Entrepreneurs Lose Sight of their Profit
Small Business Owners Have Questions About Financial Statements
Show Me the Money
I’ve recently been introduced to a system of management for business finance called “Profit First.” It’s based on a book by Mike Michalowicz called, not surprisingly, Profit First. Please CLICK HERE to get a copy of the core chapters of the book, as well as to subscribe to my almost weekly newsletter. No cost involved.
This volume spoke to me immediately because it provided a systematic approach which answered questions I have been asked by clients and potential clients for years. I understood the reason for those questions, but being hopelessly “geeky” about accounting, I could not readily answer. I had the accounting explanation, but not the common sense one.
The crux of those questions has to do with financial statements. Small business owners may get a set of those statements from an accountant, bookkeeper or even their computer accounting software. But most don’t understand what those statements are telling them. It’s like trying to read the Canterbury Tales in their original Old English. You recognize some of the words, and you might even be able to understand a sentence or two, but the whole story just escapes you.
To cut to the chase on this, most people concentrate on the Profit & Loss statement. After all, isn’t it profit and loss that marks the success (or failure) of our business? But every accountant knows that the statement of Cash Flows is the real treasure trove of information about the performance of our business. A quick example: We look at a P&L which shows a bottom line profit of $1000 and on the balance sheet the bank balance is $1000. Hooray! But our balance sheet also shows a bank loan of $15,000 (liability). OK, so I write a check for a loan payment of $1,000. Now I do a new set of financials. The P&L still shows a profit of $950, the balance sheet says the bank balance is zero, and the bank loan is now $14,050.
Is there a profit or not? It says I have one, but the bank balance is zero. What happened to the payments I made on the loan? Oh, only the interest shows up on the P&L as an expense of $50. That explains why the profit went down by that amount. The rest of the payment reduced the bank balance by $1000 but it only reduced the liability balance by $950. Oh, wait, I see an account called equity. By comparing the two balance sheets I see that on the second sheet equity is $50 lower than on the first sheet. Seriously? What’s up with that?
Confused yet? Let’s clear the air.
All of us, except maybe the treasurer of Amazon or General Motors, check our bank balance to see how our business is doing. Right? Admit it, one of the first things you do each morning at the office is to go online to your bank and see the balances. There’s absolutely nothing wrong with that. After all, it is your money.
The problem is, looking at that one account is just like looking at a P&L. It doesn’t tell the whole story. Are taxes due? Is there a loan payment due? Payroll? And when do all of those have to be paid? So using one account for account balance checking is like pulling out the money in your pocket to see whether you are wealthy or not.
The Profit First system has you set up a variety of accounts–Income, Profit, Owner’s Compensation, Taxes, and Operations. Do you see the outline of the program? Now you put all your income into the Income account and distribute it to the other accounts on a schedule. First you put aside the profit. And since you know your taxes have to be paid, you put money aside there to pay them. As an owner you deserve compensation–either a salary or regular draw–to provide a living income, so you allocate money for that. And that leaves the money to pay expenses like rent and payroll to employees.
Your profit account is where you put the money that you want to keep for yourself and provide the satisfaction of “making it.” It’s the pay-off for all the sweat and worry and thinking and planning and doing without that you have had to do to create your business. And you put money in that account first–let me repeat–first.
Now when you look at your bank balances (notice the plural) each morning you have an accurate snapshot of where your business is. True, it is a thumbnail, lacking in certain details, but still accurate. You can see how much income you are getting from the flow of deposits in the income account. You can see that you have your profit safely tucked away for distribution at the proper time. You can also see that there is money to pay taxes and to pay your “salary.” All of these are put aside for use at the proper time. Then the operations account represents the money you can spend on everything else. It’s clear, and it’s concise.
Don’t get me wrong. You may still have a financial problem. The accounts may not have as much as you want to have or even as much as you really need. But you cannot fool yourself with this tool. The money you must have later is put away. If what’s left is not enough to do what you want or need to do, it is a call to action. It lets you know it’s time to put on your thinking cap, or ask for advice or coaching. It will let you know it’s time to cut expenses or staff. And, if it is better than you expected, you can add even more to the Profit account when the time comes. But whatever it shows, it is what it is. And only action will make it different.
The first thing to do, if you haven’t already, is CLICK HERE and sign up for my newsletter. You’ll also get immediate access to the core chapters of Profit First. Read it and see if it doesn’t make sense to you.
Next, take action by going to your bank and setting up the accounts we talked about. Then, using the suggestions in the book, divide up the money you already have by the percentages suggested and move that money into all the accounts except Income.
Now you have a start. Read and study more. Take the lessons from this blog and from the newsletter. Watch for future opportunities to interact with like-minded businesses who are using Profit First to ease anxiety and build wealth.
Write me an email, or comment here with your experiences in undertaking this program.