A large part of creating a Consistent Cashflow is to always have funds available to cover your expenses – personal & business!
What would your life be like if you were able to implement a system that allowed this to happen? Such a system does exist – Profit First!
Profit First was developed by Mike Michalowicz ( a speaker at a conference I attended a couple of years ago) and is a clever book about budgeting and managing cash flow.
The principle behind Profit First is to change the way that business owners think about their cashflow. It does this by flipping traditional accounting on its head.
The traditional method of accounting, as we all know is:
Sales — Expenses = Profit.
Mike’s theory reverses this equation, educating entrepreneurs to ‘put profit first’. The result:
Sales — Profit = Expenses.
On face value you would think that the result will be the same — but is it?
Technically speaking, yes.
Mike argues this re-framing has psychological benefits. You see, traditional accounting wasn’t built for humans. It was designed for rational, number crunching, robots? — i.e like us Accountants!
Traditional accounting fails entrepreneurs, and humans alike.
Let me introduce you to Parkinson’s Law to link behavioural psychology to accounting
Flipping the accounting equation on it’s head causes us to prioritise profit instead of ‘taking what’s left’ which is how most business owners will view profit.
This re-framing forces us to think differently about our spending habits.
An example Mike uses is toothpaste.
When you buy a new tube of toothpaste, one is generally liberal with the application of it. Big, fat generous gloops of minty freshness are applied to the brush.
When the brush is moistened under the tap, normally half of it falls down the drain.
But hey, who cares — there’s plenty more where that came from!
Yet, when that toothpaste is almost on empty, our behaviours are quite the opposite. We work so hard to extract every little morsel of what’s left in the tube. We squeeze and wring with our fingers until we can triumphately extract that last parcel of gold to be carefully applied to our toothbrush head.
In other words, we’re more frugal.
This is an example of Parkinson’s law, where:
‘work expands to fill the time available to completion’.
If we are given a week to complete a project, we will use all of that week to complete it. And, if we are given only one day to complete the same project, it will only take one day, with often better results.
We surprise ourselves with how much can get done with a bit of pressure and hustle.
Mike applies this principal to your finances.
Business owners will typically spend money and take whatever is left as their profit. By putting away your profit first, the rest of the money is budgeted for expenses. This forces you think deeply about every spending decision. It forces us to innovate by creating the same or better output, with less resources.
How is this done in practice?
The gist of this idea is that you take a minuscule percentage off the top line (or from all sales deposits) instead of the bottom line. Give some to yourself, put some in savings, put some in a rainy-day fund, some in the Tax account etc.
The system simply involves transferring percentage allocations of your cash deposits into various bank accounts.
And then whatever is left in the Operating account must be stretched to pay all other expenses!
Step 1: Setup bank accounts
Work with your bank to set-up new bank accounts for your business. You can personalise the name of the accounts in your accounting system.
- Profit — Savings account
- Owner’s Pay — Savings account
- Tax (GST, PAYG Withheld & — Savings account
- Operating — transaction account
- Revenue — transaction account
Ensure you have the proforma invoice templates setup in your accounting system so that all deposits from sales are deposited into the ‘Revenue’ account.
Step 2: Determine your Target Allocation Percentages (TAP)
This part is the most subjective piece of the system. The TAP is the formula the business owner should follow to allocate to income deposits to each spending account.
The amounts you put into each account are generally dictated by a lookup table based on your revenue.
Lookup table is available for you here as an example:
Step 3: Transfer cash
Every fortnight, enter the total amount of deposited funds in “Money In” of the spreadsheet above, then transfer the $ value into each respective bank accounts. This is your cash budget for the period.
It’s important to be disciplined with your spending from each account, otherwise it defeats the purpose and you’ve just created a lot of admin with no benefit.
The bank accounts should be used as followed:
- Profit account – used to accumulate profit for rainy day, emergency, holidays etc
- Owner’s Pay – used for payment of your wage
- Tax – used for payment of taxes
- Operating – used for payment of day-to-day running expenses
- Revenue – used for deposit of income only
By using this type of approach, for managing your cash flow, you will be squirrelling away a portion of funds on a regular basis to make sure there is always cash available for your commitments.
Let me know what you think and whether this is something you need some more help with.
Have a great day!
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