In last week’s post, I gave five reasons why small business owners should consider implementing a revolutionary, counter-intuitive accounting method called “Profit First.” (ICYMI, here’s another post I did on it last year too.)
I realize that last week was a 30,000 foot view of the idea, so you probably have a lot of questions…and that is smart! As Andy Andrews says, “The quality of your answers will be determined by the quality of your questions.” Always be asking thoughtful questions, and seeking answers that will help you make the best decisions for you and your business! Never blindly swallow something someone gives you (good advice for business or dining).
So here are some of the more frequently asked questions we hear around the office about Profit First. After this, hopefully you will have an even better understanding of how Profit First works and want to give it a closer look.
- What is Profit First?
This is for those of you just joining the conversation. If you’ve been tracking with us already, feel free to skip ahead.
Profit First is an accounting method developed by Mike Michalowicz, author of Profit First, Surge, The Pumpkin Plan, and The Toilet Paper Entrepreneur. It is designed to ensure profitability by creating separate bank accounts for specific purposes and leveraging the natural way we think about our money.
The formula from the Generally Accepted Accounting Principles (GAAP) method of accounting that most of us have used forever is:
Profit First flips that formula around to become:
The math is the same, but the difference is what it does to our behavior.
- What is Bank Balance Accounting, and why is it a big part of Profit First?
Since most small business owners don’t have the time (or interest) to dig into complicated financial reports, they resort to “bank balance accounting,” which means logging into their bank to see if the checking account has enough money to do whatever they’re wanting to do at that moment. We’ll gladly spend whatever is in there. It’s the natural way our brains think about finances.
Profit First turns that liability into an asset by helping us move money around in a series of dedicated accounts so that we can easily avoid “borrowing” from ourselves in moments of weakness. (And we’ve all been through the delightful stress that kind of behavior creates, haven’t we?)
- How many bank accounts do I need?
Profit First works best with five bank accounts…three at your current bank, and two at a different bank (more on that later). The five accounts (and types) are:
- Bank 1:
1. Income (checking) all revenue gets deposited here
2. Owner’s Pay (checking) your salary
3. Expenses (checking) this is the account that takes the place of the log-in-and-pray-there’s-enough method
- Bank 2:
4. Profit (savings)
5. Taxes (savings)
- Bank 1:
Here’s a helpful link for finding banks that support Profit First.
- Why are two accounts at a different bank? Doesn’t that just create another level of hassle?
Exactly. You’ve just answered your own question!
The “profit” and “taxes” accounts need to be at a separate bank—preferably one you can’t access without physically driving across town, or even better, to another town—so that you aren’t tempted to dip into them to buy something shiny and impulsive.
Also, those two accounts operate best as savings accounts. That way you won’t be able to write checks from them. This provides another layer of security from yourself.
- How much money do I keep in each account?
How much you allocate to each account largely depends on the needs of your business and it may change over time. (Flexibility and adaptability are two huge benefits of Profit First!)
To give you some rails to run on, Profit First suggests Target Allocation Percentages (TAPs) for each account. These have been tested by many companies, and are a great starting point. A typical TAP for a company with revenue between $250K – $500K would look like this:
Income: 100% (until you move it into the other accounts!)
Owner’s Pay: 35%
Operating Expenses: 40%
Once every dollar of revenue has a pre-planned place to go, you’ll be amazed at how 1) your business becomes instantly profitable and 2) you are able to operate within the limits of whatever percentage you set for your expenses.
No doubt you’ve got more really good questions, and these FAQs only scratch the surface.
So when you’re ready to dive deeper, we’re ready to walk through it with you every step of the way. Contact Patrick Accounting online or call us in Memphis (901-755-5858) or Little Rock (501-834-5757) to set up a time to see how we can help.
Want to learn more before you call? Click below to download a PDF of the first two chapters of Profit First for free!