Your business has the potential to generate more wealth than any other opportunity on the planet (other than, perhaps, another business).
Unfortunately, your business also has the potential to rack up more expenses than any other opportunity on the planet.
Think of this as The First Law of Financial Dynamics (which I made up). It states:
Wealth cannot be created from scratch, it can only change form—unless you’re an entrepreneur.
Naturally, with great power comes great responsibility. You need to manage your financials responsibly, but you’re probably not ready for a Chief Financial Officer or full-time accounting firm until you’re generating more than a million dollars in annual revenue.
Yes, your Essentialist Marketing Blueprint is incredibly important, but if you don’t have your financial system dialed in then nothing else matters at the end of the day.
What you need is a financial system—specifically, a foolproof financial blueprint to consistently generate profit from your business—the foundation of systemizing a thriving business.
The Profitable Equation
What is profit, at the end of the day?
Sure, of course, we all want some of it (usually we want lots of it)—but why?
Initially, the answer seems obvious. We want money; first to pay the bills, and next to buy and do things we and our loved ones enjoy. Money is a means to an end, the fuel for our lifestyle—and profit is the only money in business that you get to keep.
For your business, profit is a success score based on how well you've accomplished your purpose, combining both effectiveness and efficiency into a single unquestionable metric.
Efficacy (or effectiveness) is measured by the revenue you generate, but that's a deceivingly simple answer.
How much revenue you generate is determined by how clear your purpose is (including, who your business is designed to serve), how well your customers perceive you are at fulfilling that purpose, and how many people know that you and your business exist.
Efficiency is the simpler (if not easier) metric. Measured by your business expenses, efficiency is the amount of time, energy, and money it takes to fulfill your purpose—at least, as well as you are fulfilling it right now.
Most people think of profit as Revenue – Expenses = Profit, or the more financially literate might use Gross Income – Gross Expenses = Net Income and then land on a profit number from there.
Both equations are textbook correct—but practically useless. They’re rear-facing metrics, so by the time you’ve calculated your profit all you have are the leftovers and the rest is already spent.
This last insight was inspired by Mike Michalowicz in his book Profit First: Transform Your Business from a Cash-Eating Monster to a Money-Making Machine.
As the title implies, rather than thinking of profit as the money that’s leftover, why not calculate profit first?
A Brief Introduction to Profit First
Profit First has helped many entrepreneurs rethink their business relationship with money, and left many accountants shaking their heads that the system is “unnecessary” or “overcomplicated.”
Mike Michalowicz brilliantly describes the accounting method most entrepreneurs practice as “Bank Balance Accounting”:
You look at your bank balance and see a chunk of change. Yippee! You feel great for about ten minutes, and then decide to pay all the bills that have been piling up. The balance goes to zero and very quickly you feel that all-too-familiar tightening in the chest. . .
I’m going to go out on a limb and guess that you only look at your income statement on occasion. I suspect you rarely look at your cash flow statements or balance sheet. And if you do, I doubt you review these docs on a daily basis or understand exactly what they say. But I bet you check your bank account every day, don’t you? It’s OK. If you look at your bank account daily, I want to congratulate you because that means you are a typical—scratch that—a normal business leader; that’s how most entrepreneurs behave.
Most financial systems simply track and project where you have already earned and spent money, and the more advanced include where you think you will earn and spend in the near future.
Profit First, instead, puts hard boundaries on the flow of your finances. It starts with flipping the traditional accounting formula on its head, so that expenses are based on what’s leftover and profit always comes first:
Sales – Profit = Expenses
Practically, that means that as money flows into your business you split it into dedicated bank accounts for different purposes. That way, at a glance you have a complete view of where your money is and where you can spend it (along with where you cannot).
To practice Profit First, Mike recommends turning your primary checking account for your business into an Income account. This is the bank account where all transaction payments should come in, whether they come from online transactions, invoices, or your cash register.
Then, twice a month you should transfer the accumulated income from that account to at least four separate bank accounts for your business, based on predetermined percentage rates:
- Owner’s Pay (Checking). This is the bank account where you accumulate income you set aside to pay yourself. No matter your legal structure, you can average out your income to pay yourself a paycheck from this account with a simple biweekly transfer.
- Profit (Savings). This is exactly what it sounds like; you set aside a percentage of all income as profit first, before expenses, and only withdraw funds from here once each business quarter as a profit payout—write yourself a profit check, then cash it!
- Operations (Checking). This is the bank account where you set aside funds to pay for fixed and variable expenses to run your business, from marketing to accounting and everything in between.
- Tax (Savings). This is essentially your prepayment account to set aside funds for tax payments. Use this to pay local, state, or federal taxes as-needed without any surprise bills.
If you have employees, you should create an additional payroll account, and depending on the timing and size of your production costs you may want an account for that purpose as well.
The point of Profit First is to use Parkinson’s Law to your advantage, and limit the operating expenses your business can take on in order to guarantee you generate profit (and get paid) every month.
You still need to set your Target Allocation Percentages for each category, but thankfully Mike has done the hard work of setting guidelines for each “Real Revenue” range (in this case, Real Revenue is similar to Net Income, or sales minus the cost to produce the goods sold).
Mike covers how to determine your Target Allocation Percentages in detail in his book, but also offers a PDF Instant Assessment.
Why Profit First Is Important
You need your financial system to help you drive your business the way you drive your car: 90% of your visibility is forward, so you can see where you’re going, and a small rearview mirror is all you need looking back.
Profit First is more than just a bunch of bank accounts; it’s a system with a built-in philosophy of financial business decisions that mean you spend no more than you earn, you always pay yourself, and you stay out of debt.
This means you’re building a cash flow positive business, truly a system that generates wealth.
Yes, this also means that you are essentially “bootstrapping” your company by setting aside a small percentage of each customer payment to fund your growing operations.
With this approach, you may grow a bit slower than you would if you were leveraging debt from investors, but with each step of growth you operate with certainty about what you can pay for, without having to spend thousands of dollars hemming and hawing with a CFO or CPA.
Don’t get me wrong, I love my CPA. When I’m considering a direction that would change my business structure and potentially my tax obligations, he’s the first one I call—but other than tax time, we only talk via email once or twice each year.
Question: How consistently does your business generate profit today?