Give your cash (and profit) a jobNov 09, 2023
I've heard it from business owners all over: can I spend my cash?
Everyone wants to know... but no one has answer.
Today I breakdown a framework on 4 types of profit and how it can change your relationship with your business's money.
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GIVE YOUR CASH (AND PROFIT) A JOB
Starting a business is really hard. It’s no surprise that 49.7% of businesses fail in the first 5 years.
And the #1 reason for failure is cash flow issues (38%, per Lending Tree).
Now, I know… that isn’t the whole answer. Running out of cash is a symptom of other problems… not enough sales, too much spending, funding not coming through, etc. But cash is the forcing function that makes you acknowledge those other issues and ultimately makes you “hang it up.”
And needing to be good at managing cash is obvious.
But every business owner I talk to always asks the same question… what’s the best use of my cash?
I get questions like:
What do I need to “hold back” for emergencies?
What do I need to set aside for capital investment?
How should I manage growth?
How much do I need for taxes?
What can I actually take out of the business?
The questions go on and on.
And it addresses a common issue: sure I have (or don’t have) cash. But when it comes to my cash and profits, how am I supposed to use and think about that as the business owner?
In a podcast episode I did last year, Josh Patrick talked about the concept of splitting profits into 4 categories:
- Good lifestyle
- Emergency fund
- Business growth
- Retirement funding
I liked this framework, as it gave each dollar of profit a job.
Let’s break each of these down.
Too many small business owners forego a salary to make their startup work. Some actually see it as a point of pride.
I get it. You want to give your business a chance to succeed and make sure your employees are fed. But, you’re not valuing yourself.
Sure, there may be a period at the start where you don’t take a salary. Over time, the salary allotted to you, as the business owner, should increase to market value. If your salary isn’t market value and your profits are low, you’re actually working for free.
I’ve seen business owners take a small salary and be excited about their profit margins. But, if you increased their salary to market rate, that profit would disappear. In actuality, you’re worse off because often you’re paying both sides of the employment tax.
Then, once you’ve got your salary to market rate, be willing to pull out money as long as the next 2 items are taken care of.
You didn’t get into business to scrape by… you get into business because of the possible upside. Take some of that now and work on improving your business along the way.
Just like in your personal finances, businesses should have an emergency fund. The size of the emergency fund will vary based on a lot of factors and can range anywhere from 3-12 months.
A bigger emergency fund allows the business to weather almost any storm.
This goes back to running out of cash. Too many business owners don’t keep enough cash on hand, which means that when hard times hit they’re immediately in a cash crunch.
Hard times could be:
- an economic downturn
- an unexpected expense
- a big client not paying on time
The 6-12 month cushion gives you the breathing room to make level-headed decisions and not have to act rashly at the first bump in the road.
In March I shared a rough template sharing how much you should keep in your emergency fund. While it’s not a hard guideline, the hope is it helps you think about how much you might need.
It may seem that growth is always good, but I can assure you that’s not the case. If growth happens too quickly, you won’t be able to afford the growth. What do I mean?
Let’s say you get a new client. That client wants to 5x your annual revenue in one product order. How do you fund that order? It’s unlikely you have the cash to purchase the product, so you have to go to your suppliers and ask for special terms. If they don’t provide them, you might be out of luck.
But say you can actually front that money for inventory. Now, you pay for the product today (11/9/2023), but you likely won’t get paid by the customer until 30-60 days down the line. Sure you had a cash reserve, but that reserve is now GONE with one order.
One unexpected expense could put you out of business.
This is why forecast are extremely important. It tells you what cash you may need in the future so you can make the plan for it today. Maybe you hold back cash to protect yourself. Maybe you start seeking funding (ahead of when you need it). Maybe you try and renegotiate contract terms (with suppliers and/or customers).
Understanding your growth trajectory and the cash needed is an essential part of being a business owner.
(This is also what I can help you with as a Fractional CFO. Schedule a call here to discuss.)
So many business owners just work, work, work. They jump from one problem to the next without ever thinking about the future. What happens if you have an injury? What happens if you can no longer work? Or no longer want to work?
Many business owners assume that when they get to the end of the road, there will be someone to sell their business to. Maybe it’s internal, maybe external, but very few actually do the proper planning for this exit.
So, what happens? They end up with 2 options: wind the business down and get no big payout or sell it for a steep discount.
I’ve seen this situation first hand and it can be really stressful. Having to wind down a business is always hard and leaves you with a lot less retirement money than you expected. This could mean your 2-year plan has to turn into 5 or 10 before you can retire.
So, whether the plan is selling the company or winding it down, every business owner needs to think about how they’ll make money after the business. Examples would be:
- traditional retirement accounts
- selling the business
- real estate
But, no matter your plan, it’s best to have contingencies and put your eggs in multiple baskets.
Bringing it together
We’re still missing one piece: taxes. And it’s an important piece of the pie to miss.
Too often, tax money gets mixed with operating money and come tax time you’re surprised.
It’s smart to take a percentage of profits each month and set aside money for taxes.
Then, a few times a year check in with your CPA and figure out what you can expect come filing time.
When looking at your profits and cash through these lenses, it can completely change the way you operate your business.
I like to implement a system that labels this cash so a business owner has more confidence what his truly “available” cash is in each financial reporting period.
This sort of thinking can give you a peace of mind you’ve never before experienced.
Again, feel free to reach out if you want help implementing a system like this in your business.