Organize Your Small Business Finances Using Profit First
If you are a small business owner, chances are you have run into difficulties with cash management – money coming in from sales, money going out to pay bills or payroll. And that often turns into challenges with bookkeeping – keeping track of all your business financial transactions. Many of our clients are small business owners looking for help in getting this part of their business organized.
One of the ways small business owners can get their finances under control is through a system called Profit First. This is typically helpful for newer business owners who are just starting out or business owners who have recently made major changes to their business or entity structure, such as moving to an s-corp tax filing status which requires payroll.
Profit First was created by Mike Michalowicz, and he has written several books about using this method and other ideas for small business owners. Read on to learn about the basic structure of Profit First, plus practical tips from us to help you get started using the system.
How to Set Up Profit First
Here are the basic steps to implementing Profit First cash management system, according to Mike.
Step 1: Set up three checking accounts at your current bank. Nickname these bank accounts Income; Owner’s Pay; and Operating Expenses.
Step 2: Set up two savings accounts at a different bank. Nickname these bank accounts Profit and Taxes.
Step 3: For every $1 in revenue that your business earns, establish the percentage of that dollar that will go into each of the above bank accounts. Mike offers the following suggested percentages:
Profit: 5%
Owners Compensation: 30%
Operating Expenses: 50%
Tax: 15%
Step 4: All sales (income received) go into “Income” account.
Step 5: Two times a month, transfer all funds accumulated in the Income account to the other accounts at the various banks. Pay your bills from Operating Expenses. Pay yourself from Owners Compensation.
Step 6: Quarterly, pay your taxes from the Tax account. Distribute 50% of the Profit account to yourself as the business owner. This is not for the purpose of going back into the business, rather it’s for your personal use such as retirement savings, going on a vacation, whatever you want. The other 50% of Profit can be used for other needs at the end of the year, such as funding retirement savings, investing in the business, etc.
Practical Implementation Tips
In my experience working with clients to implement this system, many clients find this system overwhelming or overly complicated – different banks, so many bank accounts, etc. Depending on your business needs and personal pain points, feel free to customize this strategy to meet your business needs. Here are some practical implementation tips that I’ve seen work with my clients:
TIP: Use only one bank for all the accounts. Many folks decide to open all their accounts at just one bank for convenience. Some banks have minimum required balances ($1,000 minimum x 5 accounts = $5,000 required cash in the accounts at all times? No thanks.). Second, not all banks play nicely with each other. For example, one bank may move money immediately between bank accounts, but another bank requires the funds to sit for 7 days before releasing the assets. This would be a problem if you needed to pay quarterly taxes and had waited to the last minute to transfer your Tax money into the separate bank.
TIP: Start with just two accounts: Income and Taxes. From each $1 received in Income, immediately move a percentage over to the Tax account. It can feel really good to have cash in your Tax account for the quarterly tax payments, and not have to scramble to pay the quarterly amounts.
TIP: Since so many of our expenses these days are recurring and paid via credit card, business owners sometimes use their credit card bill as a way to determine their Operating Expenses.
Don’t co-mingle personal expenses on your business credit card.
If your business is brand new and doesn’t yet qualify for a business credit card, choose one of your personal cards to use for only business purchases to keep these expenses easily trackable.
TIP: Figuring out what percentage to allocate for each bank account is typically the most difficult part of the setup, because business owners often don’t know how much to allocate for each bucket. Two ideas to figure this out:
Look at the last 12 months of revenue and expenses to determine your percentages.
Use the above percentages as a starting point and move the percentages around if you notice one account is consistently out of cash or collecting too much cash after a month or two.
TIP: Tax allocation – depending on your industry, your geographic location, your operating expenses, and your business tax filing status (s-corp, partnership, sole proprietorship) your Tax allocation may need to be higher than the 15% of revenue suggested above. Check last year’s tax return to see your estimated quarterly payments for this year. You can also ask your accountant, or look at revenue earned last year and compare to this year. In Chicago for example, we pay Illinois state income tax of 4.95%, plus sole proprietors pay self employment taxes of 15.3%, so that’s already 20.25% tax burden on net income after expenses before you’ve even paid federal income tax.
Talk to the financial professionals in your life for advice on getting cash management for your business under control. Don’t have a financial advisor who helps with your business questions? Reach out.
