The number one sin when it comes to cash flow management in small business is not managing it at all. “I don’t know where it all goes” is not the right answer for the business owner. In fact, it is the answer that kills most small businesses. 82% of them, to be precise.
Cash flow deserves your attention, or else… “Or else,” in this case, means bankruptcy.
Before you even start managing your cash flow, you need to have a clue about your costs and revenue streams. Not only about their volume, but also their nature. Not paying your contractor for a month or a quarter may not prove fatal, but not paying due taxes to IRS? It may be beyond fatal, depending on your business and private liabilities.
The same goes with revenue streams. It’s great you invoiced your customer for the job finished today. But when will the money appear in your bank account? In a week? Or maybe sixty days? You still need to pay your people and cover your bills in those sixty days!
Level #0: Tracking
If you “don’t know where it all goes,” you need to start tracking your expenses (and income) immediately. If you are organized enough to have all the payments registered in one place, this is the perfect place to start. But small business is a wild creature prone to whims of the owner and the nature of the beast.
For example, I have dozens of income streams, and sometimes they are miniscule. Often, I cannot control how I’m getting paid. Amazon transfers my book royalties directly to my bank account in euro. Findaways pays me via PayPal. Customers from Reedsy pay me via Stripe. It already makes things more complex than they should be.
But that’s not all. I have a customer who transfers money to me regularly into my PLN bank account. Another, who pays me in Euro. If I get a Polish customer, they also pay me in Polish Zloty.
However, the revenue part of my business is simple comparing to the cost part. I have subscriptions paid via debit cards connected to my US dollar account. I have subscriptions paid via PayPal. I pay for Amazon ads with debit cards, in different currencies on different markets to save on the exchange rates. I pay my accountant in PLN – and my taxes and social security fees. I pay my virtual assistants via Wise.
It’s a crazy mishmash, and I track it all in Google sheets to have one place where I can see my real cash balance.
If your financial/accounting system doesn’t resemble a Frankenstein monster patched together from many different parts, tracking your finances should be a breeze. If it looks exactly like Frankenstein (like my maze of payments), you still need to track each incoming and outgoing cent. Even if you have to do it manually in a Google sheet.
Paraphrasing Peter Drucker: “You cannot manage what you don’t measure.”
Tracking your money gives you the idea – or precise numbers – of how much funds you really need on a monthly basis to operate.
Different Kinds of Costs
There are a few categories of costs you should be especially aware:
-tax and legal liabilities
-recurring fixed costs
The first category is important because it can be the difference between living with an axe over your head or the axe chopping your business’ head off.
Salaries are of sensitive nature because your people have stomachs. Their kids too. If you don’t pay them, you may not have people to work for you next month.
Fixed costs are self-explanatory. If you have a brick-and-mortar business and you won’t pay the rent for your “bricks,” you will be out of business in no time. There are some categories of costs that simply must be paid so you can continue to operate.
Operational costs are something different – those are the costs necessary to deliver your products and services. In other words, they are dependent on the volume you deliver. For example, I pay a freelancer for creating the ads for my customers. The more ads we create, the more I pay, but if there is no activity, I pay nothing. Thus, this is not a fixed cost.
Different Income Streams
Tracking only your costs is not enough, especially in an enterprise. You could’ve skipped it if you are an employee and receive the same check every month. However, in business the revenue is not only volatile, it also often comes from many different sources.
For example, my income comes from three main sources – book royalties, coaching, and my book advertising business. Yet, each of those sources divides further into more streams. My book royalties come from audiobooks, eBooks and paperbacks; from Amazon, Draft2Digital, Findaways, and PublishDrive. I don’t even count the sparse payments for foreign rights and other 1-time payments.
Level #1: Bank Accounts
Once you have a loose idea where your money comes from and where it all goes, you can get busy with setting up a simple system, which will show your cash flow at one glance.
In almost the whole civilized world, you need a bank account to run a business anyway. In most countries, it is required. Hence, you use what’s required to setup your cash flow solution.
The Profit First concept is based on the envelope system from the personal finance world. You get incoming money, and then you allocate your cash for specific purposes. And you do that all within your bank.
You need a few to several bank accounts for that purpose. First and foremost, you need the Incoming Account. This is where all your clients send their payments to. This is the only function of this account: to collect payments. You don’t use it for any other goal. You don’t pay ANYTHING from it: no taxes, bills, subscriptions. Nothing. It serves to accumulate the revenue streams.
Then, you need a few (or more) accounts for different purposes, like your grandma needed a few envelopes to manage her cash. You will need a minimum of four such accounts: taxes, owners, opex (operating expenses), and profits. It is recommended that the taxes and profits accounts are in a different bank and not easily accessible to limit the temptation of borrowing from them to pay yourself, your contractors, employees, etc. Once the money is transferred into those accounts it is untouchable.
You can make this system as robust as you prefer. I send owner’s pay to my private account, but then I allocate money further within digital envelopes: for mortgage, bills, Christmas gifts, car repairs, white goods, gas, and so on. The same goes for my business. I have a separate account from which I pay my VAs and a few accounts in different currencies to pay for goods and services. This is my way to lower the costs (I save on exchange rates) and to make sure I have the funds necessary to pay my various business bills.
You can also use the Profit First system to fund your future investments. Let’s say you want to hire a new person. You create a new bank account and name it ‘New hire,’ and each month you put there a slice of your revenue after taxes. When you will be ready to hire, you will have no headache where to get money for an additional salary. Also, allocating a part of your revenue in advance will clearly show you if your business is healthy enough to afford yet another employee.
When buying a piece of an expensive equipment, the principle is the same – keep setting aside a fraction of your revenue for a few months till you can actually afford it.
Level #2: Thresholds
OK, but how much of your revenue is dedicated to salaries, and how much for a new hire or equipment? This is where Profit First thresholds come into play. Exactly like your grandmother knew how much she should put into each envelope, you need to know how much to allocate into the bank accounts you created.
Profit First thresholds are the centerpiece of the whole system. You tracked your income and revenue streams, and you created the bank accounts, so you can now put the thresholds into use.
So, what are Profit First thresholds, and what do they do? Each of them is a simple percentage metric, which tells you how much of your revenue you should allocate into specific accounts.
Let’s stick to the simplest example: you have only five accounts – incoming, taxes, owner’s, opex (operating expenses), and profits. The incoming bank account is just a “bag” for collecting money. Then, the thresholds inform you how much to transfer to each of the remaining four accounts. Let’s say, 10% goes for taxes, 50% for owner’s salary, 35% for operating expenses, and 5% for profits.
You can have more bank accounts (a new hire…) and thresholds. Of course, the laws of the math require that all the thresholds sum up to 100%. So, if in the above example, you want to start setting aside money for a new employee, you need to open another bank account and assign a threshold to it. Let’s say, 5%. But where to get that 5% from? Stealing from Uncle Sam is a bad idea, so definitely not from the tax account. You can diminish your profits, but never to zero. Thus, take 4% from profits and 1% from owner’s. The new set of thresholds looks like this:
New hire: 5%
Seriously, you can have as many objectives connected to bank accounts, as you wish. Currently, I have seven in my business, and I’ll soon add the eighth because I’ve been delusional about my fixed costs and need to take the proper care of them.
What is the main benefit of Profit First thresholds? Automation. You don’t need to think about what to do with your money. Its destiny is already determined. When a client pays you $100, you put $10 in the tax account, you take $49 for yourself, save $5 for a new hire, set aside $1 of profit, and transfer $35 to your opex account.
You don’t need to fiddle with your money – ever again. You don’t need to steal from Paul to pay Peter – never again. You will always have the money to pay your taxes, bills, salaries… and you will always have some profit, even if it will be as tiny as 1% of your revenue.
How to assess your initial Profit First thresholds? Guesstimate! This is where tracking and analyzing past data pays off. If you have been in business for three years, you can estimate how much in taxes you really pay. I cannot tell you this. Not even an experienced accountant can tell you this out of the blue. Each business is different. The exemplary thresholds above are more suitable for a solopreneur with an online business – low revenue, so he consumes the main bulk of it; relatively low costs of running a business, relatively low taxes.
However, in case of a bigger brick and mortar business, the thresholds could’ve been very different: 0% of taxes, cos’ the business is in the red.
60% for operating expenses, including installments for the heavy equipment (thus no profits and high costs).
5% of owner’s salary, because the revenue is over a million, so it is enough for a modest lifestyle.
Level #3: Leveraging the Profit First System
Now, you have everything in place – bank accounts and thresholds. All you need to do is to use them, and keep using them.
The revenue comes to your incoming account. Every so often, you distribute the revenue among your bank accounts according to your Profit First thresholds.
In his book, Mike Michalowicz recommends doing it twice a month, on the 10th and 25th day of the month – thus you will have money for bills and salaries, which are usually paid at the middle or the beginning/end of the month.
But you can do it as often as it makes sense for you. Maybe you have such an abundance of cash that once a month is enough for you. Personally, I do it 4-7 times a month because I’m chronically short on cash (which only proves that I need to adjust my percentages). Yes, it obviously consumes more of my time, but the allocation of the funds is the business activity I enjoy the most. I don’t mind it at all; in fact, I’m always looking forward to it. I eagerly check my receivables if they summed up to a few hundred bucks and then play the Profit First game.
Which, by the way, is the way I recommend to anybody who starts implementing the Profit First system. The more often you are using it, the faster it becomes your habit. If you perform the funds allocation every few hundred bucks, in a few weeks it may become your second nature.
Michalowicz also recommends to login to your bank account once a day and check your accounts’ balances. This is the real benefit of the system: you are feeling the pulse of your business. Cash flow is like a blood circulation system for your organism. Sometimes blood flows slower, sometimes your pulse accelerates, especially when you increase your physical effort. Your overall health depends on your bloodstream. The health of your business depends on your cash flow.
Once every quarter, you use your tax and profit accounts to pay taxes and do profits distribution. At the end of the year, you may make a few serious decisions about investing your profits. That’s it. So much financial headache is blown out of the water with just a few daily, bi-monthly and quarterly actions.
Peace of Mind
If you properly implement the Profit First system, it provides peace of mind incomparable with any other “accounting” system. It eliminates dozens of daily financial dilemmas:
Should I pay this bill or that contractor?
Will this client pay before I need to process the payroll for my team?
If I pay my personal bills this month, can I still afford to pay my business’ bills?
Everything is predetermined and automated. The only decisions you need to make are about the allocation percentages and you will make them only every so often – you will cut your costs, so you will be able to allocate more for profits; or you will get a better feel for how high your real tax fee is and lower that threshold; or you will get a few new customers, so your overall revenue will jump, and you will modify Profit First percentages accordingly.
The beauty of this system is that it is so intuitive. You will have a look at your bank accounts every day. You will supervise the distribution of funds. You will quickly notice the places where you are short on cash. What is more, you will have concrete data and numbers to crunch, not just your gut feeling.
Like a bloodstream, your business’ cash flow needs constant adjustments. With the Profit First systems, making those adjustments comes naturally.
No More Overstretch
Another big benefit of Profit First is that it makes it really hard to be careless with your money. No more:
“Let’s buy this truck!”
“Let’s hire a new person!”
“Let’s move to a bigger office!”
You can do all of the above, but when following the Profit First system, you will have to find the place to get this money from. Should you cut your own salary? Increase revenue? Or maybe your threshold for the operating expenses was high enough that you can accommodate this investment? One glance at your data will provide you the right answer.
However, in most cases, I guess the answer will be: “Nope, we cannot afford this new shiny object.” Profit First grounds you in reality, provides a clear state of your bloodstream, I mean cash flow. It leaves no space for wishful thinking. It prevents you from making stupid and costly decisions.
In short, it saves your business’ butt from oblivion. 82% of small businesses go out of business because of their cash flow problems. Implement the Profit First system, and you will not be one of them.