What would you say to a system that guarantees your business will turn a profit, save for taxes, pay your expenses, and pay YOU?! The correct answer is “Uhm, where do I sign up!?”
Even as an accountant, I’m not sure I would have believed such a system was possible. But the magic unicorn is real, ya’ll. And it’s honestly so simple.
What is Profit First?
Profit First is a system (and a great book!) from small business finance expert Mike Michalowicz.
Profit First is based on the idea that we need to allocate our income and prioritize our profit before paying any of our expenses.
Typically, we take our income, subtract our expenses, and call the leftover profit (if we’re lucky enough to have any).
Income - Expenses = Profit
Mike suggests we flip the script. We take our income, prioritize a percentage for profit, and take whatever’s left and use that to pay our expenses. If there’s not enough, we have too many expenses and need to make cuts. His system guarantees profit.
Income - Profit = Expenses
The Profit First Accounts
And it’s not just profit. Mike offers recommended allocation percentages across four total accounts - literally, he says to open separate bank accounts for each category! (Did that just freak you out? No worries, I’ve got a potential bank account alternative for you later on!)
All of your income is going to be deposited into your Income account. Then, on the 10th and 25th of each month, you’ll make your allocations.
You’ll allocate a percentage to your Profit account, which will act as a cash-cushion/rainy-day fund as well as a quarterly source of profit distributions for you, the owner!
You’ll allocate a percentage to your Owner’s Compensation account, which will be the fund that you take from to pay yourself your salary. And you should always be paying yourself a salary!
You’ll allocate a percentage for Tax savings so that the government always gets their money!
And finally, a percentage will go into the Operating Expense account, which is where all of your expenses come from. What you see in this account is what you have to work with.
It’s not unlike the traditional Cash Envelope system that you may have heard of! Someone following the Cash Envelope system takes their pay, cashes it out, and distributes it to various envelopes labeled for different purposes: Groceries, Gas, Clothes, Utilities, Rent, etc. When the envelope is empty, the money has run out for that category.
Having multiple bank accounts is the digital version of this system, and it works just as well! In fact, with everything in business being online these days, I’d venture to say it works better.
The key is to have the discipline to not steal from your other accounts. Once the money is allocated, there are few-to-no reasons to move the money around again.
(Pretty confident you’re disciplined enough to not need these separate accounts? Hang in there! I’ll get to you!)
This is why Mike also recommends taking it a step further by creating second versions of the Profit and Tax accounts at an entirely separate bank. You’ll move the original funds from the first Profit and Tax accounts completely out of sight, out of mind. Personally, I don’t quite see this as a necessity, but if you think it’ll help remove the temptation (he literally calls them the No Temptation accounts), by all means!
Why the Profit First System Works!
When you work a system like this, you’re making sure that no matter what, your business is acting as it should. You’re designating funds so that all aspects of business are being covered, not just your regular expenses.
Because, when you spend all the money in your bank account on expenses, you’re robbing your business (profit), yourself (compensation), and the government (tax).
Many people will probably be averse to the idea of forcing their expenses that way, but it’s really a necessity. If you’ve allocated all the necessities (profit, comp, tax) and don’t have enough leftover for your expenses, you can’t afford what you’re paying for. That’s a sign that your business is suffocating (even if it’s been silent), and you’ll need to cut the expenses until your income can meet those demands.
Between the simplicity and the visual nature of everything, Mike’s system combines both the math and human behavior related to finance to create a system that’s honestly a guaranteed win! If you’re 100% committed, you’ll be 100% successful, no matter what.
P.S. If you’re a fan of Dave Ramsey’s personal finance teachings, you’ll like this system. They’re both working with those same core beliefs about human nature and money! (Mike even recommends the Debt Snowball for abolishing business debt!)
Do I NEED the bank accounts?!
This answer depends on you.
If you’re the kind of person that tends to justify poor spending decisions to yourself over and over again, I’d venture to say that you need the physical separation of your funds.
However, if you can commit to following a written plan for your spending decisions (versus just checking your bank account balance), there may be an alternative. But I’m only recommending this one: YNAB.
You Need A Budget (YNAB)* is the only budgeting tool that I would recommend for the purposes of implementing Profit First and not utilizing the bank accounts. Why? Because YNAB follows a very strict method of budgeting the cash currently in your bank (not planning around projected income). This essentially acts as a virtual cash envelope system in and of itself, which is exactly what Profit First’s bank accounts are for!
*This is my referral link for YNAB, meaning I’ll receive a credit on my own account if you choose to subscribe after your free trial.
However, I only really recommend this to people that I work with 1:1 to ensure they’re creating a proper budget. I just want to let you know that it’s possible - in case you were completely turned off from this system just because multiple bank accounts sound like too much work.
So, here’s my official recommendation for all of you reading this post that I don’t know personally:
Start with the separate bank accounts. At the end of the day, it’s really not that big of a deal to open them, try them out for a few months, and close them later to switch systems.
How do I start Profit First?
Do not take what you just read in this post and start implementing the system. I wrote this as a quick reference I can link people to in the future - it is not a full account of every aspect of the Profit First system. In fact, it really doesn’t do it justice!
For example, what percentage should I be allocating to each category? That depends on the size of your business and where your business is currently at!
Or, how can I get Profit First to work as effectively within YNAB? That involves diving into so many layers of your financial management story! (Which is exactly what I do with my clients in my signature program!)
I didn’t give you enough detail in this post for you to start implementing the system (because I’m not going to just rewrite the book, sorry), so it’s time to take it a step further.
For one, I’d recommend reading the book! Mike is hilarious and offers very thorough and easy-to-understand explanations for his system. While the concept is simple, the nuances can get a little tricky, and it helps to have as much information as possible.
You can also schedule a free Coffee Chat with me and we can discuss the system in the context of your business. Note that there are certified Profit First Professionals out there, and I am not one of them (yet!). Just to be totally clear about that.
Otherwise, feel free to email me with questions: firstname.lastname@example.org
Until next time!