advocates modifying this equation from “sales - expenses = profits” to “sales - profits = expenses”, thus sharpening the focus on profits.
The author’s message is that many business owners “try to force themselves to become better at accounting and to become more disciplined in their fiscal management by pure willpower. But just like a muscle, willpower can be drained. And in a moment of financial stress or bigger-than-expected expenses the entrepreneur will break their own fiscal rules and spend the money they have.
“The Profit First principle does not try to change your habits (that is nearly impossible to do), Profit First works with your existing habits. By first allocating money to different accounts, and then removing the temptation to ‘borrow’ from yourself, your business will become fiscally strong and you will benefit from regular profit distributions.”
Benefits of the approach, as described by the author, include that “when you take your profit first, your business will tell you immediately whether it can afford the expenses you are incurring; it will tell you whether you are streamlined enough; it will tell you whether you have the right margins.
“If you find that you can’t pay your bills after taking your profit first, you must address all those points and make the fixes. Taking profit first will help you figure out which of the many things you do makes money, and which don’t.
“Then the direction is obvious — you do more of what is profitable, and you fix (or dump) what is not. You will focus on what makes profit for you, naturally, and you will get better and better at it. And when you get better at what your customers already want and like, they will like you more. All this translates into fast, healthy growth.”
A quick outline of the Profit First approach is as follows:
1. Set up separate bank accounts for operating expenses, owner’s draw (salary) and income.
2. Create separate bank accounts for profits and compliance items — ideally with a different bank (bank 2). The goal is to discourage us from “borrowing” from our profits to meet our short-term cash needs.
3. Determine “target allocation percentages” for operating expenses, owner’s draw, and profits. Note — the author advocates starting with a small profit allocation percentage, maybe 1 per cent of revenue in the initial months, until we are more comfortable and have made improvements to our business.
1. All revenue should be directed to the income account. Spend a minute or to review the account daily, checking balances and familiarising yourself with cashflow trends.
Twice a month (mid-month and at month-end)
1. Transfer your profit allocation and compliance item allocations to bank 2.
2. Disburse your wage / salary allocation as owner-manager to your personal bank account (pay yourself!).
3. Pay your bills from the Operating Expenses account.
4. Note — these transfers should empty your income account.
1. Take 50 per cent of the accumulated profits as a distribution.
2. Pay your compliance obligations.
3. Review and make adjustments to your TAPs as appropriate.
I found Profit First to be an easy read and that the principles/behaviours make a lot of sense in the world of small business. For more information including free resources, visit www.profitfirstbook.com
• Kumi Bradshaw, of Firm Advisory Ltd, helps Bermuda companies measure, grow and harvest business value. For help with business advisory, brokerage or valuation, e-mail email@example.com
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