It’s tougher than ever running a business these days. Over three-quarters of small business owners haven’t fully recovered from the recession, with many working long hours and forgoing raises. To make ends meet, they use personal guarantees, credit cards, loans, and sometimes even defer their own compensation.
It doesn’t have to be this way.
Money problems occur when one of two things happen:
- Sales slow down. The problem here is obvious—when we operate check-to-check and when sales slow, we don’t have enough cash to cover expenses.
- Sales speed up. This problem here is not obvious, but it is insidious. As our income grows, expenses quickly follow suit. Consistent incoming cash flow is hard to sustain. Large but irregular deposits are followed by unexpected drought periods, causing a major gap in cash flow.
Cutting back on expenses is nearly impossible because our lifestyle, both professional and personal, is locked in at our new level. We don’t want to admit we’ve been wrong in how we’ve been growing our businesses. So rather than reduce our costs in any meaningful way, we scramble to cover high expenses. We rob Peter to pay Paul while we work on closing the next big sale.
The formula for profitability has been established for decades. Every business owner, CEO, finance leader and entrepreneur knows it. It is mandated by GAAP (Generally Accepted Accounting Principles), which is enforced by the SEC in the United States.
GAAP’s fundamental formula for profit is simple:
Sales - Expenses = Profit
There is just one problem. This formula hurts profitability.
Logically, of course, the formula is sound. A business must first sell in order to generate cash flow. Then the business deducts the expenses utilized to deliver its product or service and to run its operations. What remains is profit. Profit, effectively, is a leftover.
The GAAP formula is logical but it is managed by people. We are, first and foremost, emotional beings, prone to ignore, or even defy logic.
The famous bestseller Parkinson’s Law, proposed, “Work expands so as to fill the time available for its completion.” This theory has been generalized to state, “The demand upon a resource tends to expand to match the supply of the resource.”
Arguably, money is the ultimate resource. In GAAP’s Sales - Expenses = Profit formula, the business owner sees the cumulative deposits (resource) from sales and has a propensity to conclude that all the money is available for expenses (the demand expands to match the supply).
The new equipment purchase is justified because the money is there. A new hire starts, because the money is there. Profit is an afterthought. Therefore, there rarely is any.
Now consider a new formula, where a business takes profit first:
Sales - Profit = Expenses
Mathematically the profit formula is identical to GAAP’s, but from the perspective of human behavior, the Profit First formula is radically different. In the Profit First formula, a preset percentage of deposits generated through sales are first allocated to profit. The remainder is used to pay expenses.
As deposits are made, a predetermined percentage, for example, 15 percent is immediately transferred to a separate profit account. The remainder is available for the business leader to run business as usual. The business owner will see his available cash (with the profit already deducted) and make decisions accordingly. The new equipment purchase may be delayed, or a more cost effective alternative may be found. A new hire won’t be made because the money is not there, and perhaps the entrepreneur will conclude was unnecessary in the first place.
I sold my first two businesses for a big payout and so did not learn the ultimate financial lesson until after I invested in a dozen more businesses and the lesson came in hard – I lost every penny of my hard-earned fortune. Without an understanding of profitability, every business, no matter how big, no matter how “successful,” is a house of cards.After my house of cards collapsed, I set out on a mission to find a better way, a simpler more effective way to ensure that all businesses, regardless of size and regardless of their current state of affairs, could end the check-to-check cycle and become instantly profitable—without chasing the big payout.
And I found it.
Join me for a free webinar Wednesday 6/24 at 1PM EST to learn more about Profit First and the tools needed to make today the day your business becomes permanently profitable. Register Now.
 Data source: Bank of America Small Business Owner Report Spring 2015.