As an accountant, I’m always looking for ways to improve on the financial systems that I use to track the profitability of my business and those of my clients.  So this month I began reading Profit First.  It is authored by Michael Michalowicz and published in 2014.  Mike isn’t a CPA or accountant, but he has considerable experience as a serial entrepreneur, having launched several successful companies, including his first company, Olmec Systems, at the age of 24.  He went on to sell and create other companies, and he talks about his personal experience and what he’s learned from dealing with the financial issues of his business.

Profit First

The methods of handling small business accounting are pretty basic in general.  Most every business owner knows the basic concept of revenue – expenses = profit. This is how most business owners figure out what they owe in taxes, decide how much money they can take home, and make purchase decisions like equipment and inventory.   

This month, I started looking into a different perspective on handling business finances.  

I’m reading Profit First by Michael Michalowicz, both for my own company and those clients whose finances I monitor.  I’ve never heard of the Profit First method until this year when I learned about it from someone in my mastermind group.  Now I’m taking a serious look at restructuring my bank accounts and bookkeeping process.  Since I’ve started this book, I must say I’ve been intrigued.  Basically, the system gives you a totally different outlook on the priorities you place on your business cash flow and helps you keep cash flow positive.  

The idea in Profit First is that the traditional accounting equation should be flipped for small businesses.  Instead of sales – expenses = profit (whatever is left after spending money), a small business owner should look at his business with the priority being on taking profits first.  This is represented in the equation: sales – profits = expenses (spending whatever is left).  The premise of the book is this: businesses for the most part, are concerned only with PROFIT – what’s left from revenue after all the expenses have been paid out.  The usual quick solution to dealing with negative cash flow is just to try to increase sales.  But as sales increase, so does expenses.  The traditional mindset is that as you increase sales, your profitability will increase, but that’s not necessarily true.

Parallels to Personal Finance Principles

If you know anything about managing your personal finances, you’ll realize that even when you start making more money, somehow your expenses increase as well.  You decide to buy that house or go on that long awaited vacation because you got a major raise on your job, and when it’s all said and done, you wonder where your money went and how you don’t have anything to show for your new “jackpot”.  

The same thing happens in business.  If you don’t get a handle on the “feast vs. famine” trends in your business, you find yourself focusing on chasing money instead of solving problems for your clients.  What else does the business owner forget when they’re chasing a sale?  More profits also mean more taxes.  If you forget to calculate or allow for increased taxes, you end up overextended.

Sales don’t always increase like you want them to.  You have to squirrel money aside in the good months to make up for the not-so-healthy months, which are inevitable.  Or you may lose a client.  This decreases your income, but rarely does it decrease your expenses.  I’ve personally found this to be true.

Profit First works on the premise of saving your “profit first”.  Similar to what all the personal finance gurus suggest when it comes to your household money, the Profit First system is about paying your business first.  Instead of pocketing what’s left, make it a priority to save money first.

My Thoughts

So the new equation makes sure that you always have money in place for paying yourself, paying your taxes, and with the remaining money, you decide what needs to be purchased.  You budget your expenses based on the money AVAILABLE for expenses.   Instead of taking your pay from whatever is left after expenses, you take your expenses from whatever is left after saving for the business taxes and your own income.  Once that money is gone, it’s gone.  There is no dipping into the other accounts.  Obviously, this method requires an exercise in discipline, a new mindset, and the implementation of good habits.

So far, this is an intriguing concept to me.  I know accountants who personally who use this method and have great things to say about it.  Based on the first two chapters alone, I’ve already started looking into restructuring the bank accounts I use to create more of a streamlined process with them.  Chapter 2 talks about setting up your four bank accounts and it reminds me a bit of Ramit Sethi’s chapter from I Will Teach You to Be Rich.  I’ve set a system up for my personal finances, but never thought to create the same time of interconnected, automatic cash flow machine with my business.  On my list for this week is to set up automated processes for transferring cash from my business to my personal account and putting them on a schedule so that my business taxes and operating expenses come out of specific accounts and those accounts ONLY.

Since many of us are used to the practice of “bank balance accounting” (checking the bank account balance to judge availability of funds), Mike encourages the reader to continue using that method.  Allocating money to checking and savings accounts designated for Proft, Taxes, Payroll, etc. lets you SEE the money available for specific expenses and makes bank balance accounting less of a bad habit.

If you are interested in following along with me on this journey as I read through Profit First by Michael Michalowicz, you can pick up a copy of his book HERE.  I’ll be sharing bonus actionable tips and lessons I’ve learned with my Entrepreneur Finance subscribers as well.  

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