In recent years, many small business owners have started to use the profit first method to manage their business finances. While the buzz for the method has been going strong for several years, you might ask, is the profit first method the right choice to grow your business?
In this overview, you’ll learn what the profit first method is, its pros and cons, and what to consider before applying it to your business.
What is the profit first method?
The profit first method comes from the book Profit First: Transform Your Business from a Cash-Eating Monster to a Money-Making Machine by Mike Michalowicz.
In the book, Michalowicz stresses that bringing in sales is not enough to make your business viable and cash flow must be carefully managed.
To do this, Michalowicz recommends you create five bank accounts that can only be used for specific purposes, limiting any uncontrolled spending. Money goes into one bank account, your income account, and is then immediately transferred into accounts for profits, expenses, taxes, and owner’s compensation.
Income is split into these accounts by percentages, and by doing so you can “guarantee” a certain amount of profit upfront. For example, by transferring 15% of income into a profit account from the start, that portion of income won’t be used for your expenses, making it easier to achieve a 15% profit.
You might be thinking, why wouldn’t you use a profit first method if you’re guaranteed a profit? With any financial strategy, you’ll need to consider the pros and cons before making a decision. Here’s what you should know.
Pros of the profit first method
It’s important to establish financial controls for your business, but many businesses don’t have a controller role in place. If that’s your business and you’re not feeling confident in your accounting skills to take it on yourself, the profit first method is a great way to:
- Control income and expenses: The greatest risk to cash flow is a business owner with a company card and unlimited spending ability. Limiting the amount of money available in any bank account is a great way to make sure that you’re not able to spend more than you need.
- Prioritize profitability: The major advantage of the profit first method is in its name: it treats profitability as your primary business goal and pays expenses with whatever is left after that.
- Monitor your spending: Separating cash into accounts for expenses, taxes, and owner’s compensation also makes it easy for you to closely monitor each of these types of spending. For example, when you use the profit first method you can easily see how quickly you’re using funds intended for owners’ pay versus expenses or taxes, and you’ll quickly notice if you’re coming close to over-spending on those accounts.
Many businesses without a controller pay all expenses and consider anything leftover as profit. But, as a result of overspending and mixing business and personal expenses, businesses operating this way often have nothing left over.
Cons of the profit first method
Profit first works best for businesses with mostly stable operations, including those with shorter operating cycles and without intense seasonality. If your business falls into these categories, you may face these challenges using the profit first method:
- Seasonality: It’s easy to set a percentage of money to put into your expense and tax accounts when your income and expenses are relatively consistent. When they vary, it can cause major issues.
For example, during the slow season, your business will divert a fraction of its revenues into an expense account, but it should allocate much more to prepare for higher expenses during the peak season.
- Long operating cycles: If your business has operating cycles that last longer than a month, you need to spend money long before you earn more and get paid for your work. This is a tough scenario for the profit first method. In this case, you need to rely on sources of cash beyond your most recent sales, such as working capital and credit, and those aren’t factored into the profit first method.
- Working capital needs: Profit first can also be challenging when you’re growing your business. During this time, you’ll be ramping up expenses, usually long before you earn revenue from your efforts. In these cases, the money that goes into your income account usually isn’t enough to cover this period of high spending.
Remember, the profit first method is not a substitute for financial planning. Even if you use this method, you need to have a plan for your financial and a basic understanding of your balance sheet.
The profit first method is ideal for short-term business cash flow management. When you’re making long-term decisions for your business, like applying for business loans to expand or hiring staff that will pay off in the long term, profit first isn’t a great solution.
To be successful, you need to balance your current and long-term cash flow needs and using the profit first method exclusively may not be your best path forward.
How to use the profit first method
The profit first method helps you focus your time on generating positive cash flow. It isn’t a silver bullet for financial management, it’s just one of several important financial skills you need to have. It can be a helpful tool when used in combination with other skills like:
- Balance sheet analysis: This means being able to read your balance sheet to understand where your money is being spent, and even more importantly, where that money has come from. While the profit first method addresses what to do with money that comes from current profits, a balance sheet allows you to manage money from all sources, including investment into your business and loans.
- Financial planning: This means envisioning a goal through your financials. To do this, you need to be able to estimate your potential income and expenses after executing a plan. You also need to determine how much you need to spend to follow through on that plan. Profit First can help once your business arrives at that goal, but getting there requires putting together basic projections and budgeting your costs.
Pursuit has financing available to help your business grow
Pursuit is a leading small business lender throughout New York, New Jersey, Pennsylvania, Connecticut, Illinois, Nevada, and Washington. We have a line of credit and business loan options that can help you meet your business needs, and our expert team can provide advisory services to guide your business management.
Contact us to learn more about how we can help you grow your business.
