In business, Cash in KING. There is no getting around it. To truly succeed in business you need to master how you use your cash.
I spent the first ten years of my accounting career working with business owners who had no control over their cashflow and who basically ‘hoped’ to make profit. They were never really sure if they had made any money until the end of the year. The conversations went like this:
Me: “you made a $100,000 profit this year, congratulations!”
Business Owner: *Happy Dance*..”I didn’t realise we made that much!”
Me: “The tax bill on your profit is $25,000”
Business Owner: ….”We can’t afford that, we don’t have any cash!. If we made all that profit where did the money go? What do we do now?”
Sounds like a depressing meeting, doesn’t it? Rather than being a celebration of a job well done it quickly turned into something very different. As an advisor it was so disheartening to see clients in that situation. It was clear to me that the traditional core services offered by the accounting industry were failing business owners. Particularly small business owners who lack the resources to hire well trained, internal accounting staff.
When I took the leap and started my own accounting firm, Panic Atax, one of the first things i did was start searching for a tool to help my clients solve this problem. That was when I came across Profit First by Mike Michalowicz. By the time I got to the end of this book I was sold. There was no doubt in my mind that this system would help my clients more than any traditional accounting report. Sure, a few tweaks would be needed to customise the system for Australian businesses but fundamentally I could see this working.
I joined Profit First Professionals the next day and I’ve been working with Mike Michalowicz and his team to “Eradicate Entrepreneurial Poverty” ever since.
What is Profit First?
Profit First is a cashflow methodology designed to help Entrepreneurs and business owners increase their profit and get paid what they’re worth. The principle behind Profit First is to change the way that we, as human beings, look at cashflow and profit. Traditional accounting teaches us that Profit is calculated as:
Sales – Expenses = Profit.
Our profit is the amount ‘left over’, assuming there is anything left over! The Profit First system flips the equation, giving profit the focus it deserves:
Sales – Profit = Expenses.
Yes, i just wrote two maths equations! Don’t run… I promise that’s the last time i’ll do it in this article.
In theory the calculations should work exactly the same but the benefit of the Profit First approach is psychological. That simple tweak to the equation will result in a profound shift in your mindset. Here’s why…
Conquering Parkinson’s Law
Profit First is focused on helping you beat Parkinson’s Law. Usually Parkinson’s Law is discussed in regard to efficiency in the workplace. “Work will expand to consume the available time for completion”. A perfect example of this is a school assignment. If you have three weeks to complete an essay it will take three weeks. If the teacher only gives you 24 hours to complete the same essay you will get the job done in 24 hours. It’s human nature, we allowed the same task to consume all the available time.
Parkinson’s Law actually effects all resources..not just time! Examples:
- Food: Anyone who has met me knows I’m a big lad. I’ve always loved my food. If I’m served up a meal I eat what’s on my plate because that’s what people do… I consume the available resource. This is why diet professionals recommend smaller portion sizes. If you reduce your serving size and then you consume all the food you were served (Parkinson’s Law) you’ve actually consumed less calories;
- Toilet Paper: Ever been to the bathroom with a fresh roll of toilet paper? I’m sure you pulled paper off the roll to your heart’s content. I don’t care if you scrunch or fold, as long as you wipe front to back I wont judge! The point is you probably used a lot of toilet paper. I’m sure you’ve also been in a similar situation except this time there are only 4 sheets left on the roll..and its single ply! I wont go into detail here but needless to say i’m sure you still got the job done! In both cases you consumed the available resource to achieve the desired outcome.
Profit First helps you stop Parkinson’s Law from eating all of your business cashflow. It reduces the funds available for business expenses and forces you to consider every business purchase more carefully. Essentially, it makes you budget without actually telling you to budget. It forces you to innovate to solve problems rather than throwing money at them!
How do we implement Profit First in Australian businesses?
1. Set-up the Profit First bank accounts
First of all, open bank accounts to perform the core functions in your business. The book details five core accounts:
- Income / Revenue Account
- Profit Account
- Operating Expenses Account
- Owner’s Pay Account
- Tax Account
In addition, you may need a number of other accounts depending on your business and the goals you want to achieve. Most businesses can get started with these five accounts and build out from there.
The account types used will depend on your needs. For example the Owners Pay account can be either a savings account or a transaction account depending on whether or not you want to be able to make payments directly from the account.
You will also want to consider having some of the accounts at a different bank. Again, this helps us beat Parkinson’s Law..out of sight, out of mind!
2. Determine your CAPS and TAPS
This is the more technical part of the system. The first concept to understand here is ‘Real Revenue’. All Profit First calculations are based on your Real Revenue, not your total income which is what your accountant would normally focus on. Real Revenue is total income minus the cost of your materials and subcontractors. This is your businesses real income figure. If you turn over $5,000,000 a year but you spend $4,000,000 on the stock you sold then your Real Revenue is $1,000,000.
Your Current Allocation Percentages (CAPS) show where your real revenue is being spent NOW. What your business is actually buying day-to-day in its current format. Often this is the most profound discussion in the whole implementation process because business owners rarely pay close attention to this information. Seeing the numbers in black and white is an eye opening experience..
The Target Allocation Percentages (TAPS) detail where we want your Real Revenue to go once the business in running at peek efficiency and profitability. You won’t hit these numbers over night, or even this year in many cases but you can’t work towards them until you know what they are. It’s important to note that depending on the size and nature of your business some of these numbers may deviate significantly from those outlined in the book.
Your Profit First Professional will help you build an implementation plan to move your business from the CAPS to your TAPS.
3. Transfer your cash
Establish a rhythm for transferring the funds that are accumulating in your income account to your other accounts. How often should that happen? It’s completely up to you. Almost every business owner starts out thinking they need to conform to the 10/25 rhythm outlined in the book but this isn’t necessary. Some business owners do it fortnightly while others do it weekly. I have clients who do it every time a customer pays them because they love the process that much. There is no right or wrong answer here but i probably wouldn’t do it more than weekly to begin with just to avoid creating a lot of admin work. Once you establish your rhythm you need to stick to it!
4. Make Payments
Use your profit first accounts to pay your bills. The key is to ensure that each account is only used for its designated purpose.
Accumulates a very small amount ‘off the top’ that can be used for debt reduction, emergencies and for the business owner to receive a bonus for all their hard work. Profit First is about generating profit so this account comes first!
This account is used to pay the business owner’s after tax salary or wage. Fight the temptation to ‘re-invest’ this into your business because it’s yours salary. You need to get paid!
Use this account to meet all of your tax and superannuation obligations. Remember my sample clients from earlier in the article? The ones that couldn’t afford their tax bill? They can now because they’ve been setting aside the money all year…
This is all the money your business has available to pay its operating expenses. Get creative and spend it wisely because all the other accounts are spoken for.
5. Review and Adjust
At the end of each quarter the system should be reviewed and adjusted. The Profit First mindset shift will challenge you to re-evaluate every element of your business model as well as your personal financial situation. As your situation changes so to will your need for cash and your account transfers should reflect these changes.
Yes, i’m an accountant. I can read traditional financial reports and prepare cashflow forecasts. I could monitor and control my business cashflow according to all the usual/traditional methods…but i don’t! I’ve been using Profit First in my own business since day one and I intend to continue. The system has forced me to build an efficient, profitable business and keeps me in check when ever i’m tempted to throw money at a problem.
Profit First doesn’t completely replace traditional accounting in my business but it does allow me to focus on what’s important. I still review management reports to look at where my income is coming from and how each service to growing month to month. The step I skip now is reviewing the reports each month to check if my business is profitable because Profit First takes care of that for me.
More importantly, this experience has been shared by the business owners I’ve helped to implement the system. Profit First has allowed me and my clients to have far more meaningful conversations and i can see them making a solid profit for all their hard work.
Profit First is certainly not the only book/method out there to help you manage money but its certainly the one I use and endorse because I’ve seen it work, first hand.
If you’d like to learn more you can grab a copy of the book from Amazon. Australian business owners should keep in mind that the concept is great but the implementation requires a tweak, especially if you are registered for GST and have employees.
If you want to work with a Certified Profit First Professional to get the system up and running properly contact me. Our team can set it up for you and keep you on track with one of our profit coaching programs.