A Profit First business is, for the most part, debt free. While there are some notable exceptions the general principle is “accumulate cash rather than borrow”. At Panic Atax we refer to the process of stopping all debt as The Debt Freeze *cue a chilling wind*.

Why is it so important that we do not take on debt right now? Because debt will allow Parkinson’s law to re-establish a hold on your Cashflow. By borrowing you allow yourself to circumvent Profit First and your spending habits continue. It’s particularly important to avoid debt in the early stages of implementation while you are still working out any initial kinks in the system.

This week we have started working with a business owner who had previously self-implemented Profit First. They have been kind enough to let us use their business as a Case Study. They are a perfect example of what happens when you take on debt while using Profit First. We won’t use real names or professions, but the situation is very much one business owner’s reality.

 

The Debt Freeze – A Case Study

Background

Bob owns a Painting and Decorating business in Queensland. He read the original Profit First book a couple of years ago and loved the concept. The business had around $50,000 left on a business loan that he was keen to pay down. He headed off to the bank to open some accounts and started his Profit First journey.

The system was working perfectly within the business. His customer’s paid for his work via the Income Account. He took a portion of this out to pay off the cost of the Paint and other materials used and the rest of the money was split between his Profit, Tax, Owner’s Pay and Opex accounts. To clear the business debt Bob had set a reasonably low Owners Pay percentage and a high Profit percentage. This mean that at the end of each quarter he had a decent sum of money to pay onto the loan. The system was working exactly as the book says it should.

Where it went wrong

Fast forward two years and the business debt is cleared. Hooray! The business is now debt free and continues to be profitable. However, because Bob’s Owner’s Pay percentage was so low the salary the business was paying him each week was insufficient to cover his living expenses. Rather than cutting back  personal expenses or revisiting his Owner’s Pay allocations the shortfall was covered with personal credit cards. Each month the credit card bill would come in and he would use most of his salary to chip away the balance. Since he was spending more than he earned the balance continued to rise. While the system seemed to be working on the surface, by failing to freeze his borrowing Profit First wasn’t working at all. He was just shuffling debt.

The result

Essentially Bob has traded a $50,000 business loan for $45,000 in personal credit card debt. The credit cards have a significantly higher interest rate than the business loan did. Also, where the interest on the business loan was tax deductible the credit card interest is not.

Arguably, Bob’s situation is now worse than it was when he first implemented Profit First.

 

Exceptions to the Rule

There are a couple of situations in which businesses can still use debt facilities effectively without ending up like Bob.

Operating Expenses Credit Card

Many Profit First practitioners use a business only credit card to pay business expenses and then pay the card off from the Operating Expenses account. Using a rewards card can be a great option here. If you implement this strategy it’s extremely important that the balance of this card is tightly controlled. If the card isn’t regularly reaching a $0 balance you may need to revisit your expenses list.

Equipment Finance

Loans to purchase essential business equipment are permitted so long as the monthly repayments can be made from the Operating Expenses Account. Notice the use of the word essential. If you want the new Macbook Pro just because you like it better than the 12-month old one you are using right now then don’t do it! Borrowing for non-essential items is a step backwards.

 

Summing Up

In summary – If you are new to Profit First then all borrowing needs to be put on hold for the moment. You must  give the system time to establish itself or I can guarantee you will trade one debt for another. Worse still, you can actually start to accumulate debt where there was none before!…Don’t be like Bob! (Sorry Bob).

 

Further Information

Read our comprehensive review of Profit First here

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