Profit First is a profoundly simple, yet shockingly effective accounting strategy that will transform your business from a cash eating monster into a reliably profitable system.
Accounting isn’t known as the most interesting subject in the world (except for accountants like us = we love it!). The book Profit First, is one of the few easy to read and understandable books on accounting out there, helping owners and entrepreneurs escape the growth trap that many businesses fall into.
Profits First is a systemised way of running your business’s finances, without the complexity of accrual accounting. It focuses on cash and cash flow, rather than accounting profits – which is the accurate measure of business profitability for small and medium enterprises (SME).
It works because it improves your cash flow management and profitability without having to think too hard about it. The process forces the owner to ‘pay themselves first’ and to focus on expenses by using segregated bank accounts.
The author of Profit First, Mike Michalowicz, noticed that despite many businesses he was involved with growing fast, they continually had cashflow issues. They were reactive, rather than pro-active with cash flow management. If there was a significant expense coming up, the way to deal with it was to chase debtors or make another big sale. These businesses were growing fast, but it was cashless growth.
Profit First takes the traditional accounting equation of sales – expenses = profits and turns it on its head to become sales – profits = expenses. By using this formula, it forces business owners to take profits first and to pay their costs out of what’s left.
He based his work on two psychological principals. The first, Parkinson’s law, is the adage that work expands to fill the time allocated to it. This is true not just of work but of many areas of life, including cash. If there is cash in the bank, it will be spent (and if there is credit available on the credit card, it will be used).
Entrepreneurs and SME owners often spend more time looking at their bank balance than they do their P&L and balance sheet.
Making Expense Plate Smaller
The next observation is that in dieting, using a smaller plate and eating healthier helps to lose weight. Profit First takes this concept by making the expense plate smaller, forcing you to spend less, and by changing the “meal sequence.” If you eat your greens and veggies first, you fill up on highly nutritional foods before getting stuck into the carbohydrates. Same with cash – filling up your profits, owner salary and taxation accounts ensure these are fully-funded.
Dieting succeeds when you remove temptation. If there is no chocolate in the cupboard, you can’t eat it! Same with Profits First. It required you to set up a separate bank account for different types of cash flows. By quarantining cash, it removes the temptation to spend it.
The final key to Profit First is to make it a habit. By periodically allocating cash to your various accounts, you build a rhythm. The book suggests allocating capital and paying bills on the 10th and 25th of each month, to correspond with fortnightly pay cycles. By not being reactive – like saying, “Cash has come in, I’d better pay the bills.” Business owners must take control of their cash flows, rather than let it control them.
Profit First starts by setting up separate bank accounts for each of the key areas of your business. Five accounts are set up at bank A and two separate accounts at a second bank. Then, by following a process of allocating cash from sales through these accounts periodically, it ensures that businesses have sufficient funds to pay bills, payroll, taxes, and most importantly, to pay the owners.
All cash inflows from sales flow into the first account. This cash is then streamed into accounts for:
|INCOME||For all incoming cashflows|
|PROFIT||Reserved owner’s profit|
|OWNER’S COMP||Set aside salary and wages for the owners|
|TAX||Covers all tax payments, including tax payments for the owner’s salary|
|OPEX||All operational expenses, including employee payroll|
The other two accounts at the other bank are “no temptation” accounts for PROFIT and TAX. It takes a fair amount of self-discipline not to raid the piggy bank, especially when there is a hefty bill to be paid. By setting aside surpluses in these account in a separate bank, it takes a large amount of effort to withdraw cash from them, reducing the chances of impulse purchases.
Once these accounts are set up, the next step is to assess the financial health of your business.
Assessing the health of your business – The instant assessment
The Instant Assessment (IA) is the core of the Profit First system. By running your businesses numbers through the matrix, it gives owners a good sense of how business is performing. It’s likely that on your initial IA that most business owners find their profit allocation is too low, while their expenses allocation is too high. The steps to calculate your IA are (see below for the form):
- Determine top line revenue. If materials and subcontractors make up more than 25% of revenue, then deduct their costs to give you Real Revenue. Don’t subtract the costs of your own staff – this is OPEX.
- Write down profit for the past 12 months – might be zero. It’s the amount sitting in the bank or distributed to yourself as dividends.
- Take note of the owner’s compensation. This is the amount paid to owners as regular payroll, not as profit.
- Tax is the amount the company has paid on your behalf, which may not be the same as the amount you paid. Include both corporate tax and income tax of owners (note there is a difference).
- Finally, jot down operating expenses. This is all other costs incurred by the business over the year.
|Top Line revenue|
|Material & Subs|
Next, you enter in your Target Allocation Percentages (TAPs) for each of the five lines above. TAPs are not the starting point, and they are the targets you are moving towards to make your business profitable. Profit First gives the following TAPs, based on revenue.
|Real Revenue Range ($)||0-250k||250k-500k||500k-1M||1M-5M||5M-10M||10M+|
Real Percentage Revenue
The PF$ is the Real Revenue multiplied by the TAP for each line. Finally, calculate the Delta, which is the difference between PF$ and Actuals. It tells you how much cash you need to change, either up or down for each line item. This might be ugly – your expenses could be too high or the amount of profit too low. That doesn’t matter. What matters is that you have a target to work towards over time.
You are calculating your actual OPEX, tax, profit, etc. as a real percentage revenue gives you Current Allocation Percentages (CAPs). This is the number that will slowly move towards your TAPs over time. At first, there might be a considerable gap between these two numbers, but with careful, deliberate, and incremental steps, you will bridge the gap and make your business profitable.
Calculating the right TAP for your business is the most laborious and most subjective element of the calculation. The TAP percentages outlined above are a good starting point but should be adjusted for your company and industry, something your advisor can help with.
The profit TAP is going to depend upon the maturity of your business and industry. It will also get bigger as your business grows!
Set the Owners Comp Tap as a realistic salary for the work you do. As the owner of the business, you are the most valuable employee. Don’t underpay yourself to pay for everything else. The business won’t survive without you.
The TAX TAP sets aside enough to cover not only the company tax due but also any tax that the owners pay (such as PAYG). After all, you got into business to make more money, not less.
Steps to implement
What’s the best way to stick to a plan? Tell everyone about it and have them keep you accountable! So, the first step to implementing PF is to make sure your accountant is on board. Tell us, and we will work with you each quarter to review your CAPs and make sure you’re not cheating yourself on your tax.
Next, set up your accounts, calculate your TAPs and CAPs.
Then look at the cash in your current bank account (which will be your OPEX account going forward) and do the first allocation.
Make your first profit distribution and celebrate! Your business is now paying you a profit, even if it’s only enough for a small cup of coffee.
The Profit CAP
After you have determined your CAPs, for the first quarter make this 1 % better than you have historically done. For example, is your PROFIT CAP is 0%, which is most businesses before they start this process, add 1% to it and reduce whichever account is too high (probably OPEX). Incremental changes are more likely to become permanent, lasting ones.
In week one, start cutting expenses (see below).
At the end of the first quarter, distribute 50% of profits to the owner. This money isn’t for reinvesting into the business or paying your tax bill. It’s for spending. The remaining balance serves as a cash reserve in case of emergency (ideally around three month’s expenses). Any amount above this can be reinvested back in the business. Then, review your CAPs and make small 1% steps towards your TAPs.
At the end of your first year, review your TAPs and reassess. Was tax too high or owner distribution too low (hopefully!)?
Debt freeze and expense reduction
If your company has debts, use 99% of the amounts in the profits account to pay these, before paying owners the remaining 1%. Having no liability frees your business from the biggest cause of failure.
To conduct your expense review, print off your detailed P&L. Start by marking up which expenses go to profit (P), expenses that can be replaced with less expensive option (R), and unnecessary expenses (U). It includes salary and wages – are all your employees necessary?
Add up all expense and divide by 12. This is approximately the amount you need to cover each month. Determine the difference between currently monthly operating expenses and the amount it must be per the IA. You should work out a plan to cut the costs next. Cut “U” expenses first. Then, negotiate with your suppliers on “R” and see where “P” can be reduced.
How do I find money within my business?
At first, it might seem like a daunting task; after all, you’re spending money because you have to, right? Wrong. Not all expense are “good” expenses. One of the beautiful things about Profit First is that it moves you slowly to your end goal. Start chipping away at unnecessary costs. If it’s not a priority, get rid of it.
Next, review your clients. Fire your bad clients and clone your best ones. Not all clients are profitable or worth the time and hassle. If a client is unprofitable, fire them. Seek out more of your best clients. Good clients tend to stick together, so use your networks.
Finally, sell smart. Focus on your core business. Just because an opportunity arises, doesn’t mean you should take it. By all means, look at ways of adding new products and services to your clients, but do so strategically.
Once you have the basics set up, you can work toward more advanced techniques which might include using different types of accounts. For example, a stock account for large inventory purchases or employee payroll account (highly recommended). You may need a pass-through account or a GST account to quarantine cash that isn’t actually yours.
It’s important to make these accounts part of your process & accounts procedure. Write instructions down and stick to them. Part of becoming a more mature company is systematising your operations, allowing you as the owner to work on your business and less in the business.
Finally, Make Habits Stick
To succeed with Profits First, it needs to become a habit. Regularly allocate cash through your accounts, get someone who will help you remain accountable.
The biggest issue when heading towards your TAP is cutting the wrong costs. Some costs are reasonable costs to cut (do you really need the butler service?), but the wrong ones could be detrimental to your business.
The self-discipline of not raiding your bank accounts (or not setting up the accounts in the first place) also needs to be enforced, be it using the tax account to pay expenses or reinvesting profits back into the company. Avoid the temptation!
Finally, Profit First is designed to keep it simple. Adding complexity doesn’t make for a better outcome. If you need further accounts for a specific purpose, set these up and document what they are to be used for.
For further assistance with Profit First accounting just reach out to our progressive VCFOs for further guidance.