What should you do with profits (cash)?
Sep 05, 2024The most common question I get from business owners is “how should I manage my cash?”
Today, I break down three “jobs” for cash in a business and what they mean.
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What should you do with profits (cash)?
The #1 reason for business failure is cash flow issues (38%, per Lending Tree).
Running a business is an inherently hard thing. To start a business you have to be optimistic. To continue running one when struggling requires even more optimism. And that optimism usually carries to the bitter end… until the bank account tells you you can go no more.
So, while running out of cash isn’t always the root issue, it’s one that forces you to acknowledge failure. It forces you to stop.
And my sales calls confirm this. Cash is at the top of everyone’s mind. It’s a topic in every call, even more so among experienced business owners.
Yet, when you get into the nuts and bolts of cash flow, it seems no one gets it. Everyone has questions and very few have answers.
It’s not easy.
The same questions come up over and over again from business owners I talk to:
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?
I like to split the use of cash into three categories:
- Personal spending
- Business maintenance
- Investment growth
Let’s break each of these down.
Personal spending
The pattern is the same with every new business. The owner starts out not taking a salary to give the business a chance to succeed. Next thing you know, the business is profitable and stable, but the owner still isn’t taking a salary.
And there is always a reason. The next investment. The market conditions. The fear of losing your biggest customer. It’s always something.
But the stress of not taking a salary is exhausting. It burns you out as the owner and the frugalness required personally carries over to the business. Ultimately it hurts you AND the business.
The other problem with not taking a salary is you’re lying to yourself about profit margins. When your salary isn’t market rate, profits are inflated and lead to underpricing.
This cycle continues and can result in burnout and the business dying.
Instead, business owners should think about two types of personal spending:
- Lifestyle spending
- Retirement/future planning
Lifestyle spending is reflecting on what a “comfortable” living is for you and your family. This isn’t scraping by. This is doing better than you could as an employee.
Until the business is at a level to support your best comfortable living, you’ve just got yourself another job.
Once your best comfortable living is taken care of, it’s time to consider the future.
In a business you own, it’s easy to just work, work, work, and 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. I’ve seen business owners say “I want to sell in two years” only to realize at year two that there is no buyer.
As a result, they have to work in the business 5 or 10 years past their expected retirement date just to have enough.
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.
Business maintenance
All businesses require some sort of maintenance capital.
I consider three things:
- Emergency funds
- Replacement needs
Emergency funds
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.
I created a rough “formula” for identifying how much cash your business needs to hold which takes into account the big levers that impact a business’s cash needs.
Read it and let me know: how many months does your business need?
Based on the result of the formula, you can then look at three different cash scenarios:
- Low month/seasonality need: how much cash do you burn during the low season of the business? Look at the last 2-3 years and adjust for business growth.
- Average overhead expense: take all overhead expenses over the last 12 months and average the expense; if conservative, take the highest months and use that for your number.
- Average bare bones expense: look at commitments plus salaries. Rent, insurance, and loan payments are all examples of these expenses.
Based on the range of these three numbers, pick a number that feels good to you. Multiply that by the number of months from the formula and you have your number.
I will do a deeper breakdown on this at some point, but cash and available cash from loans (LOC or unmortgaged assets) could be added together to reach this goal number. It’s a personal preference on how much risk you want to take.
My goal is to always over-index how much cash I need so in a downturn I have time to make measured decisions and turn things around.
Replacement needs
Once you’ve established your emergency fund needs, it’s time to consider what the ongoing capital expenditure needs are for the business.
This will be:
- Vehicles
- Computers
- Equipment
- Furniture
- Facilities
Other things could fall into this depending on what you feel the business needs are.
Consider setting this money aside in a different bucket so it doesn’t get rolled into the operating funds or emergency funds.
Investment growth
Notice I didn’t say business growth. I said investment growth.
After you’ve invested the money necessary to take care of personal and business maintenance needs, it’s time to think holistically about your finances… not just about the business you’re in.
But let’s lay this out there first: all returns aren’t the same.
Reinvesting in your business takes advantage of scale, leverage, and compounding in a way that a general market investment can’t. So, business growth should be the first priority.
But at some scale, it makes sense to diversify. Whether that’s market returns, real estate, passive investments, active investments (such as starting another business), it makes sense to evaluate your options.
Ideally, you want every dollar of excess cash to go to the area of highest return. There are more knowns in your business, so other investments should be discounted to account for that.
But the benefits of diversification and more experience are something to consider.
We’ll deep dive into this at a later point, but these decisions will be extremely personal.
The best piece of advice I can give you is this: create a consistent and repeatable process for evaluating these decisions and stick with it.
You won’t always make the best decision, but this allows you to get the best returns over time. Read my recent article on focusing on avoiding bad decisions instead of making the best one for more on this.
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 in what their truly “available” cash is in each financial reporting period.
This sort of thinking can give you peace of mind you’ve never experienced before.
Managing cash is a complex topic. You can’t master it overnight.
Let me know what questions you still have. I’ll look to incorporate those into future issues.