I AM AN ACCOUNTANT AND THIS IS HOW I USE PROFITS FIRST.
Profits First by Mike Michalowicz contains a very good set of principles for small and medium business owners to actually run their businesses. I am an accountant based in Australia and I use an adapted version of profits first in my own business and have found it very successful.
As an initial warning though, it does not remove the requirement for an accountant and/or a bookkeeper. The profit that you pull out does not equal what your profit is for taxes and you still need to make adjustments to lodge your BAS and Income Tax Returns. That being said clients of mine that I have implemented this system with has seem massive improvements in their business and personal financial situation as have I.
By creating a cloud based ‘technology stack’ you can really streamline and improve your bookkeeping process.
The system is built around the insights of Parkinson’s law and some behavioural economics basics. The traditional law is that “work expands so as to fill the time available for completion.” Mike has adapted this to say that the demand for resources (spending) tends to expand to match the supply of the resource (bank balance). By adapting the way we control our money, by removing the profit first we are able to take advantage of this law. Once the profit, money for taxes, super and owners pay is removed we then become naturally more frugal and look for ways to manage our business more efficiently. The practical example Mike uses is Toothpaste. When you have a nice shiny new tube of toothpaste you empty out a massive slug of toothpaste, half of it then falls off while you moisten the brush under the tap.
But hey, who cares — there’s plenty more where that came from!
Yet, when that toothpaste is almost on empty, our behaviours are quite the opposite. We work so hard to extract every little morsel of what’s left in the tube. We squeeze and wring with our fingers until we can extract a small blob — a parcel of gold to be carefully applied to our toothbrush head.
In other words, we’re more frugal.
These principles change the way that business owners think about their cash flow. Business owners have traditionally will spend all their money on the expenses and take whatever is left as profit. They use the traditional method of accounting that we were thought at university is:
SALES – EXPENSES = PROFIT
Michalowicz’s methodology reverses this equation, teaching business owners to “put profits first”. The result:
SALES – PROFIT = EXPENSES.
It may sound simple but it works.
By putting away your profit first, the rest of the money is budgeted for expenses. This forces you to think deeply about every spending decision. It forces you to innovate by creating the same or better output, with less resources.
I have found it has really made a massive difference to people that just withdraw their money from their business ad hoc, through directors loans or drawings account and then just balance it at the end of the year and pay a tax bill. It is also great combined further with the simple barefoot investor outline to further manage your personal finances.
SETTING EVERYTHING UP
STEP ONE - SETUP FIVE DIFFERENT BANK ACCOUNTS
The first step is to setup five different bank accounts at one bank:
1. Profit Account (Used to accumulate profit)
2. Owner’s Pay Account (Used for paying out your net wage)
3. Tax (and Super) Account (Used for the payment of taxes)
4. Operating Account (Used for payment of day-to-day expenses)
5. Revenue Account (Used to deposit revenue only)
Make changes to your invoices so that all your payments into your revenue account.
STEP 2 - DETERMINE YOUR TAP.
The Target Allocation Percentages is how you will allocate the deposits that come into your revenue account. This is a subjective measure and something that you will have to work through to get right. The aim is constant improvement, from where you are now to where you want to be.
An example of the TAP that I am currently aiming for in my business.
Real Revenue - 100%
Profit - 15%
Owner’s Pay - 17%
Tax (and Super) - 32%
Expenses - 36%
Please note that I am in the service business and am a sole trader. All these numbers to aim for are unique, also I include other employees super and tax in the tax account (This again is different to the book).
It is unlikely that your business will be operating at these percentages straight away or that these percentages are right for you but it is something to work towards with your accountant/business advisor and once you have a target in your head it gives you something to really focus on. It is also something that really benefits from an accountability partner.
STEP 3 - TRANSFER THE MONEY
In the book it recommends to transfer on the 10th and 25th but I feel for myself and most of my clients it is best done fortnightly. I find that it has better rhythm to it. Only doing your bookkeeping and bill paying every fortnight is important as it allows you to actually get a pulse on your business and how it is running, when the income comes in and where the money actually goes.
Every fortnight allocate the deposited funds that have come into the revenue account that fortnight as per the TAP’s. It is important that you are disciplined in this and only spend the money in each account for its specific uses, which are:
· Profit – Used to accumulate profit
· Owner’s Pay – Used for payment of your wage
· Tax (and Super) – Used for payment of taxes and super
· Operating – Used for the payment of day-to-day running expenses
· Revenue – Used for the deposit of income only
Here is a Link to the spreadsheet I use in my own business. Simply put this periods income in cell C5 and then transfer as per the results of the spreadsheet.
Another thing I do differently to the book is I pay out Tax and superannuation with every payment cycle. I know this may be hard to fathom but at the moment there is virtually no interest to be earned and by keeping on top of these amounts and paying them every fortnight it just taxes the temptation away for that money to be used for anything else.
Once you get into this rhythm you will be able to use Parkinson’s law to your advantage and will work for any business owner that wants to improve their relationship with their finances.
STEP 4 - QUARTERLY REVIEW AND ALLOCATION
Now comes the fun part. Now that we have reached the end of the quarter it is time to take a profit distribution, a quarterly dividend. Take out half of the money that has accumulated in the profit account and transfer it to your own bank account to be spent as you see fit.
There should now also be a transfer to a vault account (emergency fund account) or to a reserve account for capital purchases.
At the end of each quarter you need to review and adjust you system (review the TAP). It is also a very good time to meet with your advisor for an accountability review.
8.Reduce Cash Transactions:
While it might be convenient to have cash in your pocket for small expenses, the use of cash can increase the risk of errors and mistakes with the financial system. It’s hard to know how much you are spending if all of the transactions are managed with cash. Instead, implement a digital system so that you have a paper trail that shows the transactions and categories for your spending.
As I have mentioned previously I am an accountant. I can read traditional financial reports, have probably lodged over 5,000 tax returns and prepared god knows how many cash flow forecasts. Despite cajoling I still perform some of them for some clients as that is what works for them but as I always tell them that’s not how it works for me.
I could monitor and control my cash flow this way but I don’t. I just use the profit first method and it just works for me. It makes sure that I get paid for all the hard work that I do in my practice and helps me run my own business.